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How corporate tax policy affects foreign investment

How corporate tax policy affects foreign investment

Marcel Olbert discusses the findings of new research examining how corporate tax cuts in developed countries affect developing economies

Nick Mickshik

20 January 2022

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Research investigates how multinationals respond to major corporate income tax cuts in terms of their foreign subsidiaries’ investments in developing countries
Results show that UK multinationals increased their subsidiary presence in sub-Saharan Africa by 17-24% following the announcement of UK tax rate reductions in 2010
Research implies that developed countries’ corporate tax cuts are liable to have a significant economic impact in developing countries

In October 2021, following more than a decade of discussions on the reform of tax rules for multinationals, US President Joe Biden gave his “warm approval” to a proposed agreement for the reforms. If fully implemented, US multinationals would pay less tax to the US government and more to overseas governments, while the foreign earnings of companies would be subject to higher taxes.

Multinationals would pay more taxes in countries where they have customers and less in countries where their headquarters, employees and operations are located. The proposed agreement also establishes a global minimum corporation tax rate of 15%, which would increase taxes on companies with earnings in low-tax jurisdictions.

The measures are intended to end the “race to the bottom” in which nations compete to attract big businesses to their shores by undercutting corporation tax rates in other countries. Over the past decade, for instance, the UK has lowered the top rate of corporation tax from 26% to 19%.

It is clearly in the short-term interest of any country to maximise tax revenues from companies that operate within its borders, and it is often tacitly assumed that an agreed global minimum corporation tax rate will benefit all countries by levelling the economic playing field.

Unforeseen consequences

But any universal reform of corporation tax rates would almost certainly have great unforeseen global consequences – and these could be more damaging for developing economies than for wealthier OECD countries.

New research by Marcel Olbert, Assistant Professor of Accounting at London Business School, and others sets out to examine whether – in distinction to setting an agreed global minimum corporation tax rate – significant corporate tax reductions in the developed world could have positive spillovers for developing countries through spurring additional foreign investment by multinationals.

Currently in progress, ‘Foreign aid through domestic tax reforms? Evidence from multinational firm presence in developing countries’ investigates how multinationals respond to major corporate income tax cuts in the country where they are headquartered and analyses their investment behaviour through foreign subsidiaries in developing countries.

To identify the effect of changes to the national corporate income tax regime on foreign investment by corporate subsidiaries in developing countries, the research examined the correlation between a major UK tax cut in 2010 and corporates’ investment behaviour in sub-Saharan Africa. Difference-in-differences estimates showed that UK multinational firms increased their subsidiary presence in sub-Saharan Africa by 17-24% following the announcement of UK tax-rate reductions.

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“Developed countries’ corporate tax cuts are liable to have a significant economic impact in developing countries”

Increased economic activity and employment

By exploiting location-specific night-time luminosity data and data from the African Demographic and Health Surveys, the researchers also detected increased economic activity and higher employment rates of African citizens within close proximity (10 kilometres) of UK-owned subsidiaries. The results clearly imply that, beyond the goal of stimulating home-country investment, developed countries’ corporate tax cuts are liable to have a significant economic impact in developing countries, given that multinationals account for a significant portion of resource allocation in the global economy.

The idea for the paper stemmed from recent research that shows that tax cuts motivate multinationals to invest more in their home country; hence the authors posited that, because they operate globally, multinationals might also invest more in foreign countries. Dr Olbert says, “This gives us a unique tool to investigate the effects of multinational firms’ investments in developing countries, which is super-important and relatively under-researched because not a lot of high-quality data has historically been available.”

The real area of interest for the researchers is the development-economics angle, says Dr Olbert: “We saw this tax-policy setting more as a tool to study the actual research question, which is: what are the broader economic consequences in developing countries when multinational firms invest more? We are interested in the local consequences. That was really the idea that led to the research.”

The paper offers insights on an important but unexplored consequence of corporate income tax cuts for corporations in developed countries such as the UK. Its findings imply that, beyond the goal of motivating home-country investment, developed countries’ corporate tax cuts are a channel for economic impact in developing countries.

But, as Dr Olbert is quick to point out, the long-term sustainable benefit to developing countries is not clear-cut: “There is a lot of debate around whether multinational firms’ investments are a positive or negative outcome for developing countries. Is it always a good thing? Is it exploitation of local developing economies? For example, are domestic firms suffering from competition? Or is it a good thing in terms of increasing average income and employment and other social benefits for the local population?”

With regard to targeting tax reforms at increased foreign investment by multinationals, Dr Olbert again advises caution: “You have to be careful in terms of saying there can be a direct expected consequence. We simply document what are probably unintended or under-explored externalities of domestic tax policies and say that these consequences may follow a particular reduction. It does not mean that if, for example, Germany reduced the corporate tax rate today by 10%, developing countries would gain. We can only say, ‘This was an unexpected spillover effect of UK tax policy’.”

Implications for the investment community

There are, however, useful takeaways for the investment community, Dr Olbert says: “The competition angle is important. Consider you are an investor or an entrepreneur or a business owner in a given country and you have competitors that are based or headquartered in another county, and that other country makes the tax regime more attractive. It probably places you at a competitive disadvantage, because your competitor now benefits from the more attractive tax regime. I think that is the key takeaway for the business owner or investment community, and research I have with another co-author team yields consistent evidence of this effect.

“For the investment community, the question of relocation risk and tax policy at a broader level is also important. Where businesses are very mobile – and they are getting more mobile every day in the digital economy – they may decide to relocate functions or resources or maybe even whole operations to a foreign country where the tax environment becomes more advantageous.”

Marcel Olbert is Assistant Professor of Accounting at London Business School. He teaches a core course in LBS’ MBA programme and was recently placed first in the list of Top 10 MBA professors to watch in 2022.

‘Foreign aid through domestic tax reforms? Evidence from multinational firm presence in developing countries’ is currently in progress. It is co-authored by Jeffrey L. Hoopes, Associate Professor of Accounting, University of North Carolina at Chapel Hill; Daniel Klein, PhD Student, Business Economic, University of Mannheim; and Rebecca Lester, Associate Professor of Accounting, Stanford University.