Effects of government tax and nontax incentives on foreign direct investment, The

effects of government tax and nontax incentives on foreign direct investment, The

Porcano, Thomas M

Tax and nontax government incentives are used to attract foreign direct investment. However, the efficacy of these provisions in influencing such investment decisions is uncertain. Many factors affect this decision such that the importance of tax and nontax government incentives is reduced and/or mitigated. This study presents an analysis of the importance of government tax and nontax incentives in the foreign direct investment decision of American, British, Canadian, French, German, and Japanese firms. The results indicate that nontax government incentives are perceived as unimportant and that tax incentives at best are perceived as marginally important in the decision.. Other factors such as product demand in the host country and the ability to produce a quality product are more important.

INTRODUCTION

There are numerous factors that affect a firm’s decision to make a direct foreign investment (FDI). Tax and nontax government incentives (i.e., government grants) are two such factors. The effects of these incentives on the FDI decision are uncertain for several reasons. First, results of previous studies are mixed; some find these incentives to be an important factor in the decision, while others do not. Secondly, other factors might mitigate the effects of the government incentives. For example, the type of host country (developed or less developed) and the firm’s plans for sale of production (market penetration in the host country or exportation to other countries (e.g., home)) might affect government incentives’ effectiveness.

This paper is an extension of Porcano’s (1993) study. In that study, Porcano analyzed 21 factors that might affect a firm’s FDI decision. While tax and nontax government incentives were addressed, he did not specifically analyze their impacts. The purpose of the current study is to analyze the relative effects of tax and nontax government incentives on the FDI decisions and to identify the perceived role of tax incentives of American, British, Canadian, French, German, and Japanese firms. Some of the data reported in Porcano (1993) are used and some additional data are analyzed. The six countries were selected because they are major industrialized countries and are members of the “Group of Seven.” A questionnaire was mailed to the Vice President of Finance of a sample of firms in each of these countries. They were asked to rate the importance of numerous factors in the FDI decision. Respondents also were asked questions regarding the role of taxes in the FDI decision. The results suggest that while government incentives have some role in the FDI decision, there are more-important factors.

The remainder of this paper is organized as follows. The next section provides a brief review of relevant literature and the hypotheses tested. The research method then is presented, followed by the results section, study limitations, and implications sections.

PREVIOUS RESEARCH

The efficacy of government incentives in stimulating investments in fixed assets has been studied via econometric models, experimental economics, and surveys. These studies primarily deal with the investment decision within a country, not into another (foreign) country. The results of econometric studies are mixed. Chirinko and Eisner (1983) suggest that the differences are due in part to model specification and that “one can get any answer one wants by making sure that the chosen model has specifications appropriate to one’s purpose” (p. 139). In a different study, Chirinko (1986) concludes that empirical evidence regarding the efficacy of tax incentives in stimulating investment in fixed assets is lacking.

Using an experimental economics approach, Davis and Swenson (1993) found that tax incentives (depreciation and investment tax credit) did not increase investment in fixed assets. Demand for such assets was unresponsive to tax incentives, in part because of the implicit tax on the tax-favored assets. Survey results also generally indicate that tax and nontax government incentives are not very effective stimulants (or important in the fixedasset acquisition decision), both in the U.S.A. (Eisner and Lawler 1975; Porcano 1984; Rose and O’Neil 1985) and within other industrialized countries (Porcano 1987).

Studies of the efficacy of government incentives in the FDI decision have produced mixed results. Some studies suggest that they are important and other studies suggest that they are insignificant. Other factors either are more important or mediate the effects of the incentives. Cable and Persaud (1987) indicate that tax incentives have moderate importance in the FDI decision; other factors offset these incentives. However, if all other factors are equal then tax incentives might influence the FDI decision (Mukherjee 1987). Also, Rolfe and White (1992) note that the type of manufacturing FDI decision is important. Market penetration decisions might not be sensitive to tax incentives whereas productsourcing investments might be influenced by the incentives. Finally, the level of industrialization (developed or less developed) not only affects the FDI decision but also affects the efficacy of government incentives because other factors such as economic conditions, political climate, labor supply, physical infrastructure, product demand, etc. can vary significantly between each type of country.

The results of studies dealing with the incentive effects of government tax and nontax provisions suggest that these provisions are not very important in the FDI decision, especially in developed countries, yet they still are used to some extent. Perhaps they still are used because some countries believe that they do influence the decisions of some foreign firms, especially those of a specific country. The results of previous. studies and the uncertainty regarding differential effects across firms from different countries indicate that a simultaneous analysis of firms’ perceptions from different countries might provide insight into the overall efficacy of such incentives. Results of such an analysis would provide policy makers with useful information. For example, if firms from many countries have similar beliefs that the provisions are ineffective and not important in their decisions, then existing provisions could be changed accordingly.

The current study presents such an analysis, and the following hypotheses are tested.

H^sub 1^: Government nontax incentives (i.e., grants) are not important in the FDI decision

H^sub 2^: Government tax incentives are not important in the FDI decision

RESEARCH METHOD

A questionnaire containing 21 factors which might affect the FDI decision was sent to the Vice President of Finance of a sample of American, British, Canadian, French, German, and Japanese firms. Respondents were asked to provide certain firm-demographic data such as major industry, total assets, sales, net income, annual capital and expenditures. Respondents also were asked to rate the importance of the 21 factors in the FDI decision using a 5-point Likert scale where one was very unimportant and five was very important. The 21 factors were obtained from a review of the literature (see Porcano 1993, pp.27-28). Included in the 21 factors were seven tax factors (national and local tax rates; tax depreciation and tax credits at the national and at the local levels; tax holidays at the national and at the local levels; and dividend policy) and two nontax government incentives (government grants at the national and at the local levels). Finally, respondents were asked four questions regarding the role of taxes in the FDI decision process. Specifically,

1.the role of tax provisions in the FDI decision process (integral, marginal, minor, none);

2.when tax considerations enter the FDI decision process (beginning, middle, end, never);

3.which country’s tax provisions were more influential (host country, home country, neither–equally important); and

4.whether the host country’s tax provisions affected several components of the FDI decision (country to locate, location within a country, timing of FDI, size of FDI, and type of FDI).

Each firm was sent a cover letter and questionnaire. The cover letter briefly described the nature of the study, the expected time to complete the study, assured anonymity, and was written in each firm’s native language. Three mailings were used in one-month intervals.

The sample of foreign firms was drawn from Moody’s International Manual. The U.S firms were randomly selected from the Fortune 500 list. One-hundred fifty American firms, 100 British firms, 34 French firms, 2 German firms, and 85 Japanese firms were selected. Firms were selected from these two directories because large firms with international operations were of interest and firms listed in them met these criteria.

RESULTS

The response rate varied from 30 percent for Canadian firms to 49 percent for German firms. The usable response rate by country was: American firms, 21 percent; British firms, 18 percent; Canadian firms, 18 percent, French firms, 26 percent; German firms, 31 percent; and Japanese firms, 34 percent. Although these response rates are not high, studies using a small percentage of respondents are not uncommon in the FDI area (for example, see Kimura 1989). Also, these response rates are typical of those obtained in other studies of large firms (see Porcano 1987).

Table 1 contains a summary of the respondentfirm attributes of asset size, sales, net income, and capital expenditures. Although the firms are large, they are diverse. The size ranges for each attribute are very large. Also, 36 industries are represented. The respondents represent a wide variety of multinational firms which make FDI decisions.

Tests for nonresponse bias using the early/late hypothesis were performed (Oppenheim 1966). The means of the 21 factors for early respondents and late respondents were compared for each home country. Only ten of the 126 comparisons (21 x 6) were significantly different. As such, nonresponse bias did not appear to be a problem.

IMPORTANCE RATINGS

Table 2 contains the mean ratings of the 21 factors by firm home country and overall. The range in importance ratings is quite large within each country and overall for all firms. Clearly, some of the factors are perceived to be significantly more important that are others.

The results of a two-way analysis of variance (ANOVA) for unbalanced designs where mean response is the dependent variable and home country and factor are the independent variables are presented in Table 3. The model is significant at the .0001 level, as are the main effects and the interaction effect. These results confirm the observation regarding the perceived importance of the factors. Some are perceived to be significantly more important in the FDI decision than are others.

Since tax and government nontax incentives are part of a large group of factors that might affect the FDI decision, it is necessary to analyze their importance relative to all the factors. Such comparison provides an indication of the relative importance of the tax and nontax government incentives. A review of the overall ratings presented in Table 2 indicates that product demand in the host country is considered to be the most important factor (mean = 4.21) and that exchange rates were the least important factor (mean = 3.09). This suggests that the firms probably are concerned with market penetration as opposed to product exportation. The mean ratings of the two government nontax incentives were 3.17 and 3.10, ranking them 17th and 20th among the 21 factors. For firms in this study, government nontax incentives (government grants) have little influence in the FDI decision. The mean ratings of the seven tax incentives ranged from 3.46 to 3.14. In relative terms, these mean ratings rank 7, 8, 9, 10, 15, 17 and 19 among the 21 factors. The ratings for national tax rates, dividend policy, and national depreciation and tax credits were 3.46, 3.44, and 3.38, respectively. This indicates that at best these factors are perceived to be moderately significant in the FDI decision. Local tax rates also were moderately important (mean = 3.37). Local tax rates and depreciation and tax credit provisions, and national and local tax holidays were perceived to not be very important in the FDI decision.

A review of Table 2 means by country and of the ANOVA results indicates much disagreement between firms of different countries. A comparison of the firms’ ratings of each tax incentive confirms this; their ratings are quite varied. These incentives appear to have different perceived levels of importance in the firms’ FDI decisions. Converting the ratings to rankings provides another relative measure for comparison purposes.

The two government nontax incentives were not in the top third of importance for any country, again confirming that these types of incentives are not very important in the FDI decision of firms in this study. None of the tax factors were in the top third of importance for French and Japanese firms, and only one was in the top third for American and German firms. Finally, only two of the tax factors were in the top third of importance for British and Canadian firms. Thus, while there is some degree of disagreement regarding the perceived importance of the tax factors in the FDI decision, firms are reasonably consistent in attaching moderate to little relative importance to tax and nontax factors.

A general profile of each country’s firms indicates that French and Japanese firms seemed most concerned about general conditions in the host country (product demand, labor quality and cost, the economy, and the host countries attitude regarding foreign investment). Tax and nontax government incentives were perceived as having little relative importance. American firms seemed most concerned about product demand, labor supply and cost, and trade restrictions and tariffs. They did perceive national tax rates as somewhat important. German firms also were concerned about product demand and labor supply and quality. They also perceived environmental laws and the host country’s physical infrastructure as somewhat important. The only tax factor they perceived as important was local tax rules (depreciation and credits). British and Canadian firms seemed most concerned about product demand, labor quality and cost, and host country economic conditions. They perceived national tax rates and dividend policy as somewhat important.

An analysis of the factor ratings and relative rankings of said ratings indicates that most firms, regardless of home country, perceive nontax government incentives as relatively unimportant in the FDI decision. Tax factors are perceived to be more important than the nontax incentives, but even so, only one of two of these factors at best have moderate importance to some firms. A closer analysis of the role of tax factors in the FDI decision follows.

ROLE OF TAXES IN THE FDI DECISION PROCESS

A review of the importance ratings in Table 2 indicates that tax laws in general are considered to be of marginal importance in the FDI decision. The ratings of the tax factors placed them in the middle of the group. In order to explore the effects further, respondents were asked four questions regarding the effects of taxes on their FDI decisions.

Table 4 provides a summary of the responses to questions regarding tax provisions in the FDI process. The frequency percentages of responses by firm nationality and overall are presented. Results of Chi-square tests indicate that although the relative frequencies between countries are different, they are reasonably consistent; that is, no Chi-square values were significant at the .05 level.

Taxes have some role in the FDI decision. No respondents indicated that they had no role or that they never entered the process, and only 17 percent indicated that taxes had a minor role. Also, taxes have the greatest role for American and French firms’ FDI decisions and the smallest role for Japanese firms’ decisions. A majority of the respondents (55 percent) indicated that the provisions have only a minor role in the FDI process. These results were consistent across all but American firms, who were almost equal in indicating that tax provisions play an integral or a marginal role.

Tax provisions appear to be considered at either the beginning or the middle of the FDI decision process. The results were reasonably consistent across all but French firms, many of which indicated that tax considerations entered at the middle or end of the decision process. These results also suggest that at best, taxes have only a marginal role in the FDI decision.

A majority (60 percent) of respondents indicated that tax provisions in both the home country and the host country were equally influential. This view is consistent with a global view of tax burdens and a desire to maximize the firm’s overall after-tax cash flows. However, a substantial number of respondents indicated that the tax provisions in the host country were more influential than those in the home country (31 percent versus 9 percent). Again, these results were consistent across all but one country. A majority of Japanese firms felt that tax provisions in the host country were most influential.

In those situations where they might affect a decision, a majority of respondents indicated that the choice of host country and the type of FDI (56 percent) are most affected by the host’s country’s tax provisions. The timing and size of the FDI are least affected by the host country’s tax provisions.

The results do not provide evidence to reject H^sub 1^. Government nontax incentives are perceived to not be very important in the FDI decision, regardles of the firm’s home country. The results with respect to H^sub 2^, are mixed, and at best provide marginal support to reject it. Government tax incentives and provisions are not perceived to be unimportant in the FDI decision, but they also are not perceived to be important, especially by French and Japanese firms, and to a large extent by American and German firms.

LIMITATIONS OF THE STUDY

Limitations of the study arise because of the use of a survey questionnaire. The major limitations deal with: (1) what the responses measure; (2) population representation; and (3) sample representation. Responses reflect the perceptions of the importance of the factors and the role of taxes in the FDI decision. These perceptions might be different from the actual importance when the decision is made, but given the level of respondent (upper-level management), there should be a strong correlation between them.

The population of interest was large corporations with FDIs The firmswere from six industrialized countries which have a major impact on global markets. The firms were large based on various financial measures and were active in a variety of industries. The total and usable response rates ranged from 30 percent to 49 percent and 18 percent to 34 percent, respectively. These rates are typical for studies of this type. Regardless, whether nonrespondents are significantly different than respondents is unknown. However, tests for nonresponse bias indicated that such bias did not appear to be significant.

IMPLICATIONS

The tax and nontax government incentives evaluated in this study should affect FDI because they affect the cost to produce the product. The greater the incentive the lower the cost to produce and therefore the more attractive the host country becomes. However, this effect is only influential if cost minimization or control is a primary concern or if the dollar benefits of such incentives are substantial. Large firms investing in major industrialized countries probably have more important considerations than cost reduction, especially when making an FDI decision because such an investment generally is done for the long run and involves a major capital expenditure. The findings with respect to the importance ratings are consistent with this view and are consistent in that when making an FDI decision, firms appear to be most concerned about factors that directly affect their ability to produce and sell a quality product, and not concerned about government incentives.

Nontax government incentives were considered to be unimportant. These incentives can be quite varied and the application and approval process can be very cumbersome and lengthy. These conditions reduce the attractiveness of the incentives. Also, the dollar amounts generally are not substantial unless the government is trying to attract investment to a particular target area (e.g., investment in West Berlin when the two Germanys were separate countries). In these situations usually other factors have much greater prominence. Additionally, such incentives might be more attractive in lessdeveloped countries than they are in developed (industrialized) countries used in this study.

Tax incentives (factors) are one of many factors that affect the FDI decision. The moderate ratings of the tax factors, the fact that 55 percent of the respondents indicate that they have a minor role in the FDI decision, and the fact that 61 percent of the respondents indicated that they were considered in the middle or end of the decision process suggests that taxes have a minor role and come into consideration only after the project decision process is well along. That is, once a firm has decided to locate in a country, then it attempts to maximize the aftertax cash flows of the project (minimize the aftertax cost of the project). However, if taxes are of primary importance then the overall economic viability of the project probably is questionable.

Taxes are not the most important factors; yet, they are not unimportant and in certain instances might be the final consideration that causes the investment. That is, tax incentives might be important for marginal projects. The tax advantages provide the additional benefit needed to make the project a “go.” In these instances the economic efficiency of tax incentives is questionable because tax-driven investment, especially a very large one such as FDI, generally are not beneficial to a country in the long run.

The results also provide evidence in support of Mukherjee’s (1987) findings that tax incentives might be influential if other factors are equal. Finally, the results provide additional evidence regarding the efficacy of tax and nontax incentives in stimulating/influencing firms’ decisions to make capital investments. In general, they are not very effective and countries might be better served if they developed policies to increase the attractiveness of some of the other factors that are perceived as more important than tax incentives.

NOTES

This is exemplified by actions taken by the U.K. in 1984. Changes to tax incentive provisions were made because there was little evidence that said investments had strengthened the economy or improved the quality of investment. The incentives might have encouraged some investments that had just the opposite effect. (See U.K. 1984).

REFERENCES

Cable, V. and B. Persaud, 1987, “New Trends and Policy Problems in Foreign Investment: The Experience of Commonwealth Developing Countries,” in V. Cable and B. Persaud, Developing with Foreign Investment, London, England: Croom Helm.

Chirinko, R., 1986, “Business Investment and Tax Policy: A Perspective on Existing Models and Empirical Results,” National Tax Journal (June), 137-153.

Chirinko, R. and R. Eisner, 1983, “Tax Policy and Investment in Major U.S. Macroeconomic Econometric Models,” in M. Blume et al., Economic Activities and Finance, Cambridge, MA: Ballinger.

Davis, J.S. and C.W. Swenson, 1993, “Experimental Evidence on Tax Incentives and the Demand for Capital Investments,” The Accounting Review (July), 482-514.

Eisner, R. and P.J. Lawler, 1975, “Tax Policy and Investment: An Analysis of Survey Responses,” The American Economic Review (March), 206-212.

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Mukherjee, B., 1987, “Foreign

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Oppenheim, A.N., 1966, Questionnaire Design and Attitude Measurement, Basic Books: New York.

Porcano, T.M., 1984, “The Perceived Effects of Tax Policy on Corporate Investment Incentives, Journal of the American Taxation Association (Fall), 7-19.

____, 1987, “Government Tax Incentives and Fixed Asset Acquisitions: A Comparative Study of Four Industrialized Countries,” Journal of the American Taxation Association (Fall), 7-23.

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Rolfe, R.J. and R.A. White, 1992, “Investors’ Assessment of the Importance of Tax Incentives in Locating Foreign Export-Oriented Investment: An Exploratory Study,” Journal of the American Taxation Association (Spring), 39-57.

Rose, C.C. and C.J. O’Neil, 1985, “The Viewed Importance on Investment Tax Incentives by Virginia Decision Makers,” Journal of the American Taxation Association (Fall),34-43 .

U.K., 1984, 1984 Budget Statement (March 13, 1984).

Copyright College of Business Administration. University of Detroit Mercy Spring 1996

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