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A review on "FDI between EU member states: Gravity Model and Taxes" (Pavel Folfas)

Our group will introduce a review on that paper, specifically define what is OK and what should be added.

Nhan Dinh

on 23 September 2012

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Transcript of A review on "FDI between EU member states: Gravity Model and Taxes" (Pavel Folfas)

INTRODUCTION CONTENTS 1. Introduction & Research Qs
2. Literature Review
3. Data & Research Methodology
4. Econometric Model Result
5. Explaination
6. Conclusion 1. Definition of FDI
2. FDI's determinants
3. Research Qs Definition of FDI Foreign direct investment reflects “the objective of establishing a lasting interest by a resident enterprise in one economy (direct investor) in an enterprise (direct investment enterprise) that is resident in an economy other than that of the direct investor” (OECD). “FDI usually flows as a bundle of resources including capital, production technology, organizational and managerial skills, marketing know-how, and even market access through the marketing networks of multinational enterprises (MNEs) who undertake FDI”. Kumar (2003, p.6),
accelerated growth
economic transition
economic development. The global foreign direct investment (FDI)
flows grew strongly in the 1990s, giving rise to almost 54,000 transnational corporations, and have since grown rapidly at a rate above global economic growth rates. Recorded global inflows grew by an average of 13% a year during 1990-1997, compared with the average rates of 7% both for world exports of goods and nonfactor services and for world GDP at current prices (Carson, 2003). Determinants of Foreign direct investment
Bernish, 2000; Dumming, 1998; Malampally and Sauvant, 1999
The size of market will encourage their bilateral FDI
Geographical distance factors discourage the amount and impact of FDI
Cultural similarity plays a positive role in enhancing FDI within EU
EU integration does not affect FDI
Differences in corporate tax system encourage FDI RESEARCH QUESTIONS History of gravity model
GDP and distance
Investment creation (EU integration & cultural similarity)
Corporate taxation LITERATURE REVIEW HISTORY OF GRAVITY MODEL HISTORY OF GRAVITY MODEL H.Carey: 1858, The Principles of Social Sciences -> size of population, distance and attractive force between people
gravity models applied in: migration, traffic flow, Seduction science, … Social Science Economics Reilly's Law of Retail Gravitation
-> trade boundaries between cities

*Assumption: the cities are on a flat plain without any rivers, freeways, political boundaries, consumer preferences, or mountains to modify an individual's progress toward a city Economics Xij: Trade flow
Yi, Yj: economic mass of each country
D: distance
C: constant GDP AND DISTANCE GDP AND DISTANCE GraViTy mOdeL Giuseppina: PCS (Pooled cross-sectional data)
GDP per capita of host and home country, common language -> positive effect on FDI Scaperlanda and Mauer (1969):
threshold level economies of scale, efficient utilization of resources positively related to FDI
Edwards (1990) and Asidu (2002): GDP growth no significant impact on FDI flows
Loree and Guisinger (1995), Wei (2000): market size and growth impact differ under different conditions
Difference between GDP of both countries >< FDI flows Jovana (2005): levels of transportation infrastructure increase -> FDI increases
located in the center of Europe -> attract more FDI than isolated nations
more proximate of nations to the top GDP in the world market -> easier to attract FDI distance between economic centers: raises the cost of transportation, decreases the number of FDI flows
the distance between cultures
social or psychological distance
tend to invest in their neighbor Gwartney, Skipton and Lawson (2001): importance of market purchasing power and proximity in trade among nations using Distance Adjusted Demand Scalar
Some countries are not in good location
BUT: technology, labour,…. -> accept to travel a long distance Most researches conclude that GDP has positive impact
Distance has negative impact but… INTEGRATION EFFECT INTEGRATION EFFECT Motta and Norman (1996): integrated countries with better access to regional market attract more firms.
Demonstrating the trend of “market interpenetration”
Using comparative analysis in EU, NAFTA, ASEAN
=> extra-regional barriers to trade and market size are determinants of these firms. Dr. S.K. Tayyebi and Dr. A. Hortamani (2004): the positive link between integration and FDI flows.
Using panel version of standard gravity model with time-invariant pair-specific factor: distance, borders, common language, colonial links
=> GDP coefficients of both home and host countries have positive signs and real exchange rate affected negatively on FDI, but hypothesis is rejected in the case of EU-15. Folfas: influence of monetary integration on bilateral FDI flows and stocks
Using a gravity model, the Hausman-Taylor method as well as random effects.
=> found an ambiguous link between exchange rate volatility and foreign capitals within EU member states. CULTURAL EFFECT KielerArbeitspapiere, No. 1190: analyze the relationships between cultural distance and FDI stocks.
Using gravity model with proxies for regulations and cultural proximity.
=> greater political freedom has a positive impact and speaking a common language has a positive and significant impact on FDI.
Bruce Keillor: the relationship between culture and FDI and the role it plays as a determinant.
Using “political risk” and Hofstede’s culture dimensions (power distance, uncertainty avoidance, individualism versus collectivism, and masculinity vs. femininity and long-term orientation) with OLS estimator.
=> Two out of six were significantly related to the dependent variable, FDI/GDP: Political Risk and Uncertainty Avoidance CORPORATION TAXATION SYSTEM Agnes. B.Q, Lionel. F and Amina L.H (2002): The link between FDI and tax
The response of FDI to tax variations is asymmetric
Higher tax rate in the host country is more harmful to inward FDI than a lower tax rate is attractive for foreign capital
Tax disincentives are more influential in investment decisions than tax incentives
Nonlinearities in the response of FDI to tax differentials
When investors operate under exemption arrangements, they react linearly to tax differentials
When a credit scheme is applied, investors’ sensitivity to tax differentials is nonlinear Asa Hansson and Karin Olofsdotter (2010): Tax differences and foreign direct investment in the EU27
The impact of the lower taxes on FDI are unclear
For new EU members, tax differentials play a significant role for whether FDI takes place as well as the amount invested.
For the EU15, however, tax differentials seem to be less important Dana Hajkova, GiusepeNicoletti, Laura Vartia and Kwang-YeoIYoo (2006): the importance of taxation on foreign direct investment
Impact of Tax Policies on FDI location choices
+ Creating a wedge between pre-tax and after tax require returns on investment.
+ The relevance of this wedge actually relies on the nature of firms’ investment
+ Focusing only on Tax lead to a serious bias in analyzing tax elasticity
+ Ignore some policies that are relevant to firms’ choices of FDI locations.
+ A serious upward bias on estimation of tax elasticity.
DATA & RESEARCH METHODOLOGY DATA & RESEARCH METHODOLOGY Research methodology Fix effect model Advantages & Disadvantages of FE FE cannot estimate effects of time-invariant variables which vary across individuals
Cannot predict effects in level outside of sample, not generalized
If subjects change too little across time=> Standard error from FE is too large Random Effect Model In which : yit : dependent variable observed for entity I at time t
xit: independent variable , constant
t: the error term, i: unobserved time-invariant individual effect ( set of fixed parameters)
there is correlation between i and xi
+ control for the entity i’s own features
=> able to identify the independent variable’s net effect. Vi : individual differences are supposed to be random
assume that the entity’s error term is not correlated with the predictors
=> allows for time-invariant variables to play a role as explanatory variables Advantages & Disadvantages of RE Advantages :
could include time-invariant variables into consideration
Able to generalize for larger population

Assumption: corr(xi,v) = 0
Coefficient are more likely to be biased Decision to choose between RE & FE Nature of omitted variables
Variability within subjects
Want to investigate the effects of time – invariant variables or want to control for those variables MODEL DATA SOURCE VALIDITY & RELIABILITY Validity is the extent to which an instrument measures what it is supposed to measure and performs.
used random effects and fixed effect model which are considered to be suitable
Reliability : all of the data is collected from the prestigious sources like OECD , World Bank (WDI) ,Eurostat etc….
recommended by the author of the research “FDI between EU member states : gravity model and taxes” Econometric model & Main results Using random effect model control for heteroskedascity Using Random effect model control for heteroskedasticity EXPLAINATION EXPLAINATION GDP & distance
EU integration
Cultural similarity
Corporate taxation GDP The size of the market = positive impact

Bigger market more buying power and capacity

A safer place to invest ROI will be more secure and hopefully big. Scaperlanda and Mauer (1969): “in order for FDI to increase, a host country must pass a threshold in GDP for it to be considered a suitable investment opportunity”

Economies of scale utilize resources effectively DISTANCE Distance = negative impact

Reduce transaction cost

More cultural similarity EU INTEGRATION No positive impact on FDI flows when both host and home country belong to the EU, euro zone or both joined the EU (EC) in the same year

Weak investment creation effect
individual characteristics of host and home country affect FDI more than the regional integration

Dummy variable = not enough
+ The integration process is discrete not continuous
+ The impact could happen earlier during negotiation The Single market program + the European Free Trade Association (EFTA)

Early 1990´s: New members to EU – Increased FDI flows from EU-15 countries.

FDI from outside Europe like US or Japan CULTURAL SIMILARITY Model 1: Cultural similarity = positive impact WITH CAUTION
More familiarity with countries  with same history and ways of thinking

Ex: From Hofstede’s cultural dimension point of view, the countries with similar low uncertainty avoidance will create a better environment for FDIs. This means that these two countries will be less rule-oriented and have fewer definitive laws which multinational corporation can use to leverage their advantages

Common language
Same business environment (judicial environment, contract enforceability, labor regulations) Model 2: Cultural similarity = insignificant

Small time range (Model 2: 2005-2010)
Missing variable (Greece) in author’s classification.
Inappropriate country classification of Folfas based on inconsistent criteria (geographic distance, language, etc) instead of an universal one like Hofstede,
Ex: German, Mediterranean, Francophone, etc CORPORATE TAXATION Model 1: Differences in corporate taxation = positive impact

Transfer pricing + intra-firm debt = fundamental firms’ tax avoidance method
+ Gordon and Hines (2002) stated that “tax policies are obviously capable of affecting the volume and location of FDI since higher tax rates reduce after-tax returns, thereby reducing the incentives to commit investment funds”

The impact of offshore financial centers (OFC)
+ Tax havens like Cyprus, Luxembourg, Malta, etc
+ The variable OFC is significant Model 2: taxpayments, taxtime and taxtotal = insignificant

All results are consistent with model 1 except cultural variable

Small sample: from 2005-2010

The importance of tax differences

Missing values (some countries only have available information about tax variants from 2008 to 2010)
Assumption of no correlation between individual specific effects and independent variables in random effects model
Group assessment
New development for further research
Policy implication MAIN FINDINGS Except for culture’s influence on FDI, our finding generally support the review with following conclusions:
Market size has positive effect on the flow of FDI
Distance acts as a hindrance to FDI between two countries
Culture similarity also has possitive impact on FDI.
Higher corporate tax rate decrease FDI and tax avoidance, on the other hand, becomes an incentive for FDI inflow Weakness
Using fixed and random effect approach, our model may be weaker than Folfas’s model that exploits Hausman-Taylor estimation method. GROUP'S ASSESSMENT: STRENGTH & WEAKNESS StrenGth:
More thorough literature review
More update data
More reliable evidence to back-up the explanation New Development For Further Research Investigate the significance of factors not analyzed in this study :
- Social Variables
- National and regional factors
- External environment factors
Examine FDI in different industries
Include investigation of regional integration factors.
Policy Implication The policies to attract FDI of EU-27 may vary widely from one country to another. However, some general policy recommendations can be drawn from the findings:

Tax may be the most feasible variable to deal with. A lower tax rate and loosened fiscal policy will make the country a more ideal destination for FDI

FDI inflows need a stable macroeconomic environment,namely: low inflation, stable interest and exchange rates, robust public finace and mature financial and legal institutions.
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