How Much Do Taxes Affect Business Location Decisions?

December 7, 2006

Everyone agrees that taxes affect economic behavior. But when the economic behavior in question is where companies locate and invest, conventional wisdom holds that taxes are far down on the list of factors that affect those economic decisions.

A common argument is that factors like proximity to roads and ports, an educated workforce, and natural resources are far more important to companies than differences in tax policy. If true, that would imply that lawmakers can safely ignore flaws in their tax systems, because those flaws are almost never important enough to affect their long-run economic performance. So goes the conventional wisdom.

But is that conventional wisdom true empirically? Do taxes not matter to companies’ location decisions? That’s the question we posed in a recent podcast interview with Prof. Mihir Desai of Harvard’s Graduate School of Business. According to his scholarship in the field of international foreign direct investment, the conventional wisdom that taxes are irrelevant to firms is incorrect. From the transcript:

Tax Foundation: Well, let me start out having you talk about an article that you coauthored earlier this year with Fritz Foley and Jim Hines, titled “Taxation and Multi-National Activity, New Evidence and New Interpretations.” Can you give me an overview of that article, and especially, I guess, it’s important for Congressional staff and members of Congress to understand where the economics profession is today with international tax.

Prof. Mihir Desai: Sure. I think it’s a really wonderful effort to think a little bit about what recent research has told us about how taxation influences foreign direct investments. Specifically, I think in the early 1990s, there was almost an implicit consensus or folklore that taxes were second-order or third-order in determining locational decisions for firms. And what we’ve been able to do is turn to the data and analyze whether that’s true or not. And I think what comes out of that is an upending of that wisdom, which is that taxes are, in fact, a first order of concern or firms when they make a variety of decisions.

So, specifically, what that research shows is that taxes and corporate income taxes, but also indirect taxes, limit FDI in a fairly significant way, such that 10 percent increases in corporate tax rates are associated with seven or eight percent reductions in the levels of foreign direct investments. Second, all kinds of financing decisions, including where the firms use debt in countries, how they actually choose to repatriate to support the first-order issue, are also highly sensitive to tax factors.

And finally, that the ways in which firms organize themselves around the world is also highly sensitive to tax factors. The final piece of that that has been fun for us is a reconsideration of the role of tax havens. Typically, tax havens are viewed suspiciously, particularly because they are thought to divert activity away from nearby countries that are not tax havens. And what our research shows is that that idea is not quite right, and it’s not right for the following reasons, which is the presence of tax havens can actually make it easier for firms to invest in nearby countries that are not tax havens.

In short, that by investing in the tax haven jointly with non-tax havens, they can actually reduce their tax obligations and they invest more in the non-tax havens than they would have in the absence of the tax havens. So it was kind of fun to kind of upend that wisdom.

But I think consensus now is that, (A), taxes are a first-order effect of FDI, and (B), there’s good reason for that to be the case, which is that FDI is quite different than it used to be. It used to be, you know, FDI was just about, well, let’s invest in countries that we can produce for that country. Now it’s much more about a global production process, where cost factors, especially taxes, are central.

Listen to the full interview here, or read the transcript here. Prof. Desai is also affiliated with the National Bureau of Economic Research, and you can view some of his research here.

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