As we explained in Part One, the existence of …xed setup costs generates many observations with zero FDI ‡ows. In our dataset, there are indeed about 62% host-source pairs for which no FDI ‡ows appear. Therefore, as explained in Part Two, the Heckman selection method is adopted to jointly estimate the likelihood of surpassing a threshold generated by the latent
…xed setup costs (the selection equation) and the magnitude of the FDI
8.3. EMPIRICAL EVIDENCE 135
‡ows, provided that the threshold is indeed surpassed (the ‡ow or gravity equation).
The Source OECD dataset reports FDI ‡ows from OECD countries to OECD and non-OECD countries, as well as FDI ‡ows from non-OECD countries to OECD countries. However, it does not report FDI ‡ows from non-OECD to non-OECD countries. We therefore estimate the model under several alternative assumptions concerning the missing observations on FDI
‡ows from non-OECD to non-OECD countries. Most likely, these missing observations re‡ect zero FDI ‡ows and this is how we treat them on one alter-native. In another alternative, we discard the observations with the missing data on the FDI ‡ows (from non-OECD countries to non-OECD countries).
In addition, we present the estimation with and without instrumenting the potentially endogenous output per worker variable, by the capital/labor ra-tio and years of schooling variables. The estimara-tion results are presented in Tables 8.3-8.4. In each table, Panel A presents the results when the produc-tivity factor is approximated by the output per worker variable. In Panel B, the latter is replaced by instrumental variables: the capital/labor ratio and the years of schooling variables. Table 8.5 presents the results of the estimation of the instrumental equation.
(Table 8.3 about here)
Table 8.3 presents the estimation of the equations for bilateral FDI ‡ow and selection (ignoring missing observations on FDI ‡ows from non-OECD
to non-OECD). The e¤ect of the education variable, namely the source-host di¤erence in education levels, on the selection mechanism is signi…cant and negative, but not so on the magnitude of the ‡ows, across di¤erent alternative versions of the productivity variable. Host-country …nancial sound rating is important in most of the speci…cations in this table, both in the ‡ow and in the selection equations. But we …nd no evidence for the importance of the source …nancial sound ratings on bilateral FDI ‡ows, neither in the
‡ow nor in the selection margins. Host GDP per capita is important in the ‡ow equation only. As expected, and consistent with previous "gravity"
literature, we …nd that common language raises, and distance reduces the volume of FDI ‡ows. These two explanatory variables have similar e¤ects in the selection equation. Host population size has a signi…cant coe¢cient in the ‡ow equation but not in the selection equation. Source population size is insigni…cant in either equation. The e¤ect of the existence of past FDI relations is positive and signi…cant in the selection equation, as it may help to reduce the setup costs of establishing a new FDI ‡ow, which is in line with our theoretical predictions. We also note that the correlation between the error terms in the ‡ow and the selection equations is negative and signi…cant at the 5%-level. As explained in Chapter Seven, this result may be interpreted as an evidence for the existence of …xed costs, because in their absence the correlation coe¢cient is one (and the Heckman model reduces to the Tobit model). The past FDI dummy is used as am exclusion restriction variable.
The positive coe¢cient is interpreted as an indication for a lower threshold
8.3. EMPIRICAL EVIDENCE 137 barrier for pairs of countries that had positive FDI ‡ows in the past.
We turn now to the variables at the focus of the investigation: the pro-ductivity factor, as approximated by output per worker. In Panel A the host output per worker has a positive and signi…cant e¤ect in the ‡ow and selection equations. Source-country output per worker has a negative and signi…cant e¤ect only on the selection mechanism, but has no signi…cant ef-fect on the ‡ows of FDI. These results about the e¤ects of the source-country productivity shocks on the ‡ow and selection equations are consistent with the analytical framework developed in Chapter Five. In Panel B, with the productivity variable instrumented by capital per worker and education at-tainment, the host output per worker a¤ects negatively and signi…cantly the selection mechanism, which is consistent with the model of Chapter Five, but is insigni…cant in the ‡ow equation (unlike what is predicted by our model).
The source instrumented output per worker negatively a¤ects both the ‡ow of FDI and the selection mechanism.
(Table 8.4 about here)
In Table 8.4 we present the estimation of the ‡ow and selection equations, when we treat missing observations on FDI ‡ows from OECD to non-OECD countries as "zeros". Results are broadly similar to Table 8.3 and provide evidence consistent with the key hypotheses about the con‡icting e¤ects of productivity shocks.
(Table 8.5 about here)
Note that the relationship in the selection equation between the prob-ability (P) of making a new FDI and the explanatory variables (including productivity) is described by the following (non-linear) equation:
P(prodH) =
+ZPprodH
1
(2 ) 1=2exp( y2=2)dy; (8.1)
where represents the e¤ect of all the other explanatory variables (held
…xed at their sample averages), including country and time …xed e¤ects, and
P is the coe¢cient of prodH (output per worker in the host country) in the selection equation. Note also that the estimate of P is negative and statistically signi…cant. The marginal e¤ect of prodH onP is
@P=@prodH = P(2 ) 1=2exp[ ( + PprodH)2=2]<0:1 (8.2) Moreover, the expected value of FDI ‡ow is
E[F DI] =P(prodH) exp( + PprodH) + [1 P(prodH)] 0; (8.3)
where represents the e¤ect of all the other explanatory variables (held
…xed at their sample averages), and P is the coe¢cient ofprodH in the ‡ow equation. Note that we useexp( + PprodH) for the observed FDI ‡ow in that our dependent variable in the ‡ow equation is the log of FDI. Therefore,
8.4. CONCLUSION 139 the marginal e¤ect of prodH on expected bilateral FDI ‡ows, normalized by exp( + PprodH)P(prodH), is:
The …rst component, P(proddP(prodH)
H)dprodH, is negative, while the second compo-nent, P, is positive (see Panel A in Table 8.3). The net e¤ect depends on which component is the dominant force. Figure 8.1 depicts this normalized marginal e¤ect for the U.S. as a source country, with all variables except prodH …xed at their sample average (based on Panel A in Table 8.3). Figure 8.1 clearly shows that as productivity increases, its marginal impact decreases nonlinearly. Expected FDI ‡ows decline in the level of host country produc-tivity2. That is, holding constant US productivity as a source country, the e¤ect of an increase in the host country productivity depends crucially on the initial value of the productivity parameter.
(Figure 8.1 about here)
8.4 Conclusion
In this chapter, we take to the data the prediction of our theory (Chapter Five) about the con‡icting e¤ects of productivity changes on FDI ‡ows. A
positive productivity shock in the host country typically increases the volume of the desired FDI ‡ows to the host country, through the standard marginal pro…tability e¤ect (the ‡ow equation). But, at the same time, the same shock may lower the likelihood of making any new FDI ‡ows by the source country (the selection equation), through a total pro…tability e¤ect, derived from the a general-equilibrium increase in wages and other input prices. Using a sample of 62 OECD and Non-OECD countries, over the period 1987-2000, we provide supporting evidence for the existence of such e¤ects of productivity shocks on bilateral FDI. That is, the empirical …ndings is that productivity would a¤ect the aggregate ‡ows of FDI in one way and the likelihood of positive FDI ‡ows in another.
Finally, we mention a potential caveat. The predictions from the model with …xed costs are predictions related to investment in capacity, but the FDI ‡ow data captures …nancial ‡ows associated with such investment. A fraction of FDI investment is often …nanced in an a¢liate’s host country, coming from host country sources. To the extent that this fraction is not correlated with the productivity shocks, the empirical predictions though are not biased.
NOTES 141
Notes
1To complete the picture, note also thatP(prodH)has an in‡ection point at prod= = P:
2In our data sample, output per worker in host countries ranges from 2.45 to 86.6.
Chapter 9
Source and Host Corporate Tax Rates
9.1 Introduction
In this chapter we focus the empirical analysis of the determinants of bilat-eral FDI ‡ows on the e¤ects of taxation. In the era of increased globalization, cross-country di¤erences in taxation may play a major role in the interna-tional allocation of investment:
"European countries have been steadily slashing corporate-tax rates as they vie for foreign investment, potentially adding to pressure on the U.S. for similar cuts as it weighs a tax overhaul.
Following the lead of Ireland, which dropped its rates to 12.5%
from 24% between 2000 and 2003, one nation after another has 143
moved toward ‡atter, lower corporate rates with fewer loopholes"
(Wall Street Journal Europe, January 28-30, 2005).
More recently, Turkey has also jumped on the band of wagon of slushing tax rates in order to attract foreign direct investment:
"Turkey is to slash corporate and personal tax rates in an e¤ort to attract foreign direct investment. Recep Tayyip Erdogan, prime minister, said yesterday the standard rate of corporate tax would be cut from 30 per cent to 20 per cent to allow Turkey to compete for investment against the new European Union member states.
The overall tax burden for all companies would fall to 28 per cent from 37 per cent, while the top rate of personal income tax would fall to 35 per cent. These cuts will attract investment from abroad and greatly increase our competitiveness with neighbor-ing countries and with the European Union." (Financial Times, November 30, 2005).
Indeed, the economic literature has extensively dealt with the e¤ects of taxation on investment, going back to the well-known works of Harbeger (1962) and Hall and Jorgenson (1967). Of particular interest are the ef-fects of international di¤erences in tax rates on foreign direct investment;
see, for instance, Auerbach and Hassett (1993), Hines (1999), Desai and Hines (2001), De Mooij and Ederveen (2001), and Devereux and Hubbard
9.2. SOURCE AND HOST TAXATION 145