Impact of economic volatility on corporate income tax rate the case of 20 asian countries

UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF ECONOMIC VOLATILITY ON
CORPORATE INCOME TAX RATE:
THE CASE OF 20 ASIAN COUNTRIES
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

TRUONG HOANG YEN

Academic Supervisor
Dr. NGUYEN HOANG BAO

HO CHI MINH CITY, JANUARY 2015


UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF ECONOMIC VOLATILITY ON
CORPORATE INCOME TAX RATE:
THE CASE OF 20 ASIAN COUNTRIES
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRUONG HOANG YEN

Academic Supervisor
Dr. NGUYEN HOANG BAO

HO CHI MINH CITY, JANUARY 2015

ABSTRACT

This paper examines the impact of economic volatility on the corporate income tax
rate in the context of globalization and international taxation competition. The
impact is analyzed by two models, direct and indirect effect model. The former
investigates directly the relationship of corporate income tax rates and economic
volatility in terms of real interest rate, exchange rate, and growth rate. The latter
applies a system of equations to examine simultaneously the determinants of tax
rate and tax base. The study finds out that economic volatility impacts negatively on
corporate income tax rate and also negatively on foreign direct investment (FDI)
inflows. Moreover, corporate income tax rate affects negatively and significantly on
FDI inflows, meanwhile FDI inflows influence corporate income tax rate with
positive and significant impact.


CONTENTS
CHAPTER ONE: INTRODUCTION .......................................................................... 1
1.1.

Problem statement .............................................................................................. 1

1.2.

Research objectives and research questions ....................................................... 4

1.3.

The structure of research .................................................................................... 5

CHAPTER TWO: LITERATURE REVIEW ............................................................. 6

2.1.

Theoretical literature........................................................................................... 6

2.1.1.

Roles of corporate income tax rate .............................................................. 6

2.1.2.

Economic volatility ...................................................................................... 7

2.1.3.

Foreign direct investment ............................................................................ 9

2.1.4.

Tax competition ......................................................................................... 11

2.2.

Empirical literature ........................................................................................... 15

2.2.1.

Economic volatility .................................................................................... 15

2.2.2.

Corporate income tax rate .......................................................................... 17

2.2.3.

FDI inflows ................................................................................................ 19

2.2.4.

FDI outflows .............................................................................................. 19

2.2.5.

Country size ............................................................................................... 20

2.2.6.

Capital openness ........................................................................................ 21

2.2.7.

Government expenditure............................................................................ 22

2.2.8.

Productivity ................................................................................................ 23

2.2.9.

Employment rate and demographic structure of population...................... 23

2.2.10.

Personal income tax rate......................................................................... 24


CHAPTER THREE: ECONOMIC VOLATILITY AND CORPORATE
INCOME TAX: DESCRIPTIVE AND DATA ANALYSIS .................................... 25
3.1.

Variable measurements..................................................................................... 25

3.1.1.

Measurement of economic volatility ......................................................... 25

3.1.2.

Measurement of corporate income tax rate ............................................... 26

3.1.3.

Measurement of capital openness index .................................................... 26

3.2.

Summary of variables description and data sources......................................... 28

3.3.

Descriptive statistics ......................................................................................... 29

CHAPTER FOUR: METHODOLOGY AND RESULTS ....................................... 33
4.1.

Analytical framework ....................................................................................... 33

4.2.

Direct effects ..................................................................................................... 34

4.2.1.

Model specification.................................................................................... 34

4.2.2.

Method specification.................................................................................. 37

4.2.3.

Results ........................................................................................................ 38

4.2.4.

Indirect effects ............................................................................................... 43

4.3.1.

Model specification.................................................................................... 43

4.3.2.

Method specification.................................................................................. 46

4.3.3.

Results ........................................................................................................ 48

CHAPTER FIVE: CONCLUSIONS AND IMPLICATIONS ................................. 53
5.1.

Major findings .................................................................................................. 53

5.2.

Policy implications ........................................................................................... 55

5.3.

Limitations and suggestions for further study .................................................. 56

REFERENCES ............................................................................................................. 57


APPENDICES .............................................................................................................. 63
A.

Graphs ............................................................................................................... 63

B.

Tests .................................................................................................................. 67

C.

Estimations ....................................................................................................... 70

D.

Others................................................................................................................ 78

LIST OF FIGURES
Figure 1.1 Average top statutory corporate income tax rate in 20 Asian countries.........2
Figure 1.2 FDI inflows in 20 Asian countries ..................................................................3
Figure 2.1 Theoretical framework..................................................................................15
Figure 3.1 Corporate income tax rate, capital openness index and FDI inflows
(1982-2011) ....................................................................................................................33
Figure 3.2: Corporate income tax rate, Real interest, Exchange rate, Growth
volatility, and FDI inflows (1982-2011) ........................................................................35
Figure 4.1 Direct effect framework ................................................................................39
Figure 4.3 Method for Direct effect model ....................................................................41
Figure 4.2 Indirect effect framework .............................................................................49
Figure 4.4 Method for Indirect effect model..................................................................52

LIST OF TABLES
Table 3.1 Variables description and data sources ..........................................................29
Table 3.2 Descriptive statistics ......................................................................................31
Table 4.1: List of variables in direct effect model .........................................................38
Table 4.2: Direct approach in various methods with interest rate volatility ..................43
Table 4.3: GMM estimation with and without volatility in three proxies .....................47

Table 4.4: List of variables in indirect effect model ......................................................48
Table 4.5: Indirect approach with interest rate volatility through various estimators ...53


CHAPTER ONE: INTRODUCTION
1.1. Problem statement
Taxation is the major source of government revenues for funding public
expenditure, such as infrastructure, education, public health, and other social
investment programs. Governments adjusted their taxation policies to facilitate
economic growth (Barro, 1991; Bleaney, Gemmell, and Kneller, 2001). On the
purpose of providing an economic environment to foster economic growth,
corporate income tax plays a crucial role in the taxation system, especially an
important part in tax reform (Arnold et al., 2011).
Corporate income tax serves the economy with three vital functions. Firstly, the
corporate income tax rate is regarded as an effective way to raise tax revenues.
Secondly, corporate income tax is popularly perceived as fair charges for public
goods and services consumed by companies. Lastly, corporate income tax is
considered as a reasonable substitute for personal income tax. Because it is hard to
administer personal tax on capital income, especially the gains which are retained in
a company (Bird, 1996; Devereux and Sørensen, 2006).
In high tax rate countries, governments have to allow some profit shifting because
of tax competition from lower tax rate countries (Becker and Fuest, 2012).
Therefore, governments also restrain that process by competing in reducing the
effective average tax rate and statutory tax rate (Devereux, Lockwood, and
Redoano, 2008). During the period from the 1980s to the late 1990s, the average
corporation tax rate decreased from nearly 40% to around 30%, specifically, in the
European countries from 38% in 1990 to 33% in 2000 (De Mooij and Ederveen,
2003; Devereux et al., 2008). Figure 1.1 presents the dramatic downturn of average
top statutory tax rate on corporate income of 20 Asian countries from more than
40% in 1982 to approximated 25% in 2011. Different from European countries,

Asian countries decrease their statutory corporate income tax rate roughly after

1


2007. The highest rate of statutory corporate income tax is 60% in Pakistan in 1989
whereas the lowest one is 12% in Macau from 2005 to 2011. In 2011, policy makers
in Pakistan reduce this variable to 35%, nearly 50% reduction. This may imply a
serious competition on corporate income tax rate between these countries for recent
three decades (Devereux et al., 2008).

Corporate tax rate (%)

40

35

30

25
1980

1985

1990

1995
Year

2000

2005

2010

Source: Author’s collected dataset

Figure 1.1 Average top statutory corporate income tax rate in 20 Asian countries
In order to attract more capital inflows, governments compete each other by
reducing corporate income tax rate (Genschel and Schwarz, 2011), because a
corporate income tax rate rise conducts to a decline in multinational investment
(Hong and Smart, 2010). As illustrated in Figure 1.2, the inward FDI volume is
increasing sharply and significantly. From the roughly zero initial level in 1982,
FDI inflows increase approximately to the landmark of 200 billion US dollars in
2011. Despite the crises in 1997 and 2008, this tendency still continues over time.
The combination of downward trend in corporate income tax rates and upward
tendency in capital inflows illustrates the tax competition among countries for the
purpose of capital attractiveness.
2


200

150

100

50

0

1980

1985

1990

1995
Year

2000

2005

2010

Source: UNCTAD (2014)

Figure 1.2 FDI inflows in 20 Asian countries
From another point of view, economic volatility is believed as a determinant of tax
reform (Feldstein, 1976). It is considered as disincentive for investments because it
distorts the location decision for investments to other stable economy instead of the
volatile one. In order to stimulate FDI inflows, the corporate income tax rates have
to be kept at a sufficient low level in order to reduce costs of capital and enhance
investment incentives (Panteghini and Schjelderup, 2006). Consequently, the
corporate income tax setting process is influenced by economic volatility
(Ghinamo, Panteghini, and Revelli, 2010).
An enormous number of researches study tax competition among jurisdictions.
However, there is a lack of study investigating the tax competition under the impact
of economic volatility. This subject is examined in the theoretical study of
Panteghini and Schjelderup (2006), and the empirical studies of Slemrod (2004) as

well as Ghinamo et al. (2010). These studies contribute to the theoretical framework
of timing choices in the investment decisions of multinational enterprises. This

3


framework is regarded as the plausible explanation for the corporate income tax rate
setting process under the influence of economic volatility. Moreover, these studies
also involve the effect of globalization on the relationship between corporate
income tax rate and economic volatility. Besides, the framework of timing choices
in the investment decisions of multinational enterprises is employed to illustrate the
mechanism of capital mobility.
Under the motivation from the works of Panteghini and Schjelderup (2006) and
Ghinamo et al. (2010), this research investigates the relationship of the top statutory
tax rates on corporate income and economic volatility in terms of real interest rate,
nominal exchange rate, and GDP growth rate. This relationship is also examined
with consideration of influences from globalization in terms of FDI flows and
capital market openness. The highlight of the paper is that the lag effects of public
policies and investment decisions are taken into account.
1.2. Research objectives and research questions
This study aims to investigate the corporate income tax rate setting process in scope
of 20 Asian countries from 1982 to 2011. The process is examined under the impact
of economic volatility in terms of real interest rate, nominal exchange rate, and
growth. Moreover, this impact is also assessed in the context of globalization, in
particular, capital mobility in terms of FDI inflows into the country. Based on these
objectives, the goals of the study are to answer the following questions:
-

Does economic volatility, in terms of real interest rate, nominal exchange
rate, and growth, affect corporate income tax rates?

-

How is the influence of FDI inflows on the relationship between economic
volatility and corporate income tax rates?
o Does economic volatility affect FDI inflows?
o How do FDI inflows influence corporate income tax rates and vice
versa?

4


1.3. The structure of research
The research consists of five chapters. The first chapter presents the introduction
which points out the main objectives and the scope as well as the time period of the
research. The second chapter covers the literature review, which is composed of
theoretical framework as the foundation of the study and empirical works on
specific variables involved in the investigation in the research. Measurements for
each variables and data analysis are discussed in the third chapter. The fourth
chapter presents the analytical framework of the study and shows the particular
models with their applied methods as well as the results for each model. Based on
the results obtained in the previous chapter, the fifth chapter demonstrates the
findings and limitations of the research. It also suggests the future directions and
implications for policy makers.

5


CHAPTER TWO: LITERATURE REVIEW
The theoretical literature section introduces the roles of corporate income tax rate,

economic volatility, and tax competition through various studies to illustrate the
mechanism of their relationship. Afterwards, the relationship between corporate
income tax rate, economic volatility, and FDI. Then the empirical literature section
synthesizes numerous studies on economic volatility, corporate income tax rate, and
FDI inflows as well as control variables. This section aims to point out the
benchmarks for the coming empirical models.
2.1. Theoretical literature
2.1.1. Roles of corporate income tax rate
Corporate income tax rate is analyzed under three functions.
Firstly, corporate income tax rate is regarded as an effective way to raise tax
revenue without affecting economic behavior. Corporate income tax is designed to
charge on economic profits, particularly on economic rents with particular
investments. However, this function is only effective in a closed economy. In case
of existing capital mobility, the choice for location of investments is distorted by
high tax rates. Therefore, Mintz (1995) concluded that the high tax rates may cause
a company to change their location of investments to another jurisdiction with lower
tax rate.
Secondly, corporate income tax is perceived popularly as fair charges for public
goods and services consumed by companies. The government provides public
supplies such as infrastructure and other public investments. These supplies create a
better economic environment in order to foster the economic growth. To fund the
public investment, according to Bird (1996), government levies on the profits of
companies at a fair share of tax for the value of public goods and services the
companies consumed.
6


Thirdly, Devereux and Sørensen (2006) pointed out that corporate income tax is
considered as a reasonable substitute for personal income tax. Because it is hard to
administer personal tax on capital income, especially the gains which are retained in

a company. However, this role is weakened in the context of capital mobility. The
owner of the capital gains may reside in a different country from where the
company locates so that the individual capital profits are levied at the different tax
rates. This is the cause of poor substitute of corporate income tax for personal
income tax. In conclusion, capital mobility weakens the “backstop” role of
corporate income tax for personal income tax though it does not eliminate
completely the role.
2.1.2. Economic volatility
Economic volatility, the instability in economic factors, especially in terms of
uncertainty, is considered as an important parameter in the theory of tax reform
(Feldstein, 1976). The fact of choosing particular tax rates not only influences social
welfare, but also alters the information available for later decisions. To that extent,
changing a tax rate imposes a gamble that reduces expected utility. Gamble
argument implies that if value of information, regarding economic volatility
parameter, is not taken into account, the variance in optimal tax may exert a smaller
difference than normal. Therefore, Eaton and Rosen (1980) debates that if ignoring
volatility, estimates of optimal tax rates may be biased to incorrect results.
Likewise, Barro (1989) examines the change of tax rates due to the effect of new
information about government expenditure, total income of the nation, and so on.
Using the tax-smoothing approach, he derives that tax rate changes are due to
business cycles and plans of government expenditure. During recessions, tax rates
descend to a lower level than normal. During wars, tax rates ascend to a higher level
than normal. There is a correspondence between this insight and that of Sahasakul
(1986).

7


Dixit and Pindyck (1994) stated that volatility affects negatively on investment
timing. An increase in volatility implies the increase in both good and bad

directions. The increase in good direction causes no impact, but the increase in bad
direction deters the investment decisions in order to wait for other information. In
other words, economic volatility reduces the current investment rate into a country.
Consequently, the government will reduce tax rates to alleviate the negative effect.
Moreover, Panteghini and Schjelderup (2006) analyzed the taxation competition for
foreign investments among countries. They prove that an equilibrium tax rate exists
so that at that level, social marginal cost of taxation achieves the same value of
social benefit. That is the foundation for the conclusion that equilibrium tax rates
will decrease as a result of expanding uncertainty in profit income. The argument
depends on the analysis of the effect of globalization process on taxation in which
volatility is interpreted as consequence of deepening globalization, causing a great
deal of unpredictable factors in the economy (Heckman, Agell, Gertser, and
Friedrich, 2003). For given tax rate, raising volatility will lead to a rise in cost of
capital because of higher risk in the investment. This descends the expected profits
so that firms who have plans to invest tend to delay the investment decisions to wait
for new information (Bernanke, 1983; Pindyck, 1991). Those who receive good
news will invest, the remaining will cancel the investment plan. Consequently, the
total number of firms exerting investment decrease so that tax base reduces
correspondingly. Ultimately, the government will react by lowering the tax rate to
counteract the negative effect of increased volatility.
In conclusion, Koren and Tenreyro (2007) indicated that studying the volatility
impacts brings two benefits. Firstly, it assists governments in risk management by
revealing the potential trouble areas. In case a few high risk sectors bring about the
volatility impacting widely on other sectors in the country, policies should
concentrate on diversifying the economy and supporting financial institutions. In
case country specific shocks are the major sources of economic volatility,

8

macroeconomic policies should be the main aim of policy makers. Secondly,
studying the volatility impacts helps to unfold the mechanisms of economic
volatility not only to get rid of excess economic volatility but also to boost the
ability of a country to deal with extreme shocks (Prakash, 2011).
2.1.3. Foreign direct investment
Bernanke (1983) pointed out that there are based on three important characteristics
of investment: irreversibility, uncertainty, and optimal investment timing 1. The
negative effect of investment timing depends on the Bad News Principle that
volatility in terms of uncertain information retards the current rate of investment.
His central theory examines how the investment decision is affected by the newarriving information (Keynes, 2006). To analysis this effect, Bernanke presumed
two assumptions. Firstly, real investments are strictly irreversible. Secondly, new
information that used to estimate investment return arrives continuously as cost of
waiting or volatility. Due to the irreversibility of investment, investors will have a
tendency to defer his investment decision to wait for new information. Because
volatility increases the cost of waiting for new information, it discourages the
investment.
Similarly, Pindyck (1991) confirmed that increased uncertainty reduces investment
by analyzing two assumptions which Bernanke mentioned as the most important
characteristics of investment expenditures. The first is the irreversibility of
investment. The second is leaning toward decision postponement to wait for new
information. Because a firm cannot disinvest, but the investment is irreversible, so
the expenditures are regarded as sunk costs. Besides, the firm has an option to
invest or not and to choose where to invest, called opportunity cost of investing.
Due to a postponement tendency on decision to wait for new information and the

1

These characteristics are confirmed in the studies of Pindyck (1991), Dixit and Pindyck (1994).

9

high sensitivity of the opportunity cost of investing to changes in the future
economic conditions, uncertainty impacts negatively and seriously on the
expenditure and timing of investment. This defines the dynamics in investment
decision.
Moreover, Hines Jr (1999) indicated that tax policies exert a strong influence on
investment decision, particularly on the volume and location of FDI, due to the
reduction of after-tax returns under the effect of higher tax rates. And investment
incentives suffer the negative impact as a result. Moreover, based on the analysis of
the cost of capital, Devereux, Griffith, and Klemm (2002) argues that the cost of
capital will be exaggerated through an increase in effective marginal tax rate. This
effect conducts a diminution in capital inflow or an enlargement of outflow stock of
capital. This phenomenon is explained that an increase in the cost of capital is
equivalent to an increase in required rate of return. Therefore, under the effect of
corporate income tax raising, investment incentives endure reducing. In other
words, lowering the corporate income tax rate enhances the incentive to invest.
Similarly, Panteghini and Schjelderup (2006) confirmed the relationship that high
taxes exert a negative effect on the probability of a country attracting FDI (Haufler
and Schjelderup, 2000). A multinational firm can exploit this by locating capital in
the country which offers the most favorable capital investment scheme. Later, once
it starts to generate profits, it can shift some of its taxable profits to a country that
offers low statutory tax rates. This two-step strategy means that a multinational firm
can save tax payments relative to domestic firms, but it also has the implication that
national tax bases become more tax sensitive.
On the other hand, Ghinamo et al. (2010) explained the positive effect of FDI on
corporate income tax rate. The first reason relates to market openness. The lower
the economy’s openness, the lower is the incentive for inbound FDI. This means
that the government must set a lower statutory tax rate to attract multinational
activities. The second reason holds for volatility. An increase in volatility is

10


expected to discourage FDI. In this case, therefore, the government will have to cut
the tax rate in order to offset the effects of higher uncertainty. The third explanation
is that under the effect of globalization, removing market barriers brings about a
decrease in size of the sunk cost and/or an increase in profitability encourages FDI
activities. This allows the two competing countries to set a higher tax without
deterring FDI.
2.1.4. Tax competition
Tax competition models originate from Tiebout hypothesis as the theory of efficient
tax competition, based on theory of local public good provision. Tiebout (1956)
stated that competition for mobile households or mobile firms improve social
welfare. Assuming that landowners control local government, they aim to maximize
the after-tax value of their land. Therefore, they offer public goods as utilities
financed by local taxes to attract individuals to reside on their land. However, they
fail because of many “utility-taking” regions. As a result, such equilibria are
efficient with the definition of efficiency: “a central authority cannot feasibly
reallocate goods and resources in a way that makes some individuals better off
without making anyone worse off.” (Wilson, 1999). To that extent, the fact that
local taxes are kept low enough in order to tempt individuals to inhabit in the
region, with the given public goods, will cause tax competition. Based on this idea,
Wildasin (1989) contributed departure of the existence of “fiscal externality” which
occurs when a region gains capital at the expense of others by decreasing its tax rate
on mobile capital.
In contrast with the intuition of Tiebout (1956), Oates (1972) debated that society is
worse off in competition for capital between local governments. For the purpose of
attracting business investment, local governors may make an endeavor to keep taxes
low by maintaining expenditure less than the level at that marginal benefits equal

marginal costs. It means taxation impact negatively on business investment by
increasing marginal costs. Because of these additional costs, public expenditure and

11


taxes will be diminished to the level of a new equilibrium. Consequently, none gain
a competitive advantage or, in other words, it conducts a wasteful tax competition
or inefficient tax competition. This cause the “race to the bottom” in corporate
income tax rates in recent decades.
By the same token, Wilson (1999) confirmed the wasteful competition between
independent governments, which cause the reduction in tax rates and levels of
public expenditure for scarce capital. Based on the Nash equilibrium concept, he
defines equilibrium economy is a status where the objective function of the region’s
strategy is maximized with the given strategies of other regions. Particularly, the
fact of choosing tax rate of a region in comparison with that of other regions
influence the equilibrium of capital return. Because an increase in the tax rate of a
region causes a capital outflow that is considered to be a capital inflow to another
region due to the assumption of scarce capital. As a result, the region’s tax rate and
public goods are set at inefficiently low levels in order to attract capital inflow.
Based on the theory of tax competition, Panteghini and Schjelderup (2006)
contributed an analysis the tax competition with regard to economic volatility. They
used a two-period model in which investments are regarded to be irreversible and
multinational companies can shift their profit among countries. At the first stage,
governments set their tax rates. At the next stage, multinational companies decide
whether to do or deter their abroad investment operations. The behaviors of
multinational companies are based on the argument of timing investment.
Eventually, two propositions derived from the two-period model of Panteghini and
Schjelderup (2006) and analysis mechanisms of Ghinamo et al. (2010) are applied
in this paper.

The first is that an increase in FDI allows a higher tax rate setting. Globalization
means tighter integration or surge in market openness so that technical barriers are
reduced. This causes the reduction in investment costs. On the other hand,

12


globalization leads to lower transportation costs and increased skill-oriented
technologies as well as widened information systems. Moreover, the diminution in
transaction and financial costs of e-banking services eases the ability of profit
shifting. These boost the average profitability in investments. Eventually, FDI
operations are stimulated by the reduction in investment costs as well as the
increase in profitability. Additionally, the growing number of FDI firms due to the
increase in profitability enlarges the tax base of the country. This also discourages
the government to reduce tax rates.
Secondly, increase in volatility motivates reduction in tax rates. Globalization may
raise the volatility and volatility dejects inbound FDI (Ghinamo et al., 2010). Based
on Bad News Principles (Bernanke, 1983), merely firms receiving good news exert
their investment decisions, meanwhile firms with bad news deter their investment
plans. After the consideration time, firms will decide whether to invest or not.
Therefore, the number of FDI firms and the value of inward investments reduces.
The reduction in total FDI inflows leads to a decrease in the tax base. To mitigate
the negative impact, governments respond by lowering the tax rates. This illustrates
the dynamics in taxation setting.
Four hypotheses are drawn based on the analysis on tax competition.
o Hypothesis 1: whether economic volatility affects negatively on corporate
income tax rate.
o Hypothesis 2: whether economic volatility affects negatively on FDI inflows.
o Hypothesis 3: whether corporate income tax rate affects negatively on FDI
inflows.

o Hypothesis 4: whether FDI inflows affects positively on corporate income tax
rate.

13


In conclusion, this analysis is put under the circumstance of globalization to investigate the effect of capital mobility on tax rate setting
process. The picture below illustrates the effect of economic volatility on corporate income tax rate. It also demonstrates the influence
of economic volatility on FDI inflows and the impact of FDI inflows on corporate income tax rates.
Market openness

Technical barriers

Investment costs

Transportation costs

GLOBALIZATION

FDI
INFLOWS

Skill-oriented technology

Information systems

Average profitability

E-banking services’ costs

Profit shifting

ECONOMIC
VOLATILITY

Figure 2.1 Theoretical framework

14

CORPORATE
TAX RATES


2.2. Empirical literature
This section will give some justifications about economic volatility, which is
measured by the standard deviation of real interest rate, nominal exchange rate, and
growth, corporate income tax rate, and FDI inflows. This section also explains the
rationale of control variables, such as FDI outflows, country size, capital openness,
government expenditure, productivity, employment rate, demographic structure of
the population as well as personal income tax rate.
2.2.1. Economic volatility
Volatility or uncertainty is studied in a great deal of economic researches. In
formidable contribution of Knight (1921) about the idea of the relationship of risk
and uncertainty in economic analysis, both risk and uncertainty occur where there
exists unknown future. However, the risk is distinct from uncertainty in terms of
probability distribution of possible future results. It is affirmative in case of risk and
negative in case of uncertainty. Based on the theory of Neumann and Morgenstern
(1947) about game and economic behavior, associating with Knight treatise,
economists contribute a great deal of studies to explain profits, investment
decisions, demand and supply of investments, etc. (Arrow, 1951; Hicks, 1931;

Keynes, 1936, 1937; Stigler, 1939).
Economic volatility might be reflected by means of changes in actual and
unanticipated

value.

The

former

is

calculated

in

terms

of

variance

(conditional/unconditional) or standard deviation and the latter is computed in the
sense of residuals from an estimating model, according to Di Iorio, Faff, and Sander
(2013). With the aim of investigating the time varying volatility with respect to
actual changes, standard deviation is the suitable measure, as in similar strategy of
Ramey et al. (1994) and Aghion et al. (2005). However, this costs considerable data
loss. Accordingly, in order to entirely make the most of the information in the data
set, a kind of moving average of the standard deviation is computed through the

15


value in the previous five years of the relevant variable. This measurement
approach seizes the general moments in economic volatility and the risk over time
(Chowdhury, 1993; Cushman, 1988; Ghinamo et al., 2010; Koray and Lastrapes,
1989).
In this research, economic volatility is examined through variation in real interest
rate, nominal exchange rate and productivity growth rate. The two former variables
reflect the behavior of government in monetary policy decision. The latter shows
the state of the performance of the economy in macro level.
Real interest rate volatility
Irreversible investments are sensitive to volatility in many forms, for instance,
uncertainty in future interest rates causes the increase in operating costs. These
costs alter the cash flows of a project, affect the return as well as the timing of
investments. Consequently, these reduce the investment stocks (Pindyck, 1991).
Rodrik (1991) contributed the same explanation for the relationship, based on the
analysis of the cost of capital. He concluded that domestic real interest rates must be
taken into account in estimating the presence of volatility.
Ghinamo et al. (2010) considered interest rate volatility as the crucial taxation
factor in forming the financial structure of a firm. Because of deductibility from
taxable income, interest expenses are usually regarded as a tax shield by utilizing
the internal and external credit market. Multinational companies can utilize the debt
shifting option in which incomes and tax burden can be shifted to the lower tax rate
countries by using internal debt among affiliates. Therefore, in order to obtain the
optimal debt/asset ratio or internal/external debt structure, changes in external credit
market of a firm or in external credit market of their foreign affiliates could affect
the decision of investing in uncertain countries.

16

Nominal exchange rate volatility
Pindyck (1991) stated that exchange risk will descend direct investment. He debated
that exchange rate affects on investment decisions of both domestic firms and
foreign subsidiaries. However, according to a study of Diebold and Nerlove (1989),
bilateral flows of direct investment have a positive relationship with uncertainty in
exchange rate. ARCH effects are used to capture the volatility clustering through
movements of exchange rate volatility. Also, A. Dixit (1989) measures exchange
rate volatility by ARCH model. Meanwhile, Pindyck (1991) analyzes the cost of
capital in terms of sunk costs of entry and exit to estimate the effect on investment
by volatility in exchange rate and prices.
Growth volatility

Ramey et al. (1994) mentioned that a higher economic volatility associates with a
lower growth, with economic volatility measured by the proxy per capita annual
growth rates. Based on the precautionary motive for savings, they debated that a
higher volatility should conduct an increase in saving rates. This enhanced the
investment rate, considered as a premise for growth rising. Besides, Down (2007)
measured the domestic and global volatility by calculating the standard deviation of
growth rate in terms of purchasing power parity (PPP), and per capita real GDP. He
also implied that a reduction in economic volatility induces developments
associated with remarkable growth as well as the welfare for the OECD countries.
2.2.2. Corporate income tax rate
FDI inflows respond negatively to a higher corporate income tax rate. In other
words, to stimulate inward FDI, corporate income tax rate is used as an effective
instrument. Because a reduction in the corporate income tax rate will motivate the
incentive of FDI inflows (Ang, 2008; Billington, 1999; Fedderke and Romm, 2006).
Devereux et al. (2002) illustrated the mechanism of the relationship that an increase
in tax rate will boost the cost of capital, that leads to a reduction in capital inflows

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and an increase in capital outflows. Because of the higher tax rate, the cost of
capital, considered as the required rate of investment return, will raise. That
conducts a disincentive of investment. In a research of De Mooij and Ederveen
(2003), tax rate elasticity have the mean value set at the value of around -3.3. As
otherwise stated, if tax rate in the host country decreases 1 percentage point, foreign
direct investment in that country will increase by 3.3%.
Devereux et al. (2002) classified the measurements of the corporate income tax rate
into two groups of corporate income taxes. The first group of measures bases on tax
legislation, consisting of effective marginal/average tax rate, statutory corporate
income tax rate, and so on. This type is forward looking, seizing the influence of tax
on future anticipated profits from a specific investment. The second is group of
measures based on tax revenue, calculated on the basis of ratio of corporate income
tax revenues on GDP or total tax revenues. This type is backward looking,
capturing the effect of tax on the incomes in any historical period of a firm's
investment decision. This research is for the purpose of analyzing the impact of
corporate income tax rate on attracting the investment location decision of foreign
investors. Therefore, the former group is suitable for the goals of the research.
Devereux et al. (2008) examined the tax reaction function for exploring the
investment stimulation created by the tax regime via three measures. The first,
effective marginal tax rate, is defined as tax rate on new investments. In other
words, the scale of a firm’s operation is determined through this measure. The
second, effective average tax rate, is defined as the proportion of tax payment on
true economic profit. Otherwise stated, the firm’s location is determined through
this measure. Finally, the statutory tax rate is adjusted by governments to contest for
the inward location of firms.

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2.2.3. FDI inflows
According to literature on investment and taxation, investment is influenced
negatively by the uncertainty of the economy because uncertainty increase risk,
causing the increase in the cost of capital (Panteghini and Schjelderup, 2006).
However, Ang (2008) argues that macroeconomic uncertainty may motivate inward
FDI. He debates that foreign investors look for greater potential investment returns
because the higher cost of capital refer to the higher required return on capital as
compensation for the higher level of uncertainty.
Besides, tax rate impacts negatively on investment. In order to stimulate investment,
local officials tend to reduce tax rates (Knight, 1921; Oates, 1972). Reversely, a
country with high inbound FDI rate tends to raise its tax rates without affecting its
tax revenue (Panteghini and Schjelderup, 2006).
2.2.4. FDI outflows
FDI outflows tend to rise along with the higher statutory tax rates in the home
country proportionate to those in the target country (Buettner, 2002). With the same
other factors, an increase in the statutory tax rates, especially corporate income tax,
in the home country will stimulate an increase in FDI outflows for various purposes.
With reference to the purpose of financial incentive seeking, the destinations of FDI
outflows are tax havens. In the period of 2004-2006, around 80% of the outward
FDI flows from China penetrated into Hong Kong and Caribbean (Morck, Yeung,
and Zhao, 2008). Based on the UNCTAD records, Rasiah, Gammeltoft, and Jiang
(2010) point out that an enormous amount of these FDI outflows re-enters China
with the intent to gain benefits from preferential treatments for FDI, regarded as
“round-tripping” phenomena.

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