Equilibrium conditions in corporate tax competition and Foreign Direct Investment flows

We consider a collection of countries which attempt to maximize their corporate tax revenue, the latter being viewed as a function of Foreign Direct Investment (FDI) inflow and the Effective Average Tax Rate (EATR) which each country sets for itself. Under a model that assumes a direct influence of tax differentials on the flow of FDI, each country's decisions are naturally 'coupled' to those of others, leading to a non-cooperative game in which countries-players compete for FDI inflows by sequentially altering their tax rates. Their decisions are made via a differential equation-based model used to predict the effect of tax rate changes on a player's share of FDI inflows. Our model, calibrated using empirical data from 12 OECD countries for the period 1982-2005, combines FDI inflow and tax-rate differentials to arrive at a “steady-state” FDI inflow share for each player, given its competitors' corporate tax rates. We explore the game's equilibrium, including the question of whether equilibrium necessarily implies a 'race to bottom', with low corporate tax rates for all players.

Research Highlights►A numerical game-based model of corporate tax competition for FDI inflows in OECD countries. ►An empirical reduced-form model of FDI inflow responses to corporate tax-rate differentials. ►An empirical model of corporate tax revenue versus Effective Average Tax Rates and FDI inflows. ►Results show: no “race to bottom” for corporate tax rates, no room for collusion among players. ►Policy should focus on any welfare losses due to tax competition rather than on strict harmonization.