Do tax sparing agreements contribute to the attraction of FDI in developing countries?

Int Tax Public Finan (2007) 14:543–562

DOI 10.1007/s10797-006-9005-9

Do tax sparing agreements contribute to the attractionof FDI in developing countries?

Celine Azemar · Rodolphe Desbordes ·Jean-Louis Mucchielli

Published online: 15 September 2006C© Springer Science + Business Media, LLC 2006

Abstract Measuring the effects of taxation on FDI in developing countries requiresconsideration of the tax sparing provision. This provision signed between developedand developing countries protects host country fiscal incentives for FDI. This paperestimates the impact of tax sparing provisions on Japanese outbound FDI between1989 and 2000. We find evidence that the tax sparing provision influences positivelythe location of Japanese FDI, even after having taken into account reversal causality.

Keywords Foreign direct investment . Tax sparing . International taxation

JEL Classification F23 . H25 . H32

1 Introduction

The majority of governments make use of the fiscal instrument to influence the locationof multinationals within their national boundaries. Recently, a consensus seems tohave been reached about the taxation level of the investing country as a significantdeterminant of foreign direct investment (FDI). Nevertheless, several studies haveshown that fiscal incentives produce a limited impact when a certain kind of investorsis concerned, i.e. those coming from countries applying tax credit rules (Devereux &Freeman, 1995; Hines, 1996). Under the tax credit system, distributed profits earned onFDI are subject to taxation of the home country. To avoid double taxation, countriesfollowing this “worldwide” approach provide foreign tax credit for taxes already

C. Azemar ( )CES, University of Paris I Pantheon Sorbonne and CNRS. Mail adress: CES-TEAM International,Maison des Sciences Economiques, 106-112, Bd. de l’Hopital 75647 Paris Cedex 13, Francee-mail: [email protected]

R. Desbordes . J.-L. MucchielliCES, University Paris I Pantheon Sorbonne and CNRS

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544 C. Azemar, R. Desbordes et al.

paid in the host country. Thus, with this worldwide tax system, the result of fiscalincentives in the host country is only a windfall gain to the home country treasury.An interesting way to protect host country fiscal incentives for FDI in developingcountries is the ratification of tax sparing provision. Indeed, under the tax sparingprovision, income earned abroad is considered by the home country to be fully taxedby the host country even if this income has benefited from fiscal grants. The advantageof this provision is to reduce the amount of taxes paid to the home country wheninvestors benefit from reduced or exempted host country tax rates under a tax incentiveprogram.

Tax sparing provisions are currently a controversial subject. On the one hand, theyare considered to be a component of the overall foreign aid policy by developing coun-tries. On the other hand, the OECD is calling into question their inclusion in bilateraltax treaties as it assumes that they only provide marginal economic benefits and mayengender tax evasion. Although some authors, like Blonigen and Davies (2004), ex-plore the impact of bilateral tax treaties on FDI, the existent literature has neglected tomeasure the impact of tax sparing provisions on FDI location. The exception, which isthe theoretical and empirical study of Hines (2001), establishes a positive correlationbetween these two phenomena. It is somehow surprising that no more works havebeen devoted to tax sparing, which holds the possibility of conciliating investors anddeveloping country interests.

This paper integrates in an analysis of host and home country tax-interaction effects,the impact of tax sparing provisions on Japanese FDI location from 1989 to 2000. Astax sparing provisions can only be included in a double taxation treaty between adeveloped and a developing country, developing countries are only considered in thisstudy.

Japan may be more likely to invest in countries with which it has economic andcultural links and therefore more likely to sign onto tax sparing with the same coun-tries. Furthermore, FDI flows can be the cause of tax sparing provisions and notthe consequence of the latter. To take care of a potential endogeneity bias, an in-strumentation of the measure of tax sparing is performed and leads to even strongerresults.

The paper is organised as follows: in the next section, a brief overview of theliterature dealing with the influence of taxes on FDI is firstly presented. Secondly, adiscussion on tax sparing provision, including their history, their functions and theirimpact on FDI, is realised. Section 3 empirically measures the impact of tax sparingprovisions on Japanese FDI outflows. Section 4 offers concluding remarks.

2 International taxation and foreign direct investment

2.1 Empirical literature findings

The impact of tax sparing provisions on FDI is derived from the effect of fiscal in-centives on these financial flows. Since the precursory work of Hartman (1984) theempirical studies indicate that FDI are significantly influenced by taxation. How-ever, the elasticities estimated depend on the econometric model specifications and

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Do tax sparing agreements contribute to the attraction of FDI 545

corporate tax rates’ measures. The aim of this section is not to realise a complete sur-vey of the literature,1 but to shed light on the evolution of the measure of internationaltaxation effects in order to show the necessity of taking into account “tax sparingprovisions” when investigating the links between taxation and FDI in developingcountries.

Hartman (1984) explains FDI inflows in the United States by a measure of theafter-tax rate of return between 1965 and 1979. The results indicate a positive rela-tionship between after tax rates of return and FDI. After distinguishing FDI financedby retained earnings and transfer of funds, the results imply that retained earningsFDI, with an elasticity of 1.4, are more strongly influenced by U.S. taxes than trans-fer of funds, with an elasticity of 0.5. A number of subsequent papers2 have closelyfollowed and extended the Hartman approach, but this first literature was limited byits methodological framework which does not allow distinguishing the effect of taxesfrom other FDI determinants. Slemrod (1990) realises a considerable extension ofthe earlier studies. He distinguishes FDI in the United States by the tax regime inforce in the home country and regresses these FDI on an alternative measure of thetax rate: an effective marginal tax rate. In the estimations Slemrod also introducesindependent variables controlling for macroeconomic events. Slemrod’s results sug-gest that U.S. taxes have a significant negative impact on FDI between 1962 and1967. However, contrary to previous studies, disaggregating the FDI variable, hefinds that taxes are more successful in explaining FDI financed by transfers of funds.Finally, he finds no clear evidence that FDI coming from territorial system coun-tries are more sensitive to US tax changes than FDI coming from worldwide taxcountries.

The following studies enlarge the scope of investigations exploiting the differencesin corporate tax rates among OECD and developing countries and using more sophis-ticated measures of tax rates. Grubert and Mutti (1991) and Hines and Rice (1994) es-timate the effect of average tax rates on the distribution of aggregate American-ownedproperty, plan and equipment (PPE). From their cross-sectional analysis, Grubert andMutti report a −0.1 elasticity between taxes and the distribution of PPE in 33 coun-tries in 1982 and Hines and Rice report a larger elasticity of −1 of PPE location in 73countries with respect to tax rates. Examining bilateral FDI flows between 7 countries,Devereux and Freeman (1995) extend this approach through a panel data analysis. Themore significant extension is their measure of the effective marginal tax rate whichpossesses the advantage of taking into account both home and host country taxation.Their results report a negative impact of taxes on the size of FDI flows with a strongereffect on FDI from countries practising tax exemption compared to FDI from countriespractising tax credit. Hines (1996) lends credence to the latter findings. Dividing theUnited States into two groups, high-taxes and low-taxes, he compares the inter-statedistributions of foreign investors from tax credit countries with those of tax exemptcountries. In the estimations he includes state fixed effects to control for unobserv-able state characteristics, and finds that investors whose government exempts foreignincome earned are more sensitive to tax rates than those whose government grants

1 See Hines (1999), Devereux and Griffith (2002) and Mooij and Ederveen (2003) for a comprehensivesurvey of the literature dealing with the impact of taxation on FDI.2 Boskin and Gale (1987), Newlon (1987), Young (1988) and Murthy (1989).

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foreign tax credit for the income earned abroad. The results indicate that a 1% differ-ence in state tax rates reduces the investment shares of foreign tax exempt investorsrelative to foreign tax credit investors by 7–9%. Cummins and Hubbard (1995) exam-ine the influence of taxation on FDI using firm level panel data. They also assess hostand home country tax interaction effects by estimating an Euler equation composedby a measure of the cost of capital which includes both host and home tax countryparameters. Their results indicate that American foreign subsidiaries are affected bythis measure of taxes, underlining the importance to consider the impact of both hostand home country tax systems. Devereux and Griffith (1998) also use micro data butto study the choice of location of American affiliates in three European countries:France, United Kingdom and Germany. They compare the effects of effective averagetax rates and effective marginal tax rates on the location decision of U.S. affiliates andconclude that effective average tax rates are the more adequate measure to understanddiscrete location decisions.

The econometric work of the last decades improves considerably the measure ofthe corporate tax rate addressed to foreign investors. One of the innovations of thisliterature is to include the interaction of foreign taxes and home country taxes in theirempirical analysis. Concerning developing countries, the tax sparing provision, as acomponent of bilateral tax treaties, has been neglected by the literature and may playa role in the interaction effects between home and host country tax systems and hasto be added to the analysis of FDI responsiveness to taxes.

2.2 Tax sparing agreements

Tax sparing is a provision included by developed countries in a large number ofbilateral tax treaties with developing countries. Tax sparing provisions are designedto promote economic development by ensuring that special incentive measures, usedby the host country to attract FDI, are not nullified by the home country tax system.Under tax sparing, the home country basically enables the investor to benefit fromfiscal grants as he can claim a foreign tax credit for the taxes that have been “spared”,i.e not actually paid in the host country.

Developing countries often attempt to attract FDI through tax holidays or tax ratereductions. As the home country tax system can reduce the impact of host countrytax incentives, tax sparing appears to be a necessary palliative in the perspectiveof developing countries. The benefits of tax sparing can be illustrated by a simpleexample. Assume that a Japanese investor generates the equivalent of a 100 USD inprofit in any given host country with a corporate tax rate of 20% and a non-residentwithholding tax rate of 10%. Under the Japanese tax credit system, Japanese investorsare taxed on their world-wide income at a 30% corporate tax rate. The investor issupposed to pay taxes to the host country and to Japan with the possibility of claimingcredit for the foreign tax paid. Thus an investor with 100 USD in profit has to pay 20USD in corporate income taxes and 8 USD in withholding taxes3 to the host country.The grossed-up dividend (100 USD) is supposed to be taxed at a 30% tax rate by the

3 If we consider that the after tax profit (80 USD) is repatriated as dividend, withholding taxes correspondto 10% of this after tax profit.

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Japanese government. As 28 USD in taxes are paid to the host country, the investorcan claim a credit of 28 USD on the 30 USD due to the fiscal authorities, and onlyhave to pay 2 USD to Japan: in that case the total taxes paid to the host country andto Japan equal respectively 28 USD and 2 USD, with a global after tax profit equal to70 USD.

We suppose then that in order to make itself more attractive, the host country woulddecide to exempt the foreign investor income from taxes. Thus, the investor has to pay0 USD taxes to the host country and 30 USD to Japan, as no foreign tax credit can beclaimed. With the introduction of tax holidays, the investor situation is similar when atax sparing provision is not signed with a global after tax profit of 70 USD. The investorafter tax profit is shown to be unchanged but in this case the tax incentives directlybenefit the Japanese treasury. However, under tax sparing, the investor is able to ask aforeign tax credit for the foreign taxes that would have been paid in the absence of taxholidays (28 USD). With tax sparing, the after tax profit of the Japanese investor (98USD) increases due to the preservation of the host country tax incentives. Therefore,with this provision, the impact of host country incentives is not reduced by the homecountry tax system, allowing the host country to effectively influence the location ofFDI in this way.

Tax sparing is not a new concept. The first reference to this provision can be foundin the early 1950s when it was recommended by the British royal commission tosupport British foreign investments in developing countries through tax policy. Af-ter years of debate, the Commission proposal was finally accepted enabling UnitedKingdom to sign tax sparing only with developing countries in order to promote theirdevelopment. Currently, all OECD members have negotiated tax sparing provisionswith tax treaty partners except the United States. Besides the fact that developingcountries consider tax sparing an important component of their foreign aid received(Toaze, 2001), the principal arguments in favour of tax sparing are that investorscan suffer from competitive disadvantages abroad vis-a-vis investors whose homecountry provide tax sparing. In addition, the provision gives the opportunity to ex-pand treaty network with developing countries and to reduce withholding tax rates.These arguments justify developed countries’ decisions to include tax sparing in atleast some of their bilateral tax treaties. However, the OECD recently expressed somedoubts regarding the economic interest of this provision. The OECD (1998), in the re-port “Tax Sparing, A Time for Reconsideration”, suggests that “Investment decisionstaken by international investors resident in credit countries are rarely dependent onor even influenced by the existence or absence of tax sparing provisions in treaties.”(p5). The limit of the OECD’s position in regards to the reconsideration of tax spar-ing is that no theoretical or empirical analysis is realised by the OECD, in orderto corroborate with their assumption that tax sparing only has marginal economiceffects.

The first study to deal directly with the effects of tax sparing was done by Hines(2001), who shows evidence that the provision contributes to positive economic results.He compares Japanese and U.S. shares of foreign investments4 through a cross-sectionanalysis including 67 countries for the year 1990. The choice of these two nations is

4 The Japanese and U.S. FDI shares are defined as the stock of Japanese (U.S.) FDI located in country “i”,divided by the total stock of Japanese (U.S.) FDI located in all countries for the year 1990.

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particularly pertinent; both apply a tax credit system but, contrary to Japan, the U.S. hasalways been unwilling to grant tax sparing. Among other results, Hines shows that thedifferences between Japanese and U.S. FDI shares are 1–1.7% higher in countries withwhich Japan has tax sparing agreements than they are in other countries. Such effectstranslate into FDI stocks 1.4–2.4 times greater than they would have been in the absenceof tax sparing. In addition, the results indicate that tax sparing encourages developingcountries to provide special tax concessions to foreign investors. For example, whena tax sparing agreement is in force between Japan and a host country, the tax ratesfaced by Japanese investors are 23% lower than those faced by U.S. investors in thishost country.

To capture the effects of tax provision, Hines regresses the difference betweenthe share of country i in Japanese total FDI and the share of country i in U.S. totalFDI, on three independent variables: the gross domestic product (GDP), a tax sparingdummy, and an interaction term between a tax sparing dummy and the GDP. One ofthe main problems with Hines’ approach is the unusual dependent variables used. Thelocation of Japanese and U.S. FDI varies for many geographic and cultural reasons.The basic economic variable and the tax sparing dummy can hardly summarise these.Furthermore, these effects are only measured for the year 1990 and across a sampleof developing and developed countries. Pooled in the same sample, developed anddeveloping countries can be considered inappropriate as the coefficients estimated areforced to be the same for both set of countries, whereas the factors determining thelocation of FDI vary systematically between both groups of countries (Blonigen andWang, 2005). The use of cross-sectional data also forbids the consideration of unob-served country-specific effects, which may influence the location of FDI. Together,these econometric weaknesses place doubt on the real impact of tax sparing provi-sions. Through a more robust econometric approach, we propose to investigate therelationship between tax sparing provisions and FDI.

3 Empirical test: Japanese FDI location in developing countries

To test the link between tax sparing and FDI locations, we focus on Japanese outboundFDI in 26 developing countries between the years 1989 and 2000.

To establish this connection, the model to be estimated is of the form:

FDIit = f

(Hi

t ; T Sit

) + εit (1)

Japanese FDI “FDIit ” depend on a set of standard determinants Hi

t and on a taxsparing treaty variable TSi

t ; εit is the error term. The natural logarithms of the vari-

ables have been taken, this has two advantages: such transformation reduces theinfluence of large values and allows the coefficients to be interpreted as ordinaryelasticities.

3.1 Data

The dependent variable originates from the Japan External Trade Organization(JETRO). The total Japanese FDI flows, in country i, are in USD. The use of FDI

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Table 1 Average Japanese FDI, country rank and tax sparing provisions between 1989 and 2000

Rank Countries FDI FDI/GDP Rank Countries FDI FDI/GDP

1 China 1543.48 0.23 14 Venezuela 47.51 0.06

2 Indonesia 1350.43 0.88 15 Sri Lanka 39.66 0.33

3 Hong Kong 1134.03 0.88 16 Chile 37.46 0.07

4 Thailand 1072.95 0.87 17 Pakistan 29.77 0.06

5 Malaysia 645.09 0.90 18 Poland 22.44 0.02

6 Brazil 580.87 0.10 19 Russian 14.00 0.003

7 Korea 452.37 0.12 20 Colombia 13.76 0.02

8 Philippines 415.08 0.66 21 Bangladesh 13.41 0.04

9 Mexico 295.03 0.09 22 Peru 6.98 0.02

10 India 144.32 0.04 23 Cyprus 5.70 0.08

11 Hungary 65.14 0.16 24 Papua New Guinea 4.88 0.12

12 Turkey 63.69 0.04 25 Israel 4.15 0.01

13 Argentina 57.67 0.02 26 Egypt 3.81 0.01

Note: The rank and the amount of FDI are determined by the average amount of Japanese FDIflows between 1989–2000 in each country. Japanese FDI are in millions of USD. The countriesin bold are those with whom Japan has a tax sparing provision included in bilateral tax treaties.FDI/GDP: The level of FDI flows are expressed in percentage of GDP for the period average. Source:JETRO (for FDI), International Bureau of Fiscal Documentation (for tax sparing) and World Bank(for GDP).

flows is standard methodology in the FDI location literature even if they only measurefinancial flows. Table 1 describes the average allocation of Japanese FDI across the 26countries of the sample, between 1989 and 2000. Countries with whom Japan has atax sparing provision (in bold) are distinguished from the others. China is the leadingrecipient of Japanese FDI, for the period considered, with an average of 1,543 millionUSD, while several countries such as Egypt, Israel and Papua New Guinea receive lessthan 5 million USD investments on average for the same period. Among the sample,half of the countries have tax sparing agreements with Japan. The rank indicates thatamong the first thirteen countries receiving the most Japanese investments, ten aretax sparing countries. From this table we can see that tax sparing countries receive inaverage 6,646 million USD of Japanese investments and that non-tax sparing coun-tries receive 4.7 times less investments with an amount of 1,418 million of USD. InColumn 3 and 6, Japanese FDI are expressed in percentage of GDP on average for theperiod 1989–2000. Tax sparing countries still received more Japanese FDI comparedto non-tax sparing countries when FDI are normalised by market share. On average,Japanese FDI invested in a tax sparing country represent 0.34% of its GDP and 0.12%of the GDP of a non-tax sparing country. The descriptive statistics of Table 1 suggeststhat the signature of tax sparing may have substantial power for explaining JapaneseFDI flows. Table 2 gives information on tax sparing countries: this table includes thedate of conclusion and the date of entry into force of the provision. The first tax sparingprovision signed between Japan and a developing country within the sample was withPakistan in 1959. Most of the provisions were signed before the 80’s indicating thatthe inclusion of tax sparing in bilateral tax treaties is not a new concept. Bangladesh,Turkey and Mexico have concluded tax sparing provisions with Japan within the dataperiod studied.

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Table 2 Japanese tax sparingprovisions Countries Date of conclusion Entry into force

Bangladesh 28 February 1991 25 June 1991

Brazil 24 January 1967 31 December 1967

China 6 September 1983 28 May 1984

India 5 January 1960 13 June 1960

Indonesia 3 March 1982 31 December 1982

Korea 3 March 1970 29 October 1970

Malaysia 30 January 1970 23 December 1970

Mexico 9 April 1996 6 November 1996

Pakistan 17 February 1959 14 May 1959

Philippines 13 February 1980 20 July 1980

Sri Lanka 12 December 1967 22 September 1968

Thailand 1 March 1963 24 July 1963

Turkey 8 March 1993 28 December 1994Source: International Bureau ofFiscal Documentation.

The vector of explanatory variables used for the econometric estimations aredetailed in the Appendix. To estimate the effects of tax sparing on Japanese FDIflows, it is essential to capture the impact of other determinants. We adopt a tra-ditional empirical framework in line with the literature, close to the one providedby Wheeler and Mody (1992). The GDP is included as usual proxy of the sizeof the domestic market. Classical variables such as labour costs, exchange rates,country risk, quality of infrastructures, natural resources, trade openness and geo-graphical distance between the host country and the home country are also con-sidered. Two specific determinants of Japanese FDI are added to the economet-ric estimations. First, as Japanese investors tend to locate themselves in their geo-graphic zone of influence, we introduce a regional dummy variable for East Asiaand Pacific countries. Second, as Japanese multinationals tend to invest close to otherJapanese multinationals, a measure of agglomeration is also entered as an independentvariable.

The construction of the tax sparing variable is realised through two distinct ap-proaches. The first approach, which represents the more interesting way to capture theinfluence of tax sparing, is to calculate a measure of the effective statutory tax rate.This variable is constructed by considering the statutory tax rate of the host country, th ,and the statutory tax rate of the resident country, tr , under the hypothesis of tax holi-days5 provided by the host country. Under tax sparing and in the case in which the hostcountry tax rate, th , is less than the resident country tax rate, tr , but due to allowances,the host country does not levy any tax, then the effective tax rate is tr − th . Withouttax sparing, the effective tax rate is equal to tr . Indeed, without tax sparing, an investor

5 Under tax sparing, Japanese foreign income that has benefited from reduced host country taxation dueto a tax incentive program, is treated by the Japanese tax authorities as if it has been fully taxed (at thehost country statutory tax rate) in the host country. Thus, the global effective tax paid by the investor whentr > th is the difference between the Japanese statutory tax rate and the host country statutory tax rate,plus the host country reduced tax rate. When tr < th , the global effective tax paid is just the host countryreduced tax rate. Since fiscal incentives are difficult to measure in developing countries, the host countryreduced tax rate is not available. A tax holidays is assumed in host countries when constructing the effectivestatutory tax rate, in order to serve as a proxy for the exact global effective tax rate.

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Table 3 Measure of the effective statutory tax rate

Effective statutory tax rates in the presence of tax holidays

Statutory tax rates With tax sparing Without tax sparing

When th < tr tr − th tr

When th > tr 0 tr

coming from a tax credit system can only claim tax credit for the foreign tax paid. Inthe presence of allowances, no taxes are paid in the host country and the investor hasto pay taxes at the resident country tax rate level. In the case in which the host countrytax rate, th , is higher than the resident country tax rate, tr , then the effective tax rate isequal to zero in the presence of tax sparing. In that case the investor is considered tobe in excess of credit by the resident country even if due to allowances he does not paytaxes to the host country. On the contrary, without tax sparing, the effective statutorytax rate is equal to the resident country tax rate, tr , when the investor benefits fromallowances and does not pay taxes to the host country. The effective statutory tax ratemeasure is summarised in Table 3. This measure is obviously a simplification of thereality as we consider a situation where all host countries apply tax holidays. How-ever, this measure has the advantage of being easily calculated and has the opportunityto summarise the advantages of tax sparing on the level of the effective income taxpaid. The second approach consists in including a simple dummy variable indicatingwhether there is a tax sparing provision in effect with the host country partner. We alsointroduce the host country statutory tax rate variable to control for a less complex taxvariable that may influence the Japanese investor locations. The statutory tax rate dataare from the University of Michigan. Values of the statutory tax rates and the effectivestatutory tax rates are available in the Appendix.

Following Grubert and Mutti (1991, 2000) the effective statutory tax rate (ESTR)and the statutory tax rate are entered into the logarithm of (1 − t). This measure hasthe advantage of dealing with values equal to zero.

3.2 Empirical results

Table 4 reports generalised least squares (GLS) random effect estimates of the de-terminants of Japanese FDI flows location in developing countries. The econometricspecification includes a full set of time dummies and all variables are in logarithms.The variation of the dependant variable explained by the model is relatively high, withan R2 of 78%. Table 4 also reports an Hausman test and a Wooldridge test. On the basisof the Hausman test, a random effects model is used. The Wooldridge test indicates theexistence of serial correlations of the residuals. A serial correlation of residuals impliesestimators which are less efficient as their standard errors may be underestimated andtherefore their statistical significance overstated. Thus, on the basis of the Wooldridgetest, the results of all regressions have been corrected for first-order autocorrelation ofthe error term using Baltagi and Wu (1999) estimators.

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Table 4 Tax sparing provision as a determinant of japanese FDI location

Japanese FDI flows

Random effects Random effects Random effects

(1) (2) (3)

GDP 0.618a 0.687a 0.705a

(0.149) (0.137) (0.134)Trade openness 0.334 0.588b 0.564b

(0.287) (0.273) (0.268)Exchange rate 0.047 0.036 0.037

(0.035) (0.030) (0.030)Distance 0.540 0.746b 0.791a

(0.332) (0.295) (0.296)Labour costs −0.111 −0.092 −0.077

(0.131) (0.115) (0.112)Japanese FDI stocks 0.470a 0.347a 0.324a

(0.109) (0.111) (0.103)ICRG 1.704b 2.096a 2.039a

(0.720) (0.694) (0.688)East Asia and Pacific 1.708a 1.591a 1.648a

(0.643) (0.563) (0.558)Natural resources −0.957b −0.500 −0.582

(0.421) (0.384) (0.372)Infrastructure −0.036 0.029 0.055

(0.202) (0.188) (0.188)(1- STR) −1.472 −0.944

(0.961) (0.933)Tax sparing dummy 1.030a

(0.310)(1-ESTR) 2.589a

(0.718)

Constant −28.956a −34.248a −33.129a

(6.056) (5.793) (5.664)

Observations 280 280 280

Number of countries 26 26 26

Overall R2 0.7593 0.7817 0.7825

Hausman test (Prob > chi2) 0.3193 0.2474 0.3262

Wooldridge test (Prob > F) 0.0368 0.0370 0.0247

Notes: The letters “a”, “b” and “c” indicate respectively a significance level of 1, 5 and10 percent. Standard errors are in parenthesis. All variables are in logarithms. Timedummies are included.

Many of the coefficients have the expected sign and are significant across the speci-fications. Host country GDP, which is an indicator of the market size, and the degree oftrade openness exhibits a positive impact on Japanese FDI flows. The agglomerationeffect, measured by the stock of Japanese FDI, appears to be a strong determinantof Japanese FDI flows. This result is in line with Head, Ries, and Swenson (1995),who find that Japanese firms tend to locate themselves near other Japanese firms.

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As expected the East Asia and Pacific regional dummy has a significant positive co-efficient, demonstrating that Japanese FDI tend to invest in their geographical zoneof influence. There is also strong evidence that Japanese FDI are highly attracted bylowest risk destinations, since the ICRG composite risk rating coefficient is significantwith a positive sign. However, determinants such as labour costs, exchange rates, andquality of infrastructure are not significant. The dummy variable indicating the avail-ability of natural resources does not have a robust significance across the estimations.In regards to the distance, one explanation for the positive sign of its coefficient is thatpart of the explanatory power of this variable is captured by the East Asia and Pacificdummy.6 The presence and significance of this dummy is of great importance, sinceit shows that Japan tends to invest more in nearby countries with whom it possesseseconomic and cultural links. More importantly, it insulates the effects of tax sparingprovisions, since geographical, cultural and economic links are likely to be strongdeterminants of the signature of this provision.

Dealing with the variables of interest, we first examine in Column 1 a basic modelignoring the effect of tax sparing with a common measure of the corporate tax ratewhich is the statutory tax rate. This statutory tax rate may have an influence overJapanese FDI location for at least one reason: the possibility that investors do not ac-tually take into account more complex measures of taxation. However, the estimationindicates that the statutory tax rate plays an insignificant role in this specification. Thisresult is not surprising since the presence of a tax sparing agreement in developingcountries tends to increase the difference between the statutory tax rate and the corpo-rate taxes effectively paid by investors.7 The uncommon sign of the coefficient of thestatutory tax rate has been rather expected in this empirical analysis. The descriptionof tax sparing agreements seems to suggest that Japanese firms should prefer highstatutory tax rates in tax sparing countries. This is because high tax rates would gen-erate a larger fictitious tax payment to the host government, which would offset truetaxes owed in Japan.

Considering now the influence of the tax sparing provision on Japanese FDI flows,we first simply include a binary variable that takes the value of “1” when the provisionis in place between Japan and the host country. The tax sparing dummy is statisticallysignificant with the correct sign. Thus, there is strong evidence of a link between thesignature of a tax sparing provision and the location of Japanese FDI in developingcountries. Column 2 shows that Japanese FDI flows are 2.8 times8 greater in tax sparingcountries. This result is in line with the previous work of Hines (2001), as he finds thatthe volume of Japanese FDI is 1.4 to 2.4 times larger in countries with which Japanhas tax sparing provisions.

6 When the regression is run without the East Asia and Pacific dummy, the distance variable has a statisticallysignificant negative sign.7 In a non-reported estimation, the effect of the maximum host and home country statutory tax rate wastested. This variable is equal to the host country statutory tax rate when tr < th and equal to the residentcountry statutory tax rate when tr > th . This measure which would be the natural measure to use in theabsence of tax sparing is not significant, underlining the importance to consider tax sparing provision.8 Because the dependent variable is expressed in logarithmic form, the exponent of the coefficient of thedummy variable should be used for its interpretation.

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Of particular interest, the effective statutory tax rate is added in Column 3. Aspreviously explained, this variable allows the investigation of Japanese investors’international taxes responsiveness with a tax measure that takes into account fiscaladvantages when a tax sparing provision is in force. The effective statutory tax ratevariable exhibits a high degree of statistical significance and has large positive impactson Japanese FDI locations. The elasticity of this variable indicates that if the tax rateincreases by 1%, Japanese FDI flows decrease by 2.6%. To have a better grasp ofthe implications of this elasticity we can consider and compare two countries (a taxsparing country and a non-tax sparing country), which have the same statutory tax ratesuch as Mexico and Columbia (in 2000). Thanks to its tax sparing agreement, Mexicoreceived 111%9 more Japanese FDI than Columbia which has not signed a tax sparingagreement.

It is interesting to underline that the inclusion of the effective statutory tax rateincreases the explanatory power of the model. This result reinforces the relevance of theESTR measure which takes into account the influence of tax sparing provisions. Thus,the ESTR measure seems to be a good approximation of the level of international taxeseffectively considered by Japanese investors and strengthens the interest of measuringtax sparing.

Finally, the effective statutory tax rate influence on FDI location can be linkedwith multinational decision making. Devereux and Griffith (1998) make a distinctionbetween the location decision (whether to locate in country i) determined by theeffective average tax rate, and the level of investment chosen conditional on havingselected country i, determined by the effective marginal tax rate. Our measure of theeffective statutory tax rate is fairly close to a measure of the effective average taxrate (EATR). Devereux and Griffith find evidence that the EATR is significant for thelocation of US firms. Their results indicate for instance that a 1% point increase inthe EATR reduces the conditional probability of a firm locating itself in the UnitedKingdom by 1.3% points, in Germany by a 1% point and in France by a 0.5% point.The difference between the sensitivity of U.S. investors to the EATR and Japaneseinvestors to the ESTR can be explained at least by one reason: since they are taxedon their worldwide income, U.S. investors located in developed countries can onlybenefit from low tax rates if they defer U.S. taxes until the repatriation of their profits.On the contrary, Japanese investors in tax sparing countries can directly benefit fromreduced tax rate. The tax credit system tends to limit the effect of host country taxrates except when a tax sparing provision is signed, justifying the difference in termsof sensitivity between the ESTR and Japanese FDI, and the EATR and U.S. FDI.

3.3 A potential endogeneity bias

As it was suggested by Hines (2001), tax sparing variables may be endogenous.Basically, Japan is more likely to invest in countries with which it has close cultural

9 Both countries have a statutory tax rate of 35% in 2000, but only Mexico has concluded a tax sparingprovision with Japan. The effective statutory tax rate of Mexico and Columbia are respectively 0 and30%. Since the ESTR are entered into the logarithm of (1 − t), the difference between Mexico ESTR andColumbia ESTR correspond to a decrease of 42.8%. Thus, 42.8% ∗ 2.6 = 111%.

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and economic ties or which belongs to its geographical zone of influence. By exten-sion, it is probable that Japan has signed its tax sparing treaties with the same countries.If we consider again Table 1 we can see that seven of the top eight of Japanese FDIlocations are Asian and that six of them have a tax sparing provision with Japan. Thus,high inflows of Japanese FDI may be the cause of tax sparing agreements and not theconsequence of the latter.

Our econometric model specifications try to reduce the possibility that the rela-tionship between tax sparing and FDI reflects the influence of omitted variables. Theuse of the East Asia and Pacific dummy and the distance variable should proxy forhistorical, geographical, political and economic effects that can be at the origin of taxsparing agreements between two countries. Therefore, these two determinants shouldpermit us to insulate the impact of tax sparing on Japanese FDI location. However, ifthe endogeneity problem persists, it would bias our coefficient on the effective statu-tory tax rate and possibly cause an irrelevant correlation. This is thus necessary toinstrument the effective statutory tax rate.

The choice of the instrument should stem from the development purpose of the pro-vision. Other Japanese efforts to contribute to the economic development of a countrycan be measured by its official development assistance (ODA). Japanese governmentregards ODA as an important diplomatic instrument to ensure national security bypromoting economic development and political stability in the developing world. Ac-cording to Kawai and Takagi (2001), there is a controversy dealing with the natureand motives of Japanese ODA. On the one hand, the Japanese business communitycriticises the ODA which has not benefited Japanese economic interests. On the otherhand, outside observers such as Arase (1993) contradict these claims. A large size ofJapanese ODA seems to reflect the country’s pursuit of economic and commercial in-terests. Dominance of hard infrastructure assistance instead of the promotion of betterenvironment, poverty reduction, education health and nutrition show that the Japanesegovernment has tended to stress the economic rather than the social needs of recipients.The nature of the Japanese ODA plays a key role in the determination of economicallyrelevant instruments. Two instruments are chosen. The first instrument is the JapaneseODA grant flows minus technical co-operation (z1). The goal of this subtraction isto exclude the share of investment related technical co-operation which is directlyassociated with the implementation of foreign investment projects. This allows theinsulation of social aid which corresponds to the promotion of democracy and humanrights in the recipient countries. The second instrument is a ten years’ lag of ODA grantflows (z2). With a lag of ten years, the potential link between ODA and FDI should becancelled.

Table 5 reports the instrumental variables (IV) estimations, applying a Baltagi’serror component two-stage least squares procedure10 (Baltagi, 1981, 2001 chapter 7).Two tests are run to estimate the IV on the effective statutory tax rates. Column 1 reportsthe IV estimation with the set containing both instruments (z1, z2: ODA-technical

10 Analogous to the random-effect estimator, which is a matrix-weighted average of the estimates producedby the between and within estimators, the error component two-stage least squares (EC2SLS) estimator isa matrix-weighed average of a between 2sls estimator and a within 2sls estimator.

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Table 5 Tax sparing provision as a determinant of Japanese FDI location:IV estimations

Japanese FDI Flows

IV IV

(1) (2)

GDP 0.677a 0.694a

(0.110) (0.118)Trade openness 0.607a 0.621b

(0.228) (0.244)Exchange rate 0.033 0.033

(0.023) (0.026)Distance 0.757a 0.804a

(0.242) (0.269)Labour costs −0.088 −0.088

(0.088) (0.096)Japanese FDI stocks 0.374a 0.348a

(0.092) (0.099)ICRG 2.289a 2.240a

(0.601) (0.621)East Asia and Pacific 1.364a 1.465a

(0.438) (0.477)Natural resources −0.521c −0.496

(0.299) (0.336)Infrastructure 0.043 0.067

(0.157) (0.168)

(1 - ESTR) 2.911a 3.032a

(0.798) (0.924)

InstrumentsODA-technical cooperation (z1) X X

ODA t-10 (z2) X

Constant −33.546a −33.844a

(4.865) (5.204)Observations 280 280

Number of countries 26 26

Overall R2 0.7841 0.7836

Overidentifying Restrictions (n R2 test) 0.14 −Joint Significance (F test) 11.79a (270) 15.41a (271)

Covariance between x and z 0.6435 0.4249

Davidson and Mackinnon test (chi2) 1.70 2.54

Notes: The letters “a”, “b” and “c” indicate respectively a significancelevel of 1, 5 and 10 percent. Standard errors are in parenthesis. All variablesare in logarithms. Time dummies are included.

cooperation and ODA t-10), and Column 2 reports the IV estimation with only the z1(ODA-technical cooperation) instrument.

After controlling for a potential endogeneity bias, we still find that the coefficient ofthe effective statutory tax rate is positive and statistically significant for both instrument

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specifications. Furthermore, the magnitude of the coefficient increases substantially,compared to the GLS estimation. In regards to the control variables: GDP, trade open-ness, Japanese FDI stocks, ICRG, East Asia and Pacific dummy and distance remainsignificant.

The first stage regression tells us a great deal about the relevance of the instru-ments. As suggested by Bound, Jaeger, and Baker (1995), the F statistics of the in-struments in the first stage specifications are reported, showing that z1 and z2 arejointly significant. However, z1 is individually more relevant, that is why we alsodecided to test it alone. Another condition, which is crucial for the validity of the IVestimation, is whether the instruments are valid in the sense that Cov(Z ; ε) = 0. ASargan (1958) test of over-identifying restrictions with statistics that are less than thechi-squared value with one degree of freedom which at 5% level is 3.84, indicatesthat the instruments are valid. Obviously, this verification can not be realised whenthe model is simply identified. New literature focuses on the case of weak instru-ments which are weakly correlated with the endogenous variable in question. Thesekinds of instruments are also likely to produce estimates with large standard errors.According to Alastair, Rudebush, and Wilcox (1996), instrument relevance is fairlygood when the covariance between z and x is around 0.4. The correlation betweenthe potential endogenous and z1, and the canonical correlation between the potentialendogenous and Z(z1 and z2), indicate that ODA can not be considered as a weakinstrument.

Based on these findings, the official development assistance fulfils the conditions ofgood instrumentation. It is economically meaningful and as it is not correlated with theregression disturbance, it is a valid and strong instrument for the effective statutory taxrate. However, the Davidson and MacKinnon (1993) test indicates that the exogeneityof this variable can not be rejected, indicating that with this specification, the effectivestatutory tax rate is not endogenous.11 Though there is an absence of endogeneity biasin the model, the IV approach remains well specified and reinforces the relevanceof the finding that the signature of a tax sparing provision positively influences thelocation of investors.

4 Conclusion

The signature of a tax sparing provision over the last 50 years experiences conflictingpositions in regards to the effectiveness of this foreign aid in promoting economicdevelopment. While the OECD has called for a reconsideration of tax sparing as aneconomic development tool when from the perspective of developing countries thisprovision is considered to be a component of the overall foreign aid, few formaltheories for this link have been presented. This paper attempts to shed light on the

11 Control variables such as distance and the East Asia and Pacific dummy play a non-negligible role inthe model estimated, as they seem to insulate the impact of tax sparing on FDI location. Indeed, when werun the same specification without the distance and the East Asia and Pacific dummy, the ESTR becomesendogenous according to the Davidson and Mackinnon’s test.

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relationship between tax sparing and FDI. Specifically, we confirm the existence ofa link between the provision and FDI, using a panel dataset including 26 developingcountries for the 1989–2000 period. Our results suggest that Japanese FDI flows intax sparing countries were almost three times bigger as in non-tax sparing countries.Furthermore, the significance of an effective statutory tax rate, accounting for theinfluence of tax sparing, indicates that tax sparing provisions are strongly taken intoaccount in investors’ strategic location choice decisions. The regressions indicate that a1% higher effective statutory tax rate decreases Japanese FDI flows by 2.6–3%. Theseresults are robust to reverse causality between FDI and tax sparing provisions. It canbe concluded that host country taxation strongly influence the location choice of taxcredit investors in developing countries, when the influence of tax sparing provisionsis taken into account.

Appendix

Data appendix

Usual control variables

Market size (GDP): Gross domestic product measured at market prices in current USD.These data are from the “Global Development Network Growth Database” publishedby the World Bank.

Trade openness: The trade openness measured by the sum of export and importof goods and services divided by GDP, and lagged by two years in order to avoidan endogeneity bias. These data are from the “Global Development Network GrowthDatabase” published by the World Bank.

Exchange rate: The bilateral nominal exchange rate between the Japan and country“i”, expressed as the number of local currency units for one yen is obtained by dividingthe bilateral nominal exchange rate between the local currency and the United Statesdollar (expressed as the number of local currency units for on dollar) and the bilateralnominal exchange rate between the yen and the United States dollar (expressed asthe number of yen for one dollar). These data are from the nominal annual countryexchange rates compiled by Mathew Shane from the “Economic Research Service”of the United States Department of Agriculture.

Distance: The distance data, between the host country and Japan, are from theCEPII.

Labour costs: Labour cost per worker in manufacturing is expressed in currentUSD. The data are from Rama and Artecona (2002) “A Database of Labor MarketIndicators Across countries”.

Natural resources: To capture the availability of a natural resources endowment,we use a dummy variable which takes the value of one if the country is an exporterof primary products, and the value zero otherwise. These data come from the WorldBank.

East-Asia and Pacific Dummy: According to World Bank classification: China,Hong-Kong, Indonesia, Korea, Malaysia, Papua New Guinea, Philippines, and Thai-land are considered to be countries of the East Asia and Pacific region.

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Japanese FDI stocks: Following (Lehmann, 2002) Japanese FDI stock has beencalculated at book values, and lagged by one year:

FDISt = FDISt−1(1 − δ) + FDIt (2)

with the depreciation rate δ set at 7.5%. The Japanese FDI flows data are from theJETRO.

ICRG: The International Country Guide Risk publishes a composite risk ratingof economic, financial and political risks. Maximum ratings are 100 and minimumratings are 0. A higher score indicates a lower risk.

Infrastructure: The level of infrastructure is measured by the Telephone lines/GDP.According to Easterly and Levine (1997) and Collier and Gunning (1999), whiletelecommunications is the only infrastructure variable widely available for devel-oping countries, it is likely that different kinds of infrastructure are highly corre-lated. However, the variation in stock of telecommunications can be explained byGDP per capita (Forestier, Grace, & Kenny, 2002), thus (Fink & Kenny, 2003)propose to measure infrastructure by the per-income stock of telephone lines inorder to avoid correlations with market related variables. These data are fromthe “Global Development Network Growth Database” published by the WorldBank.

Instrumental variables

Official development assistance grant: The data are from the “Development Co-operation Report: Efforts and policies of Members of the Development AssistanceCommittee”, published by the OECD.”

ODA t-10: Total Japanese ODA grant in country i, is lagged by ten years. ODAgrant is defined by the OECD as “the flows of official financing administered with thepromotion of the economic development and welfare of developing countries as themain objective. In addition to financial flows, Technical Co-operation is included inaid. Grants, loans and credits for military purposes are excluded. Transfer paymentsto private individuals (e.g. pensions, reparations or insurance payout) are in generalnot counted. By convention, ODA flows comprise contributions of donor governmentagencies, at all levels, to developing countries and to multilateral institutions.” Weuse data lagged by ten years in order to avoid any correlation between Japanese FDIactivity and ODA flows.

Non technical co-operation aid: Total Japanese ODA grants minus technical co-operation in country i. Technical co-operation which makes a part of ODA grantflows, is composed by two categories of aid flows. The first one is the “free-standingtechnical co-operation which is the provision of resources aimed at the transfer oftechnical and managerial skills or of technology for the purpose of building up generalnational capacity without reference to the implementation of any specific investmentsprojects” (OECD). The second one, is the investment related technical co-operation.The technical services that it provides are required for the implementation of specificinvestments projects. This term is subtracted from ODA grants because of its Japaneseinvestment relation.

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Tax rate data

Table 6 Statutory tax rates and effective statutory tax rates

Countries Taxes 1989 1995 2000 Countries Taxes 1989 1995 2000

Argentina str .33 .3 .35 Korea str .3 .3 .28

estr .4 .375 .3 estr .1 .075 .02Bangladesh str — .4 .4 Malaysia str .35 .3 .28

estr — 0 0 estr .05 .075 .02Brazil str .3 .25 .15 Mexico str .37 .34 .35

estr .1 .125 .15 estr .4 .375 0Chile str .325 .35 .15 Pakistan str .6 .46 .4515

estr .4 .375 .3 estr 0 0 0China str .4 .3 .3 Papua N-G str .3 .25 .25

estr 0 .075 0 estr .4 .375 .3Colombia str .3 .3 .35 Peru str .35 .3 .3

estr .4 .375 .3 estr .4 .375 .3Cyprus str .425 .25 .25 Philippines str .35 .35 .32

estr .4 .375 .3 estr .05 .025 0Egypt str .4 .4 .4 Poland str — .4 .28

estr .4 .375 .3 estr — .375 .3Hong Kong str .17 .165 .16 Russian str — .35 .35

estr .4 .375 .3 estr — .375 .35Hungary str — .18 .18 Sri Lanka str — .45 .35

estr — .375 .3 estr — 0 0India str .5 .4 .35 Thailand str .3 .3 .3

estr 0 0 0 estr .1 .075 0Indonesia str .35 .3 .3 Turkey str .46 .25 .3

estr .05 .075 0 estr .4 .125 0Israel str — .37 .36 Venezuela str .5 .34 .34

estr — .375 .36 estr .4 .375 .3

Source: World Tax Database for the statutory tax rate. See Table 3 for the calculation of the effectivestatutory tax rate.

Acknowledgments We Thank Michael Devereux, Edward Graham, Robert Lipsey, David Margolis, Clau-dia Rivas, Deborah Swenson, anonymous referees and seminar participants at the Franco-Korean conferencein Seoul, and at the Western Economic Association conference in Vancouver for helpful discussions.

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Do tax sparing agreements contribute to the attraction of FDI in developing countries?