Non-economic factors, not fiscal policy, are fundamental in explaining the lack of investment in many developing countries, writes Global Fellow Nathan Jensen in the Financial Times.
Tax policies have a negligible impact on multinationals' decisions when political issues such as the security of private property, the effectiveness of the judiciary and the ability to uphold and enforce contracts rest on uncertain ground.
This op-ed was first published on May 15, 2006, in the Financial Times. Nathan Jensen, assistant professor of political science at Washington University in St. Louis and author of Nation-States and Multinational Corporation (Princeton University Press), has spent the 2005–06 academic year at the UCLA International Institute as a Global Fellow.
By Nathan Jensen
Politicians around the world are reducing corporate taxes in the hopes of attracting the investment of multinational companies. Cash-strapped developing countries provide generous incentives that limit companies' future tax burdens, such as Costa Rica's eight-year tax holiday on investments. Governments with deeper pockets hand out tax reductions combined with grants and subsidies to multinational companies, such as Alabama's $250m incentive package to Mercedes-Benz. These policies waste scarce resources, generate few jobs and distract governments and voters from the real reforms necessary for development.
Most governments justify tax cuts as the means for generating or keeping domestic jobs. Politicians in developing countries generally embrace the need to attract foreign capital and promote the investments of multinational companies. Most scholars agree that attracting foreign investment is an important development strategy. It is just that cutting corporate tax is not effective in attracting such investment.
Why do low taxes not attract more investment? Simply put, multinationals' investment decisions are complex. An example of one type of investment is Japanese automotive companies building production facilities in the US or McDonald's opening franchises in Red Square. These investments are driven by companies attempting to access local consumers. In many cases physical proximity is imperative. You need to be in the country to provide customers with sports utility vehicles and Big Macs. Thus, big consumer markets such as China attract investment regardless of their corporate taxes.
Multinationals accessing these large markets do not always invest to serve local customers. Automobile producers, for example, can choose to sell to consumers through exporting vehicles, licensing local companies to make them, or building a production facility. Many of the Japanese automobile plants in the US were built as a means of selling motor vehicles on the US market while Congress debated bills to limit Japanese automobile imports. Academic research finds essentially no relationship between corporate taxes and this type of market-seeking -investment.
The other form of multinational investment is when a company invests not to access local consumers but to sell on world markets, such as Intel producing chips in Costa Rica or Seagate building disk drives in Malaysia. This is the most prized form of investment - foreign companies do not compete with domestic ones for market share and the world market provides the chance of tremendous jobs growth.
Popular wisdom would have us believe that corporate taxes must have a major impact on this type of investment. Not quite. Let us assume that the US wants to attract and keep companies that generate jobs in heavy manufacturing, technology or white-collar services. What do these companies want? Obviously, companies prefer lower levels of corporate taxation to higher levels, but they also want high-quality power and telecommunications, skilled workers and existing networks of other companies to serve as collaborators or suppliers. Taxes matter for the underlying costs of doing business, but these multifaceted decisions are not dominated by taxes. Just like you need oil to attract oil investment, you need educated workers and excellent infrastructure to attract high-technology investment.
For developing countries, tax reductions are even less important. Tax policies have a negligible impact on multinationals' decisions when political issues such as the security of private property, the effectiveness of the judiciary and the ability to uphold and enforce contracts rest on uncertain ground. It is these non-economic factors, not fiscal policy, that are fundamental in explaining the lack of investment in many developing countries.
For companies that require high-skilled labour or quality infrastructure, governments would be best served by using tax revenues to generate this environment. In developing countries, political reforms that provide a more business-friendly climate will have a much larger impact on attracting investment than cutting corporate tax burdens. Focusing on taxes distracts countries from making serious policy reforms. The loss of tax revenues from this increasingly popular form of corporate welfare only makes it more difficult to pay for the real economic reforms necessary for development.