How low business tax rates attract MNE activity: Municipality-level evidence from Germany

a r t i c l e i n f o Most existing empirical evidences on the impact of profit taxation on multinational firm activity are based on crosscountry data. One major drawback of such data is that countries differ not only with regard to taxes but also with other dimensions which might be hard to capture by means of observable characteristics. We compile a database of more than 11,000 municipalities in Germany to analyze the sensitivity of location decisions of foreign MNEs in Germany with respect to business tax rates which are levied directly by the municipalities. We find that higher business tax rates have a negative effect on three alternative measures of MNE activity, after controlling for other determinants of firm location decisions: the number of foreign MNEs, MNE employment, and MNE fixed assets. Our results suggest that tax competition among regional entities for foreign investors is a game of a few. In cross-section instrumental-variable regressions, a one-percent reduction of the municipal business tax rate (equivalent to a decline by about 0.14 percentage points) leads to an increase in the number of legally independent foreign-owned firms by about 0.45. The average municipality would have to reduce its business tax rate by about 2.2 percentage points (or 15%) from its average level to attract one foreign MNE. Hence, municipalities need to be attractive in other dimensions to be able to use tax instruments to attract foreign firms at the margin. A sizable literature in theoretical public finance argues that the location of capital in general and that of multinational enterprises (MNEs) in particular reacts sensitively to profit tax policy this list is by no means exhaustive). When lumpy investment – i.e., firm or plant location – is sensitive to profit taxation, many of these models predict a race to the bottom in profit tax rates so that, in equilibrium, countries have to offer a tax rate of zero to attract investors. Otherwise, a jurisdiction will lose the whole profit tax base to its competitors. One key reason for this outcome is that – in most of the traditional models of tax competition – countries differ only in terms of profit taxes or, more precisely, low profit taxes are the only attraction governments may offer to firms. Empirically, there is hardly any evidence of a race to the bottom in profit taxes (except for the existence of a few small …