Ec689 impactfdi policyhandout

MNC Impact
& FDI Policy
Economics 689 Texas A&M University
Glass & Saggi 1999
• Glass, Amy J. & K. Saggi (1999), “FDI Policies
under Shared Factor Markets,” Journal of
International Economics 49(2): 309-332.
– Examines the consequences of FDI across countries:
• shifts labor demand across countries.
• raises wage in the host country and lowers the wage in
the source country.
• benefits host workers at the expense of source workers.
• reduces profits of host firms by raising wages abroad.
– Tension arises between worker interests and firm profits
in the two countries.

Glass & Saggi JIE 1999
Model
• One factor, skilled labor, available in fixed supply in each
country.
• n industries with homogeneous goods. All demand in a third
country.
• One unit of each good is produced using one unit of skilled
labor.
• m identical source firms and M identical host firms in each
industry.
• Market for skilled labor is competitive. Firms take wage as
given. The wage for skilled labor in the source country is z
and in the host country is Z.
Output market
• Let yj denote output of a representative source firm
in industry j.
• Total industry output of source firms is myj
• Let capital letters denote the host.
• Output of a representative host firm is Yj
• Total industry output of host firms is MYj
• Total output is Qj = myj + MYj the sum of source and
host production by firms in industry j.

FDI decision
• Each source firm decides whether to produce each
unit at home or abroad.
• Let aj denote the share of skilled labor demanded
abroad by a source firm in industry j, which provides
a measure of the extent of FDI.
• Host firms do not undertake FDI in the source
country. FDI seeks lower production costs, so in
equilibrium FDI occurs in only one direction.
FDI subsidy
• Suppose source firms are offered a subsidy sj for
each unit of output produced in the host country.
• If sj > 0, subsidy acts like reduction in host wage for
source firms.
• Negative values of subsidies are taxes.
• Net marginal cost of a source firm is cj = (1 – aj) z +
aj (Z – sj)
• Marginal cost of a host firm is Cj = Z.
• All firms take source and host wages as given.

• Source wage must equal host wage minus
subsidy z = Z – sj for production by source
firms to be split across countries 0 < aj < 1.
• FDI subsidy places a wedge between source
and host wages.
Output choice
• As Cournot oligopolists, each firm picks its
quantity to maximize its profits, given the
quantity chosen by the other firms.
• In a symmetric equilibrium, all industries are
identical and thus source firms split
production across countries to the same
extent regardless of industry.

Labor market
• Only a fixed supply k of skilled labor per industry is available
in the source country, so the wage must adjust to equate the
demand for skilled labor with the supply of skilled labor.
• The source labor constraint is (1 – a) my = k
• The source labor constraint relates production of each source
firm to the extent of FDI and implicitly the source wage.
• Similarly, only a fixed supply K of skilled labor per industry is
available in the host country.
• The host labor constraint is amy + MY = K
• Adding the source and host labor constraints dictates that the
total production of each industry is constant.
Q = my + MY = k + K
• With symmetric industries, the fixed availability of skilled labor
in each country fixes total output in each industry.
• This aspect of the model greatly simplifes the analysis since,
in equilibrium, price and total output in each industry are
unaffected by government policy.
• Only FDI responds to policy and thus FDI affects the
equilibrium through the changes in wages induced by FDI.

General equilibrium
• An equilibrium must specify the output of a representative
source firm y, the output of a representative host firm Y, the
source wage z, the host wage Z, and the extent of FDI a of a
representative source firm.
• The solution to the system of equations: the FDI equilibrium
condition, the first order conditions, and the labor constraints.
• The key parameters are the source skilled labor supply per
industry k, the host skilled labor supply per industry K, the
number of source firms in each industry m, and the number of
host firms in each industry M.
• Let f = m/M denote the ratio of source firms to host firms in
each industry and r = k/K denote the ratio of skilled labor in
the source relative to the host.
• Assume f > r (label the countries accordingly).
• The extent of FDI increases with the number of
source firms relative to host firms.
• The greater source labor demand due to the
increased number of source firms puts upward
pressure on the source wage, which encourages
source firms to engage in more FDI.
• Since part of the increase in labor demand is shifted
abroad through FDI, host wages increase. Thus
source wages as well as host wages increase with
the relative number of source firms.

• The extent of FDI increases with the number of
source firms relative to host firms.
• The greater source labor demand due to the
increased number of source firms puts upward
pressure on the source wage, which encourages
source firms to engage in more FDI.
• Since part of the increase in labor demand is shifted
abroad through FDI, host wages increase.
• Thus source wages as well as host wages increase
with the relative number of source firms.
Proposition 1
• An increase in the number of source relative to host
firms increases both the source and the host wage,
decreases both source and host output of each firm,
and increases the extent of FDI.
• An increase in source relative to host skilled labor
supply decreases both the source and the host
wage, increases both source and host output of
each firm, and decreases the extent of FDI.

FDI subsidies
• A subsidy to FDI directly increases the incentive for
source firms to shift production to the host country.
• This production shifting transfers labor demand
from the source to the host thereby raising host
wages and lowering source wages.
• This movement of wages implies that the source
firms enjoy a lower cost of production relative to
host firms and therefore gain market share and
enjoy higher profits.
Proposition 2
• A subsidy to FDI leads to a greater extent of
FDI, a lower source wage, a higher host
wage, larger output by each source firm and
smaller output by each host firm.
• So FDI subsidies help host workers at the
expense of host firms.
• Goes on to determine the optimal FDI subsidy
as a function of the parameters of the model.

Glass & Saggi SJE 2002
• Glass, Amy J. & K. Saggi (2002), “Multinational Firms and
Technology Transfer,” Scandinavian Journal of Economics
104(4): 495-513.
– Oligopoly model in which a multinational firm has a superior
technology compared to local firms.
– Workers employed by the multinational acquire knowledge of its
superior technology.
– The multinational may pay a wage premium to prevent local firms
from hiring its workers and thus gaining access to their knowledge.
– The host government has an incentive to attract FDI due to
technology transfer to local firms or the wage premium earned by
employees of the multinational firm.
– However, when FDI is particularly attractive to the source firm, the
host government has an incentive to discourage FDI.
Motivation
• Reversal of Attitudes: Bilateral investment treaties have been
spreading like wildfire.
– Most take the form of reducing constraints on foreign direct
investment (FDI).
– Some even create incentives for FDI.
• Importance of FDI: Foreign affiliates now account for at least
9% of GDP in developing countries.
– The gross product of such affiliates world-wide have been growing
rapidly.
• Technology Transfer: Global payments of fees and royalties
for technology transfer have been escalating.
– Almost all of these payments were within-the-firm rather than
between firms, so FDI is serving as a main conduit of technology
transfer.

Questions
• FDI Decision: What conditions make a host
country attractive to a potential multinational?
• Technology Transfer: Why might multinational
firms choose to pay wage premiums to their
workers?
– Under what conditions might multinational firms
control technology diffusion to local firms?
– When and why might substantial movement of
workers occur from multinational to local firms?
• FDI Policy: Do the interests of host workers
follow the interests of host firms?
– Do the FDI incentives facing source firms follow
the interests of host welfare? Does FDI
necessarily raise host welfare?
– Do higher wages or technology transfer due to
FDI assure that FDI generates host benefits?
– Can FDI inducing policies raise host welfare? If
so, under what situations?

Observations
• Labor Movement: less prevalent in less
developed countries. Gershenberg (1987)
observes only minor labor movement from
multinationals to Kenyan firms.
– Bloom (1992) finds substantial technological
diffusion in South Korea when production
managers left multinationals to join host firms.
– Pack (1997) notes similar findings for Taiwan.
Observations
• Wage Premiums: usually larger in less developed
countries.
– Aitken, Harrison and Lipsey (1996) show that in Mexico
and Venezuela, multinationals are paying higher wages
than local firms - even after controlling for size, location,
skill mix and capital intensity.
– Haddad and Harrison (1993) report that wages paid by
multinationals exceed wages paid by local firms in
Morocco, even for firms within the same industry.

Existing Literature
• Ethier and Markusen (1996): considers a lump-sum
payment to keep workers from leaving the
multinational en mass to start a new firm (using
their knowledge of the product technology).
– The parent prevents technology transfer precisely when
lack of technology transfer is in the interest of the local
partner.
– Hence, policy implications do not emerge from their
analysis.
Existing Literature
• Taylor (1993): allows firms to disguise their product
technology to limit technology transfer through
imitation.
– Knowledge of the technology is embedded in the product
and can be discovered by other firms through reverse
engineering.
• Salop and Scheffman (1987): captures the idea that
firms may take actions to raise their rival's costs
although also raising their own costs.
– Rivals have no means of avoiding the cost increase, so
the costs of all firm are higher in equilibrium when such a
strategy is pursued.

Overview
• Technology: A source/multinational firm possessing
a superior technology can conduct FDI in the host
market or produce elsewhere.
• Exposure: Workers are exposed to the superior
technology when they work for the multinational.
• Labor Movement: The host firm may gain access to
the multinational's superior technology by hiring
workers away from the multinational firm.
Overview
• Wage Premium: The multinational may choose to
pay a wage premium to keep the host firm from
gaining access to its technology (or produce
elsewhere).
• Equilibrium: Three different equilibria depending on
parameters: producing elsewhere (E), FDI with no
technology transfer (N), and FDI with technology
transfer (T).

Model
• Duopolistic Industry: one source firm, one host firm.
• Labor Supply: The industry faces a perfectly elastic
supply of workers whose wage in other sectors
equals 1.
• Informed Workers: Workers are informed if exposed
to the technology of the source firm; otherwise
uninformed.
– Informed workers are more productive at the host firm
than uninformed workers but no more productive at the
source firm (contrast with experience).
Model
• Production Technology: CRS, unit labor
requirement for the source firm is 1, for the
local firm is θ for informed workers and Θ for
uninformed workers, where 1 < θ < Θ.
• Γ ≡ Θ/θ >1 measures potential technology
transfer.
• θ > 1 measures incomplete technology
transfer.

Timing
• Source Wage Offer: The source firm chooses the
wage wS it offers to its workers.
• Host Wage Offer: The host firm chooses the wage
wH it offers the multinational's workers.
• Labor Allocation: Given the wages offered by the
two firms, the multinational's workers leave to work
for the host firm if offered a higher wage there.
• Output Market: Cournot competition - firms
simultaneously pick quantities qS and qH, where
their cost of production depends on the regime.
Technology Transfer
• Lemma 1: The host firm beats the source firm's wage if not
too high (iff wS < Γ) or wH = 1.
• Host Firm Indifference: At the wage Γ for informed workers,
the host firm is indifferent between hiring informed workers at
cost θΓ and hiring uninformed workers at cost Θ as θ Γ=Θ.
• Wage Premium: The source firm can curtail labor movement
by offering the wage wS = Γ = Θ/θ , which is the unit labor
requirement for uninformed relative to informed workers at the
host firm.
• Equilibrium Costs: No technology transfer cS = Γ > 1 and cH =
Θ > θ. Technology transfer cS = 1 and cH = θ.

Source Threshold
• Upper Boundary: At θ = Θ, source profits the same as costs
are the same.
• Lower Boundary: At θ = 1, source profits are higher with
technology transfer under appropriate conditions (Θ
sufficiently large).
• Source Threshold: 1 < θS < Θ such that source firm profits
under technology transfer and no technology transfer are
equal.
• Proposition 1: For all θ ≥ θS , the source firm offers the wage
wS = Γ and the no technology transfer equilibrium occurs,
whereas for all θ < θS , the source firm offers the wage wS = 1
and the technology transfer equilibrium occurs.
• Figure 1: Source Profits and Technology Transfer
Host Threshold
• Host Threshold: 1 < θW < Θ such that host welfare
under technology transfer and under no technology
transfer are equal.
• Proposition 2: For low θ, the host country benefits
more from wage premiums but receives technology
transfer. For intermediate θ, the host country
benefits more from technology transfer and receives
technology transfer. For high θ, the host country
benefits more from technology transfer but receives
wage premiums.

• Cost Elsewhere: The source firm chooses to
produce elsewhere if its marginal cost there, ω, is
sufficiently low.
• Proposition 3: When θ ≥ θS , the source firm
produces elsewhere iff the cost elsewhere is
sufficiently low ω ≤ Γ or else engages in FDI and
prevents technology transfer. When θ < θS , the
source firm produces elsewhere iff the cost
elsewhere is sufficiently low ω ≤ Ω or else engages
in FDI and allows technology transfer.
• Figure 2: Source Firm Chosen Entry Mode
Policy Analysis
• Induce FDI: Under what circumstances would the host
country want to induce FDI by the source firm?
• Technology Transfer: If θ < θS , induce FDI so that the host
firm enjoys technology transfer from the multinational firm.
• Wage Gains: If θ > θS , induce FDI so that host workers gain
higher wages from employment with the multinational firm.
Total subsidy payments required are less than the wage
premium generated (Γ - ω < Γ - 1 per unit of output).
• Proposition 4: The host government has an incentive to
induce FDI if FDI would not otherwise occur (when the wage
elsewhere ω is low) and prevent FDI if the wage elsewhere ω
is sufficiently high.
• Figure 3: Host Policy toward Foreign Direct Investment

Conclusions
• Simple Model: Technology transfer due to labor movement
between firms.
• Rationale for Attracting FDI: generate technology transfer to
local firms or increase wages for workers.
• Bad News: The two never occur together so cannot hope for
both.
• Good News: One benefit is bound to occur.
• More Bad News: FDI does not always increase welfare.
• More Good News: Paying a subsidy to induce FDI can
improve host welfare.
Mattoo, Olarreaga & Saggi JDE 2004
• Mattoo, Aaditya, Marcelo Olarreaga & Kamal Saggi (2004),
“Mode of Foreign Entry, Technology Transfer, and FDI
Policy,” Journal of Development Economics 75(1): 95-111.
– Foreign direct investment (FDI) can take place through the direct entry
of foreign firms or the acquisition of existing domestic firms.
– Examines the preferences of a foreign firm and a welfare-maximizing
host country government over these two modes of FDI in the presence
of costly technology transfer.
– The trade-off between technology transfer and market competition
emerges as a key determinant of preferences.
– The clash between the foreign firm’s equilibrium choice and the local
government’s ranking of the two modes of entry can provide a
rationale for some frequently observed FDI restrictions.

• In the model, the degree of technology transfer and the
intensity of market competition depend upon the mode of
entry chosen by the foreign firm.
• A foreign firm can choose between two modes of entry:
– direct entry by establishing a new wholly owned subsidiary, or
– acquisition of one of the existing domestic firms.
• The extent to which a host country benefits from transfers of
modern technologies and more competitive product markets
due to FDI may depend upon the mode of entry.
– Sheds light on the relationships between mode of entry, technology
transfer, and market structure.
• The competition enhancing effect of FDI is greater under
direct entry.
• However, one mode does not unambiguously dominate the
other in terms of the extent of technology transfer.
• On the one hand, the relatively larger market share that the
foreign firm enjoys under acquisition increases its incentive
for transferring costly technology (scale effect).
• On the other hand, strategic incentives to transfer technology
in order to wrest market share away from domestic rivals can
be stronger in more competitive environments (strategic
effect).

• Model is most relevant to situations where cross-
border delivery is either infeasible or not the most
efficient mode of supply.
• For example, in many services, ranging from
construction to local telecommunications,
commercial presence of foreign firms via FDI is
required in the host country.
• Divergence between the foreign firm’s choice and
the welfare interest of the domestic economy can
create a basis for policy intervention.
• For high costs of technology transfer,
domestic welfare is generally higher under
acquisition relative to direct entry, whereas
the foreign firm chooses direct entry.
– Thus, restricting direct entry to induce acquisition
can improve welfare, even in highly concentrated
markets.

• On the other hand, if the cost of technology
transfer is low, then domestic welfare is
higher under direct entry relative to
acquisition whereas the foreign firm prefers
acquisition to direct entry.
– As a result, restricting the acquisition of a
domestic firm can help improve host country
welfare by inducing direct entry by the foreign
firm.
• For intermediate costs of technology transfer, both
the government and the foreign firm prefer
acquisition to direct entry.
• Thus, the objective of frequently observed
restrictions on FDI may not be to limit inflows of
FDI, but rather to induce foreign firms to adopt the
socially preferred mode of entry in the host country.
• Restrictions on the degree of foreign ownership,
even when applied symmetrically to both modes of
entry (acquisition and direct entry), can induce the
foreign firm to adopt the host country’s preferred
mode of entry.

Literature
• Some of the issues addressed here have been
studied separately before, but no analytical study of
the relationship between technology transfer and
mode of entry by foreign firms (as in direct entry
versus acquisition).
• The literature has tended to focus on licensing and
direct entry where the foreign firm seeks to prevent
the dissipation of its technological advantage
• Potential motivations for international acquisition of
firms include: cost reduction, risk sharing, and
competition reduction.
• Lee and Shy (1992) demonstrate that restrictions on
foreign ownership may adversely affect the quality
of technology transferred by the foreign firm.
– However, they do not allow for direct entry.
• In a duopoly model, Roy et al. (1999) identify the
degree of cost asymmetry between the foreign and
local firm and market structure as the crucial
determinants of optimal domestic policy.
– However, they assume technology transfer be costless
and do not examine the differing incentive to transfer
technology under alternative market structures.

• Papers on mergers and acquisitions have shown
that when firms are symmetric, a firm will always
prefer direct entry to acquisition of an existing firm
when there is more than one target firm in the
market.
– Turns out that this result does not hold in the presence of
technology transfer, as shown later in this paper.
• There is a large literature is concerned with the
relationships between trade and competition policy
and the international effects of purely national
mergers.
– None of those papers are concerned with technology
transfer.
Model
• Two goods (z and y)
• Good y serves as a numeraire
– perfect competition
– constant returns to scale technology
• n - 1 denote domestic firms can produce good
z at constant marginal cost c.

• A foreign firm has two options for entering the
domestic market.
– acquire a domestic firm or
– set up a wholly owned subsidiary that directly
competes with domestic firms.
• Under acquisition the total number of firms in
the market equals n - 1 whereas under direct
entry it equals n.
• In the first stage, the foreign firm chooses its mode
of entry (E denotes direct entry and A denotes
acquisition).
• If it wants to acquire a domestic firm, it makes a
take-it-or-leave-it offer to the target firm which
specifies a fixed transaction price (v).
• If the target firm accepts the offer, they form a new
firm that is owned by the foreign firm.
• If the foreign firm’s offer is refused by the domestic
firm, the foreign firm can enter the market by
establishing its own subsidiary or by acquiring
another domestic firm.

• After selecting its mode of entry, the foreign firm
chooses the quality of technology to transfer to its
subsidiary.
– Technology transfer lowers the marginal cost of
production but is a costly process.
– By incurring the cost C(x), the foreign firm can lower the
cost of production of its subsidiary in the domestic
economy to c - x.
– If transfers no technology, the marginal cost of its
subsidiary equals that of the domestic firm.
• In the last stage, firms compete in a Cournot–Nash
fashion.
• Strategic effect of technology transfer: an
increase in x lowers the output of the
domestic firms thereby increasing the foreign
firm’s profits.
• Scale effect of technology transfer: the higher
the output of the foreign firm, the stronger its
incentive for technology transfer.
• Versus the cost of technology transfer.

• The strategic effect increases with the number of existing
domestic firms only if the domestic market is not too
competitive.
• By contrast, in a relatively competitive market, the presence
of an extra firm in the domestic market actually decreases the
strategic incentive to transfer technology.
– The intuition for this is that as the market gets more competitive, the
scope for strategic interactions among firms decreases and the foreign
firm’s choice regarding technology transfer has a small impact on their
output levels.
• This result helps explain why may observe greater technology
transfer under direct entry in environments that are not very
competitive.
• Proposition 1. The foreign firm transfers less
technology under acquisition than under direct entry
iff [s and n small].
• Direct entry may yield more technology transfer if s
and n are sufficiently small.
• The equilibrium technology transfers have
reasonable properties: under both direct entry and
acquisition, technology transfer diminishes with the
number of firms n as well as with the cost
parameter s.

• In the first stage of the game, the foreign firm
chooses whether to enter through acquisition or
direct entry.
• Since the foreign firm has all the bargaining power
under acquisition, a target domestic firm accepts an
offer that leaves it with a payoff equal to that it
makes as a competitor when some other domestic
firm is acquired.
• The foreign firm opts for acquisition iff it is more
profitable than direct entry.
• To focus on the equilibrium mode of entry chosen
by the foreign firm, restrict attention to the TT and
FF curves.
• The parameter space in Fig. 1 can be divided into
four regions: I, II, III, and IV.
– In regions I and II, direct entry leads to more technology
transfer whereas the foreign firm prefers acquisition.
– In region III, acquisition leads to more technology transfer
and is indeed preferred by the foreign firm.
– Finally, in region IV, direct entry is chosen by the foreign
firm whereas acquisition leads to more technology
transfer.

• Proposition 2. In the host country, consumers are
better off under direct entry than under acquisition
whereas a typical domestic producer is better off
under acquisition.
• Thus, we have a conflict between the interests of
domestic producers and consumers.
• Given this conflict, the main question is whether
total domestic welfare (defined as the sum of
consumer surplus and producer surplus) is higher
under direct entry or acquisition.
• Proposition 3. While an asymmetric equity
restriction makes acquisition less attractive to the
foreign firm, a symmetric equity restriction makes
direct entry less attractive.
• Equity restrictions are not the only means of
inducing the foreign firm to adopt a different mode
of entry.
• Fiscal and financial incentives (such as the
frequently witnessed tax breaks and subsidies to
FDI) can also be used to induce direct entry.
– Such concessions impose budgetary costs on the
government that equity restrictions do not.

Desai, Foley & Hines JPubE 2004
• Desai, Mihir, Fritz Foley & James Hines (2004).
“Foreign Direct Investment in a World of Multiple
Taxes,” Journal of Public Economics 88(12): 2727-
2744.
• This paper examines the impact of indirect (non-
income) taxes on FDI by American multinational
firms, using affiliate-level data that permit the
introduction of controls for parent companies and
affiliate industries.
• Indirect tax burdens significantly exceed the foreign
income tax obligations of foreign affiliates of
American companies.

• Estimates imply that 10% higher local indirect tax
rates are associated with 7.1% lower affiliate
assets, which is similar to the effect of 10% higher
income tax rates.
• Affiliate output falls by 2.9% as indirect taxes rise by
10%, while higher income taxes have more modest
output effects.
• High corporate income tax rates depress
capital/labor ratios and profit rates of foreign
affiliates, whereas high indirect tax rates do not.
• The role of non-income taxes may be particularly important
for FDI, since governments of many countries (including the
United States) permit multinational firms to claim foreign tax
credits for corporate income taxes paid to foreign
governments
– but do not extend this privilege to taxes other than income taxes.
• As a result, taxes for which firms are ineligible to claim credits
may well have greater impact on decision-making than do
(creditable) income taxes.
• Since the foreign indirect tax obligations of American
multinational firms are more than one and a half times their
direct tax obligations, there is obvious scope for indirect taxes
to influence their behavior.

• The first is to measure the extent to which levels of FDI and
rates of indirect taxation are associated, in order to assess
the potential importance of indirect taxes for FDI.
• The second purpose is to compare the effects of indirect
taxes and corporate income taxes in order to refine the
interpretation of existing evidence of the negative association
between corporate income tax rates and levels of FDI.
• Differences in the responsiveness of FDI to income taxation
and indirect taxation provide a starting point for disentangling
alternative explanations for why tax rate differences appear to
have the effects that they do on FDI.
• The likely impact of indirect taxes on FDI differs from that of
corporate income taxes in three important ways.
• First, indirect tax obligations are not functions of reported
income and are therefore little, if at all, affected by the
financing of foreign affiliates and by the prices used for intra-
firm transfers.
– Hence the measured effect of indirect taxes on FDI is unlikely to
reflect the use of FDI to engage in tax-motivated financing and
transfer pricing.
• Second, income taxes encourage firms to reduce their
capital/labor ratios (and therefore FDI), while indirect taxes do
so to a much lesser degree.

• Third, American firms are ineligible to claim foreign
tax credits for indirect tax payments, so they are
likely to be as sensitive to indirect tax rate
differences as are local firms.
• These three features of the incentives created by
indirect taxes narrow the range of channels through
which indirect taxes are likely to affect FDI.
• The empirical results indicate that high tax rates are
associated with reduced FDI by American
multinational firms, and that this association is
apparent for all types of taxes, including taxes other
than corporate income taxes.
• Indirect tax rates are negatively correlated with investment
levels - as measured by assets - roughly to the same degree
as are corporate income tax rates.
• The estimates imply that American affiliates located in
countries with 10% higher indirect tax rates have 7.1% fewer
assets, and those in countries with 10% higher corporate
income tax rates have 6.6% fewer assets.
• These effects on investment levels are mirrored in effects on
output, as 10% higher indirect tax rates are associated with
2.9% less output, and 10% higher income tax rates are
associated with 1.9% less output.

• High income tax rates depress affiliate capital/labor
ratios and profit rates, while high indirect tax rates
have no discernable effects on these variables.
• Hence it appears that high income tax rates are
associated with low levels of FDI because they
impose additional costs on investments, encourage
taxpayers to substitute labor for capital, and affect
the returns to reallocating taxable income.
• High indirect tax rates reduce FDI only by imposing
additional costs, but the magnitude of their impact is
comparable to that of income taxes, reflecting, in
part, the non-creditability of indirect tax payments.
• Reviews existing systems of taxing
international income
• Evaluates the evidence of the impact of
income taxation on FDI, and
• Considers the incentives facing American
firms investing in foreign countries using
multiple tax instruments.

International Tax Practice
• Almost all countries tax income generated by
economic activity that takes place within their
borders, usually doing so at the same rates that
they tax local businesses.
• In addition, many countries, including the United
States, tax the foreign incomes of their residents.
• To prevent double taxation of the foreign income of
Americans, United States law permits taxpayers to
claim foreign tax credits for income taxes (and
related taxes) paid to foreign governments.
• The United States corporate tax rate is 35%, so an
American corporation that earns $100 in a foreign
country with a 10% tax rate pays taxes of
– $10 to the foreign government and $25 to the United
States government,
– since its United States corporate tax liability of $35 is
reduced to $25 by the foreign tax credit of $10.
• Since the foreign tax credit is intended to alleviate
international double taxation, and not to reduce
United States tax liabilities on profits earned within
the United States, the foreign tax credit is limited to
United States tax liability on foreign-source income.

• International tax rules and the tax laws of
other countries have the potential to influence
a wide range of corporate and individual
behavior, including, most directly, the location
and scope of international business activity.
• A sizable literature is devoted to measuring
behavioral responses to international tax
rules, finding that multinational firms invest
less in high-tax countries than they do in
otherwise-similar low-tax countries.
• Extensive evidence that firms arrange financial
flows and intra-firm sales between parent
companies and subsidiaries within controlled
groups in order to reallocate taxable income from
affiliates in high-tax countries to affiliates in low-tax
countries.
• Indirect taxes include any type of tax other than
income and payroll taxes, as the BEA survey form
asks for the sum of sales, value added, and excise
taxes; property taxes; and import and export duties.

• Fig. 1 depicts the ratio of indirect taxes to foreign
income taxes paid by American multinational firms
from 1982 to 1997.
• Throughout the sample period, indirect taxes are
much larger than income taxes.
• This ratio exceeds 1.5 for every year of the sample
across all industries and for affiliates in
manufacturing.
• Also depicts a significant increase in the relative
importance of indirect taxes from the middle of the
1980s through the middle of the 1990s.

• Fig. 2 displays the ratio of indirect taxes to
income taxes across all industries by country
in 1994, the most recent benchmark year for
which data are available, and during which
the worldwide ratio of indirect taxes to income
taxes was 3.5.
• For some countries, such as the Bahamas,
this ratio is very large due to the relative
unimportance of income taxes.
• Several large countries that host considerable
amounts of United States outbound FDI impose
heavy income tax burdens but nevertheless collect
indirect taxes that greatly exceed their income tax
collections.
• In particular, indirect tax rates appear to be high in
Europe, as nine of the 10 countries with the largest
ratios are European.
• Many countries in Latin America, such as Argentina
and Brazil, also have ratios of indirect to income
taxes that exceed the worldwide ratio of 3.5.

• Fig. 3 shows the ratio of the indirect to income tax
payments of United States affiliates by industry
group.
• Indirect taxes paid exceed direct taxes paid in nine
of the 12 industry groups depicted.
• Substantial variation in the incidence of indirect
taxes across industries.
– The relative burden of indirect taxes is largest in the
petroleum sector, where indirect taxes are more than
eight times larger than income taxes.
– Indirect taxes are notably lower than income taxes in
financial services and other service industries

• The empirical literature clearly portray a
negative relationship between local corporate
profit tax rates and FDI
• There are three ways in which high profit tax
rates might reduce investment: by reducing
the scale of local business activity, by
reducing the capital intensity of any given
level of business activity, and by encouraging
the relocation of assets to facilitate the
relocation of profits.

• The first effect is that high tax rates increase total costs
incurred by businesses in heavily taxed industries, so will
generally lead to reduced production in order to maintain the
profitability of local producers.
• The net impact on FDI of this reduced scale of activity is
ambiguous; if production by foreign investors entails costs
that are similar to those faced by local firms, then FDI should
decline in a manner similar to that of local investment.
• If, however, foreign investors produce using different factor
combinations than local producers, then the factor and output
price reactions to higher tax rates will affect the profitability of
FDI, which in turn might rise or fall.
• The second effect of corporate profit taxes is
that for any given level of output, high
corporate profit taxes have a depressing
effect on investment and FDI,
– since the taxation of the return to capital
encourages firms to substitute away from capital
inputs and toward tax-deductible inputs such as
labor.

• Third, multinational firms have at their disposal
financial and other means to reallocate taxable
income from high-tax to low-tax countries.
• This carries investment implications, since high
levels of FDI may be necessary in order to justify
large profits that are reported to have been earned
in low-tax locations.
• Hence a low corporate income tax rate makes a
country an attractive location for FDI in part
because it can then provide the means of
reallocating taxable income from higher-tax
jurisdictions
Chor JIE 2009
• Chor, Davin (2009), “Subsidies for FDI:
Implications from a Model with
Heterogeneous Firms,” Journal of
International Economics 78(1): 113-125.

Glass Mimeo 2012
• Glass, A.J. (2012), “Intellectual Property Policy and
International Technology” Diffusion” Mimeo Texas
A&M.
– How do technology spillovers affect a foreign firm’s
decision whether to produce in a host country?
– How does foreign direct investment (FDI) affect the
host country?
– Can stronger intellectual property (IP) protection
attract FDI?
– Does the host country benefit?
– Is IP protection a good way to attract FDI?
Glass Mimeo 2012
Empirical Evidence
• Support for FDI generating technology
spillovers:
– Haddad and Harrison (1993), Kokko (1994).
• Support for IP protection affecting FDI:
– Lee and Mansfield (1996), Smith (2001),
Javoncik (2001), Nunnenkamp and Spatz (2004).

Glass Mimeo 2012
Existing Models
• Technology spillovers influence FDI
decisions:
– Siotis (1999), Petit and Sanna-Randaccio (2000).
• Multinational firms control technology
spillovers through labor mobility by paying
high wages:
– Markusen (2001), Fosfuri, Motta, and Ronde
(2001), Glass and Saggi (2002).
Glass Mimeo 2012
Model of Technology Spillovers
• One source and one host firm (n host firms later).
• Source firm has superior process technology.
• Source firm chooses exports or FDI.
• FDI lowers cost of source firm: marginal cost 1 with
FDI, Ω > 1 without.
• FDI also lowers cost of host firm due to technology
spillovers: marginal cost θ with FDI, Θ > θ without.

Glass Mimeo 2012
Spillovers & Host Firm’s Costs
• Host country’s IP protection sets fraction μ of
technology that may be legally imitated.
• Technology spillovers generate knowledge
flows to host firm, fraction σj.
– Spillovers larger under FDI than exports σX < σF,
σX = σF/Ψ, Ψ > 1
• Host firms able to absorb fraction α.
Glass Mimeo 2012
Host Firm’s Costs
• Host firm’s technology (unit labor
requirement) is weighted average of source
firm’s superior technology of 1 and existing
technology Γ > 1.
• Weights are ασjμ and 1 - ασjμ.
θ = ασFμ + (1− ασFμ) Γ, when FDI.
Θ = ασXμ + (1− ασXμ) Γ, when exports.

Glass Mimeo 2012
Timing
• Host country sets its IP protection.
• Source firm chooses FDI or exports.
• Spillovers and absorption occurs.
• Host and source firm pick quantities (standard
asymmetric Cournot duopoly/oligopoly).
• Resulting prices, profits, consumer surplus,
and welfare determined.
Glass Mimeo 2012
Source Profits
• IP protection limits degree that host rival can use
technology spillovers.
• Stronger IP protection raises cost of host rival more
under FDI than exports due to greater degree of
technology spillovers.
• Source profits increase with IP protection (decrease
with imitation) more under FDI than exports.
μμ
θ
σσ
∂
Θ∂
>
∂
∂
→> XF

Glass Mimeo 2012
21
Sourceprofits
0 1
Fraction legally copied
S F
S X
μ S
ExportsFDI
• Source imitation threshold μS is level of IP
protection such that source profits under FDI
equal source profits under exports.
• It is minimum level of IP protection required
for source firm to choose FDI.
• When IP protection sufficiently strong, source
firm chooses FDI (otherwise exports).
)()( S
X
SS
F
S μπμπ =
Glass Mimeo 2012

Glass Mimeo 2012
Proposition 1
• IP protection can be used to attract FDI.
• FDI occurs when imitation sufficiently low μ <
μS.
( )1
1
1
11
1
−Γ⎟
⎠
⎞
⎜
⎝
⎛
Ψ
−
−Ω
⎟
⎠
⎞
⎜
⎝
⎛
+=
ασ
μ
n
S
Glass Mimeo 2012
Proposition 2
• The source threshold decreases with
– Larger technology gap Γ.
– Larger technology spillovers under FDI relative to
exports Ψ.
– Larger absorption ability α.
– Larger number of host firms n.
– Smaller cost reduction Ω.

Glass Mimeo 2012
Host Profits
• Recall that IP protection limits degree that
host firm can use technology spillovers.
• Stronger IP protection raises cost of host firm
more under FDI than exports.
• Host profits decrease with IP protection
(increase with imitation) more under FDI than
exports.
Glass Mimeo 2012
4
Hostprofits
0 1
Fraction legally copied
H F
H X
μ H
Benefit from FDIHarm
μ S

• Host imitation threshold μH is level of IP
protection such that host profits under FDI
equal host profits under exports.
• It is maximum level of IP protection such that
host firm benefits from FDI by source firm.
• When IP protection is sufficiently weak, host
firm prefers FDI (otherwise exports).
)()( H
X
HH
F
H μπμπ =
Glass Mimeo 2012
Proposition 3
• The host country can benefit from using IP
protection to attract FDI.
• The host firm benefits from FDI by the source
firm provided IP protection sufficiently weak μ
> μH.
( )1
1
12
1
−Γ⎟
⎠
⎞
⎜
⎝
⎛
Ψ
−
−Ω
=
ασ
μH
Glass Mimeo 2012

• Host threshold lower than source threshold.
• At source imitation threshold, FDI benefits
host country: host profits and consumer
surplus rise (lower price & higher quantity).
• Possible for host country to benefit by
strengthening IP protection to attract FDI.
• Does host country always benefit? No.
4/SH μμ =
Glass Mimeo 2012
Host Country IP Protection
• Host profits may fall if start from weak IP
protection.
• FDI adversely selected in industries with least
benefits for host.
• With multiple industries, gain in one industry
can be offset by losses in other industries due
to higher costs for host firms.
Glass Mimeo 2012

Conclusions
• Raising IP protection can attract FDI,
provided FDI generates larger technology
spillovers than exports.
• Doing so need not benefit host country.
– Handicaps local firms.
– Adversely selects FDI with least benefits for host
country.
– Applied equally across industries.
Glass Mimeo 2012
• IP protection not best policy instrument for
attracting FDI.
• Use targeted financial incentives.
• Make country more attractive in other ways.
Glass Mimeo 2012

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