Tax competition for foreign direct investment under information uncertainty

a r t i c l e i n f o JEL classification: F23 H25 Keywords: Corporate taxation International profit shifting Real options FDI The relation between taxation states and foreign direct investment (FDI) has been studied from several perspectives and with states at different levels of development. Most previous studies, however, have only considered the impact of tax level on FDI volume. This paper enhances this view by assuming that multinational enterprises (MNEs) can use transfer prices systems and have investment timing flexibility. Thus, it evaluates the impact of the use of international transfer pricing systems on state policy and on the investment timings of MNEs. In uncertain business environments (with the periodic releases of news), investment can increase if MNEs delay investment decisions. This paper shows how tax differentials can attract FDI and can influence MNE behavior. The equilibrium is set in a global environment where MNEs can shift their profits between states depending on local corporate tax rates. Assuming the use of transfer pricing schemes, this paper confirms the relationship between MNE behavior and the release of business news. The aim of this paper is to model the way countries define their taxes and how this competition, to attract investment, influences firm behavior. This equilibrium is set in a global environment where international companies can move their profits between countries and where the level of profit depends on local tax rates. Hines (1999) confirmed these profit shifts and their relation to transfer pricing schemes and Slade (2004) analyzed several models of firm profitability. Generally, tax competition studies have assessed how non-cooperative governments set taxes. These studies have contained underlying assumptions about the role of capital as the full reversibility of the investments and the exogenous flexibility of the investment timing. However, most foreign direct investment (FDI) decisions can be characterized by irreversibility (at least partially), uncertainty (originated in the markets and government politics) and the dependency of its present value from the investment timing (implicit right to choose the best timing to commit to the FDI). Hines and Rice (1994) studied the influence of international tax rules on FDI using data on different countries. Bughin and Vannini (1995) considered taxation aspects to analyze the impact on the labor market to the choices made by the MNE. Wu (2000) investigated the performance of foreign direct investment in China. There is evidence that determining factors for the location for …