The Perfect Capital Mobility Theory

Published Date: 02 Nov 2017

Introduction

In this section of the paper Foreign Direct Investment has been looked upon in reference to the area of interest, i.e. Pakistan. Overall and sector wise trends of inflows have been analyzed together with public policies or tax reforms that were responsible for explaining these trends. Important definitions of keywords are given in the end followed by the study objectives of the paper.

International mobility of capital and inflow of foreign investment in Pakistan; historic evolution

Investment is the one of the four main components of Gross Domestic Product that allows economists to assess the economic condition of a country. However a major downside to this variable is its volatile nature. For any closed economy investment is induced by domestic saving, while for an open economy the stimuli for investment are not limited to the level of savings. With globalization and liberalization of trade the prospects of investment from abroad have increased. Governments formulate more market friendly policies to attract foreign capital.

The perfect capital mobility theory predicts that countries with high relative savings have higher investments; either domestic or foreign, depending on which investment offers relatively high rates of return. This freedom of capital to move across borders is called international capital mobility. In the case of developing countries like Pakistan the levels of savings fall below the desired level necessary to stimulate the economic growth process. This is a problem for these countries because they suffer from low per capital income, and rely on foreign investment to cover for the resulting investment gap.

Foreign companies were operating in the sub-continent since the time of East India Company and continued to do so after independence, despite the fact that migration process left the industrial setups and infrastructure facilities in poor operating conditions. For most years since the time of its inception, the contribution of Foreign Direct Investment to Pakistan’s GDP has remained below 1%.

In early year the investment was undertaken with local partners. The first foreign company that came in 1947 was the British-American Tobacco that established Pakistan Tobacco Company, followed by Unilever forming Lever Brothers Pakistan Limited in 1948. The pharmaceutical sector was also successful in attracting lager multinational corporations such as Abbott Pakistan and GlaxoSmithKline. Side by side the Japanese automobile companies also realized the Pakistan as potential investing market due to the availability of natural resources that were highly untapped.

It was by the end of 1980s during the governments of Benazir Bhutto and Nawaz Sharif that Pakistan’s efforts to attract FDI were intensified. This was with the introduction of liberalization, privatization and deregulation policies by the respective governments. Table 1 shows that Zulfiqar Ali Bhutto’s nationalization policy actually caused investment to flee out of the country. An important conclusion that can be derived from this trend is that the investment patterns are influenced by the host country’s policies. The amount of net inflows of foreign direct investment increased from $10.7 million in 1976-77 to $1101.7 in 1995-96. The sudden jump in 1995-96 was associated with investment in power sectors. However in the following years foreign investment fell due to political instability in the country. Under Nawaz Sharif’s government in 1998 Pakistan conducted its first nuclear test which was condemned by the world. Major trading partners especially the United States imposed economic sanctions in response and this accounted for further decline in investment in the late 1990s. Some of the sanctions were lifted after a few months but were removed completely by President Bush in 2001 after 9/11. This was because US policy makers recognized that US-Pakistan relationships had to be mended because of its unique geographical position to access Afghan borders. The data on Foreign Direct Investment flows (Table 1) shows an increasing trend from 2001-02 onwards.

Although in absolute terms foreign investment seems significant, compared to other countries the increase is trivial. Table 2 compares investment flows to Pakistan with five other East and South East Asian countries and UK and USA. Due to different economic and political situations comparison with UK and USA is of less importance to us. However, looking at Pakistan’s trend in relation with other East and South-East Asian countries is relatively more useful. FDI flows to these countries have shown rising trends during the 1909s. However due to the Asian Financial Crisis in 1997 they saw decline in investments from abroad. By 1999 economic analysts began to see signs of recovery. But it was not until 2004 that they recovered completely and began to experience high foreign investments inflows. Pakistan remained in the bottom two foreign direct investment receiving countries, while China because of availability of skilled low-wage labor was able to attract the highest level of investment.

Types of Foreign Direct Investment and sectoral analysis

1.2.1 Types

Types of Foreign Direct Investment are categorized by direction, target and motive of the investment. Characteristics of each category and their sub divisions are discussed below.

i. By Direction

a. Inward

Inward foreign direct investment is the type of investment where rather than setting-up new factories or businesses investors instead spend in local companies.

b. Outward

Outward foreign direct investment when local capital is invested in foreign resources.

ii. By Target

Greenfield Investment

This is the form of investment where multinational companies expand investment into developing countries by building new factories. And the developing countries’ governments encourage this form of investment by offering incentives such as tax-breaks and subsidies. The reason behind these flexible policies is that governments believe that losing some amount of tax revenue in the short run will benefit them by creating employment and transferring technology in the long run.

Mergers and Acquisitions

Integration of assets and operations of firms from different countries to establish a new business unit is termed as mergers. And when the control of assets and operations is transferred from local to foreign firms it is called acquisition. This type of Foreign Direct Investment is further divided into two; horizontal and vertical investment.

The company that wishes to invest abroad replicates its production activities in the host country rather than cater to its market by exports. This is because of high transportation costs or trade barriers involved. It is therefore referred to as horizontal investment. Vertical investment on the other hand is related to outsourcing of production stages. The idea behind this type of investment is to split the production chain to those countries where the input prices are relatively lower. This is further segregated into backward and forward vertical investment. Backward is the kind where the parent company establishes its input supplier in the host country, while under the forward collaborates with a local partner to produce goods from the raw material coming in from the parent company.

iii. By Motive

Resource-Seeking

This type of investment usually occurs in developing or transition economies in search of efficient factors of productions. These countries are favorable targets because of their vast unexplored and unexploited resources. And low cost or specialized labor is another major attraction for foreign companies. The goods produced from this type of investment are generally for export purposes.

Market-Seeking

Multinational companies take up this form of investment when they wish to penetrate new markets; usually the local markets of host countries. However it is argued that this type of investment is actually defensive in its nature rather than businesses’ desire to cater new markets. Companies fear being driven out of their existing market because of import barriers so seek new markets to shift their production process to.

Efficiency-Seeking

After resource or market seeking investments have taken place and theirs benefits reaped companies decide to merge operations on product or process basis in order to take advantage of the economies of scale and scope. It is a pre-requisite for this type of investment to take place that the markets are integrated because only then will each market be able to specialize in a product and trade among each other. Most developed economies such as the European Union witness efficiency-seeking investment.

Strategic Asset-Seeking

It is common in industrialized countries where companies carefully plan to invest in such activities that maintains theirs competitive advantage over the competitors. This investment is usually Research and Development based.

1.2.2 Sectoral Analysis

In Section 1.1 we examined the trends in Foreign Direct Investment to Pakistan from 1947 to 2012. Having done that it is also useful to analyze the sectoral distribution as it allows us to observe what sectors are given preferential treatments to encourage investment and what sectors are preferred by the foreign investors. During 1980-1994 foreign investors were more inclined towards manufacturing industries, mining and quarrying. Though manufacturing sector drew high investments, much of it fluctuated greatly. In 1983 it fell to a level of 26% from 74.6% in 1982 and rose back to 54.7% in 1984. From 1987-1993 it fell to an average level of 11% despite privatization and liberalization policies that were attracting high net foreign investment in the country. A possible explanation for this is that the political instability in the Pakistan during this era was deterring investment to manufacturing. However, on the other hand this decline was substituted by the rise in investment in mining and quarrying particularly in the petroleum sector.

These significant changes in the composition of FDI can also be explained in context to pre and post liberalization reforms for foreign investment. In the post reform period trade, construction and utilities sector boomed while the manufacturing industries registered sharp decline. The share of utilities in total FDI share jumped from zero in 1998 to 31.7% in 1994. This massive increase was the result of Hubco Corporation’s $ 7 billion worth of investment in the power sector of Pakistan. The banking sector flourished after the reforms were introduced. More credit was available to the private sector that engaged investment from abroad. However sectors such as agriculture, communication, transport and storage received inadequate flows because of limited resource exploitation opportunities.

Contrary to the situation in 1990s the services sector attracted major chunk of foreign investment in 2000s. The financial sector that started progressing in the 90s saw massive inflow of foreign capital by the end of 2005-06. Services sector contribution to GDP increased by 66%, with Telecom sector bringing in $ 1987.7 billion and accounting for 55% of total FDI during 2005-06. But due to political and socio-economic factors profits were repatriated and exceeding the investment entering the country, leading to major decrease in investment in subsequent years and has continued this trend till present. Also Oil and Gas exploration has been the highest foreign investment attracting sector throughout and by the end of 2012 it accounted for $302.9 million worth of FDI.

Review of public policies, investment policies and tax reforms for enhancing domestic foreign direct investment

The policies of a host country are crucial in determining the level of Foreign Direct Investment. More consistent policies imply political stability thus building up Multinational Companies’ confidence and thereby their amount of investment. Moreover, theses policies can be channel investment towards a particular sector that the government considers to be of importance in economic growth.

Pakistan was initially an agro-based economy with negligible industrial capacity, so it was an important task for all governments to improve the manufacturing capacity in order to bring about development and growth. Over the years governments have implemented a blend of policies focusing either on private or public sectors and providing incentives in form of subsidies and tax cuts.

During 1950s and 1960s policies were designed so as to target the private sector. Public sector’s involvement was limited to the arms and ammunition, developing infrastructural facilities and printing of currency notes. In 1972 Bhutto’s government began the nationalization through the country. Management of all major industries, commercial banks and financial institutions was takeover by the public sector. This shift from private to public sector control resulted in a major setback to private domestic and foreign investor’s confidence.

Following the dismal performance of the economy due to nationalization, the industrial policies introduced in the 1980s pursued a pattern of mixed economy where equal importance was given to the public and private sector. To improve the business environment in Pakistan and attract foreign investment a Board of Investment (BOI) was established to provide investment services and generate foreign investment opportunities. Additionally the exchange rate regime was liberalized and Export Processing Zones were setup in Karachi to encourage export-oriented investment. These zones offered duty free import and export of goods and tax exemptions. Despite these incentive based policies inflows of foreign investment remained low due to public ownership in major industries, high tariffs to protect domestic infant industries, price controls and inefficient financial sector.

In 1990s liberal market oriented policies were introduced and privatization process was initiated that became a chief source of attraction from foreign investors. All special registrations and governmental approval requirements for FDI were removed. Fiscal incentive such as tax holidays, custom duty and sales tax concessions were granted. Majority of tariff and non-tariff barriers were removed and more export incentives were granted.

In 2000s the policies of 1990s continued except that the government also shifted its focus towards high-tech industries along with export-oriented ones. Another policy development was that agreements for avoidance of double taxation were signed by the government with fifty-two developed as well as developing countries.

Elements of low levels and volatile behavior of MNCs

There are a number of political, institutional and socio-economic factors that affect the level of investment by multinational corporations in Pakistan. It is essential for policy makers to study these factors in order to device strategies that would make up for the lost investment.

The first and foremost element is the poor law and order situation in the country which has lead to political instability. Frequent changes in governments since 1988 were followed by regular changes in policies which have decreased investor confidence. Moreover there is another major issue of corruption and lack of transparency at all levels in the government and administration departments that deter investments. Also the fundamental obstruction to investment is our week legal system under which the enforceability of contracts is uncertain.

Then there is availability and cost of infrastructure facilities such as roads, railways, telecommunication and power, that affect FDI. Due to political and institutional failures this factor also lacks behind in attracting MNCs to invest.

On the economic side countries with higher economic growth rate and stable macroeconomic indicators attract more investment. This is because in larger stable markets people have high purchasing power thus demand more goods and services which attracts investment from abroad. But poor unpredictable macroeconomic variable of Pakistan indicate high fluctuations in foreign investment. Then there is the element of shortage of skilled labor force.

And then the factor of tax structure of Pakistan that too majorly influences the level of Foreign Direct Investment. In addition to corporate taxes on the income of companies, many direct and indirect taxes are imposed at federal, provincial and local levels. The complex nature of tax system and additional taxes levied on corporations increase their costs and discourage investment.

Data Vendor’s perspective, rational expectations and investment climate

Based on the rational expectations theory of Milton Friedman economic agents’ investment decisions are not dependent on their past experiences, but also on future economic conditions. This re-implies the concept that with changes in economic situations of a country investor’s investment decisions change.

For the purpose of making efficient strategic decisions in the future companies have to look at future forecasts on various economic variables, the data on which is made available to them by data vendors. Prominent reliable data vendors are the Economic Intelligence Unit (EUI) and the Political Risk Services (PRS) Group. They facilitate the MNCs investment decisions in other markets; especially in the emerging ones, by providing complete country reports on government and institutional strength, economic and social variables.

1.6 Keywords and definitions

1.6.1 Foreign Direct Investment

"Foreign Direct Investment is a category of international investment made by a resident entity of one economy with the objective of establishing a lasting interest in an enterprise resident in an economy other than that of the investor. "Lasting interest" implies long-term relationship between the direct investor and the enterprise and a significant degree of influence by the direct investor on the management of the direct investment enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated." (OECD Benchmark Definition of Foreign Direct Investment, 3rd edition)

1.6.2 Corporate income taxation

"Corporate income tax is imposed on net profits, computed as the excess of receipts over allowable costs." (Britannica Encyclopedia)

Study Objectives

The purpose of this paper is to analyze how Foreign Direct Investment inflows to Pakistan respond to taxes imposed on the income of MNCs. Estimating the role taxes play among other factors; that determine the level of inflows, in modifying the amount of foreign investment flowing into the country and then based on these results providing policy recommendations to encourage investors.

Literature Review

This section of the paper looks at the studies that have been conducted on a variety of aspects of Foreign Direct Investment. Initially presenting a cross country analysis of the inflow patterns in high income, developing and low income countries it moves towards establishing an understanding regarding its impacts on an economy in the short and long run. General theories that explain why and what factors stimulate Foreign Direct Investment have also been discussed to develop a solid base for empirical analysis in the following section. The last two parts of this section are based on the role of government to attract investment from abroad. A number of public policies have been looked upon along with issues of tax compliance and corruption in the administration system.

2.1 Cross country overview of the foreign investment inflows in different classification of countries

This section of the paper studies the variation in foreign investment inflows to countries that are in separate economic phases. A Range of factors affect the investment location decisions of Multinational Corporations that vary from country to country. A cross country overview will allow us to see what factors MNCs value higher than others. They have been broadly divided in three main genres; high income OECD countries, developing countries and low income countries.

2.1.1 High Income OECD countries

Mariotti, S. et al, 2003 puts forward the idea that developed countries usually witness horizontal form of foreign direct investment inflows that are driven by market seeking strategies; i.e. to take advantage of new large markets. The economic theory explains that foreign direct investment to developed countries usually flows to high technology production from other developed countries because of small differences in rates of return and availability of capital among them (Lipsey, 2000).

In economic literature Foreign Direct Investment inflows as a percentage of Gross Domestic Product is the most common indicator used for analyzing foreign investment inflows. In 2000 the developed countries received 4.6 percent FDI of their GDP, and amongst these European Union was the most attractive region obtaining 8.5 percent share of FDI. Botric and Skuflic (2005) conclude that this was a result of deep integration among European Union members and the expansion of its markets.

According to the European Competitiveness Report 2012 (15th edition) while intra EU inflows and those from the non-EU members were hit significantly by the global recession of 2008 only the investment from US remained unaffected. In contrast to movement of investment from developed countries, developing and transition economies such as Western Asia have been an important investor in the European markets. Following them are emerging countries like China and India which are becoming increasingly active in this region.

In the September 2002 issue of OECD International Investment Perspectives these countries were reported to have seen a large drop of around 56 percent in their FDI inflows. This sharp decline affected each country differently; while Germany, Belgium, United States, United Kingdom and Japan that were the largest players in attracting investment saw their inflows decline France and Italy depicted an opposite trend by attracting relatively more inflows. The decline in flows is mainly attributed to equity price deflation and loss of investors’ confidence during the cyclical slowdown.

2.1.2 Developing countries

Developing countries are usually characterized by low savings and as capital deficient. Foreign Direct Investment not only acts as a stable source of investment but allows technology transfer and generates employment thus allowing these countries to achieve economic growth (Mottaleb and Kalirajan, 2010).

In their discussion of why some developing countries have been able to attract more investment compared to others Hussain and Kimuli (2012) state that MNCs’ decision to re-locate part of their production process is driven by the differential in factor prices and factor endowment between home and host country. On one hand where high investment inflows to China and India in 2000 suggest that market size is an important determinant, the recent decline in China and a considerable rise to India implies that institutional quality is also an important factor.

Eid and Parua (2002) observed FDI trends in the Middle East region and concluded that a major chunk of investment coming in from industrialized countries; particularly US, UK and Japan, goes into petroleum related activities. Other sectors constitute of manufacturing, tourism, banking, and telecommunication. Countries like Saudi Arabia, Egypt, Bahrain and Morocco are the largest recipients of foreign investment, whereas Libya, Kuwait and Yemen received the lowest share of FDI in this region.

2.1.3 Low income countries

Generally low-income countries are perceived to be dependent on aid for growth and development purposes and practically receive no foreign investment. Sub-Saharan African countries are particularly seen to fit this opinion. And despite the fact that the relationship between FDI and growth in low-income countries strengthened during the globalization period yet the overall inflows have remained low. Many factors specific to low income countries contribute towards this trend such as high population growth, poor health facilities, lack of primary education and reliance on traditional method rather than incorporating technology.

Numerous studies present the evidence that population health is a vigorous source of growth in per capital income (Barro, 1991; Bhargava, Jamison, Lau and Murray, 2001; Bloom, Canning and Sevill, 2004). Moreover research conducted by Knaul (1999), Ribero (1999) and Savedoff and Schultz (2000) consistently show that health affects worker productivity. Thus health that is taken as a proxy for human capital affects FDI through several mechanisms. Improvement in labor productivity and rise in per capita income are among the factors that attract foreign investment.

It is often concluded in literature that foreign investment that goes to low income countries is often directed towards the mining and petroleum sector. Martin and Innes (2004) conducted a research on seven low-income countries; Malawi, Ghana, Gambia, Uganda, Zambia, Tanzania and Guyana. Their study provided contradicting the evidence, among these countries only in Tanzania and Zambia was mining the largest sector attracting foreign private capital. Manufacturing in Malawi, Uganda and Ghana, finance in Zambia and tourism in Malawi have also been successful in attracting foreign investment.

2.2 Foreign investment and the macro economy

The impact foreign investment has on the economy of the host country and its role for further growth process has been a debatable topic for many countries. This section of the paper looks at various short and long term conclusions drawn by researchers on this subject.

2.3 And overview of theories explaining Foreign Direct Investment inflows

2.3.1 The first theoretical attempt: Neoclassical Trade Theory

The neoclassical trade theory used the Heckscher-Ohlin model to explain FDI which was taken to be a part of international capital trade. The Heckscher-Ohlin model was based on the general equilibrium framework with two countries; home and foreign, two factors of production; capital and labor, and two goods; capital and labor intensive. The assumptions of this model were perfect competition in goods and factor market, constant returns to scale and no transportation costs. According to this model capital abundant home country would export the capital intensive good or move the capital itself to the labor abundant foreign country where returns on capital are higher until the return was equal in both countries.

MacDougall (1960) and Kemp (1964) confirmed the finds of Heckscher-Ohlin model but they emphasized on the idea that capital inflows despite high capital returns could be influenced if the host country imposed taxes on capital. Aliber (1970) expanded the view by including currency risk as a factor that could affect capital returns. The mechanism behind this was that when firms from countries with a stable currency borrowed money from countries with much volatile currencies, they are charged a lower interest rates compared domestic firms that have lower risk of losing their investment value due to currency depreciation. Thus international firms are at advantage to invest abroad.

Despite its usefulness in understanding the incentives for attracting FDI the neoclassical approach has been criticized for its over simplified and unrealistic assumption of perfect competition (Hymer, 1976; Kindleberger, 1969). Zerbergs (1998) argues that the model fails to explain the investment flows to less-developed or transition economies.

2.3.2 Monopolistic Advantage Theory

Having criticized the neoclassical trade theory Hymer (1976) and Kindleberegr (1969) came up with their own explanations of FDI inflows. Both of them were of the view that foreign firms needed advantages such as new technology, managerial expertise, right to product differentiation patents and other incentives by the government of the host country to compensate for the disadvantages they face by entering a new market.

In 1966, Vernon came up with the product life cycle hypothesis according to which as a product moved through three stages (new, mature and standardized production) the investment decision changes from exporting to setting up foreign production. The rationale behind this change in investment decision is that cost saving from transportation and international barriers. A drawback of this hypothesis is that it explains why developed countries make foreign investment decisions but fails to explain why developing countries might be interested in investing in developed economies.

According to Coase (1937) the neoclassical theory assumption of perfect information has a cost to pay because in real markets there is asymmetry of information resulting in transactions costs for firms. He therefore suggested that firms were better off internalizing transactions. Hennart (1982, 1991) also saw FDI as a response to nature market imperfections such as asymmetry in information rather than structural imperfections like market power (monopoly). Whereas Teece (1981, 1985) believed that only vertical FDI was in response to imperfect information while horizontal FDI was in response to both imperfect information and market power.

2.3.3 FDI and trade: Substitutes or Complementary

Another theory explaining the movement of foreign investment among countries came in 1968 when Mundell argued that high trade barriers deter the movement of commodities, i.e. reduce exports from home country to host country. In such scenarios factor movements are substituted with commodities. Firms find it more profitable to setup production abroad to cater foreign market demand. Thus FDI is becomes a perfect substitute for exports.

The theory is criticized by researchers because trade and FDI can never be perfect substitutes to each other in the real world, in fact they co-exist. Empirical evidence reveals that some typse of FDI inflows expand trade, while others reduce the trade volume. Johnson (2005, 2006) proved that the FDI outflows from economies in the transitioning stage can either be complementary or substitute to its exports.

The alternative hypothesis to the substitution theory is provided by Kojima (1975) who argues that depending on different economic development stages in the home and host country some industries might have a comparative advantage in the host country relative to home. In such case export-oriented FDI takes place thus establishing trade and FDI as complementary in nature.

2.3.4 Determinants of FDI in the OLI framework

From the tradition trade economics and the theory of internalization Dunning (1977, 1979) came up with the OLI paradigm. According to this framework foreign investment was explained by three types of advantages that the MNCs enjoy; ownership, location and internalization. Ownership advantages refer to the comparative advantages that MNCs have over domestic firms due to technical knowledge and managerial expertise. Location advantages not only include cost savings due to lower production and transportation costs but are also created by the government of the host country by providing favorable investment incentives. Thus the purpose of the framework is to establish that when these three factors are taken into account together FDI flows can be better explained.

Schneider and Frey (1985) found that when economic and political determinants were included in a model together FDI in 54 less developed countries was better explained than separately discussing these determinants. Also Ray (1989) investigated FDI in US’s manufacturing sector and found that variables such as capital-labor ratio, industry size and growth, market size, prospects of R&D in the industry and exchange rate are all significant. More recently Biswas (2002) used a panel data set of capital expenditures by US firms in 44 countries to examine how tradition and non-tradition factors affect the FDI inflows. He found that while labor cost decreased FDI, a country’s regime type (democratic) and infrastructure quality increased FDI.

2.3.5 The Theory of Traditional Multinational Activity

This theory proposes three different approaches of foreign investment; the vertical investment model (Markusen, 1984), the horizontal investment model (Helpman, 1984) and the combination of both; knowledge-capital model (Markusen et al., 1996). The vertical model assumes the relative difference in factor endowments between the home and host country to be the driving factors. And technology, preferences and factor endowment are assumed to be identical in horizontal investment model, with MNCs being motivated by high productivity, lower labor costs and favorable business environment.

In 1998 Carr et al. estimated the knowledge-capital model by making use of inward and outward sales data for US and 36 other countries’ based foreign firms. The estimation returned expected signs and strong statistical significance for most variables thus supporting the model.

A little different conclusion was drawn from the analysis of Markusen and Maskus (2002) that was aimed at finding which of the three models best explained the patterns of FDI activities in the world. They found that the vertical model has little explanatory power while it was difficult to distinguish between the results of horizontal and knowledge-capital models. The results of this analysis however did not discard the importance of vertical FDI models in some host countries.

2.3.6 Aggregate variables as determinants of FDI

In order to investigate the effects of aggregate macroeconomic variables like market size and growth rate on Foreign Direct Investment, Scaperlanda and Mauer conducted a study in 1969 on US FDI in Europe. They found a significant relationship between GNP and FDI but no strong relationship between growth rate and investment. But surprisingly when Goldberg (1972) repeated the same analysis he found significant relationship between GNP growth and investment but not for market size.

Lunn (1980) came up with the claim that along with market size and growth, tariff barriers too were important variables. Therefore all these variables play a role in explaining FDI flows among countries.

2.3.7 FDI and Risk Diversification Model

Firms’ are risk averse and this is why they diversify their investment to reduce the chances of loss. Bettis (1981) suggested that when firms have the option of product differentiation and market segmentation they perform better since their risk factors are minimized giving them an edge over domestic firms. However in the view of Baniak et al. (2002) all forms of foreign investments do not behave the same way towards risk. For short term investment risk might not be an important determinant but the long term investment is usually risk averse and so investment in a country with unstable economic situation falls. The idea of uncertainty in the investor’s home country needs to be incorporated in this analysis too because sometimes FDI is driven more by home country’s economic situation than the host country’s incentives.

2.4 Foreign Investment response to public policies

Over the last couple of decades governments have liberalized their policies and are offering more incentives to attract investment from MNCs. The motivation behind these policies are the expectations of creating employment, raising exports and tax revenue, and spillover of knowledge brought by these companies to the host country’s private sector. This part of the paper thus focuses on finding out how foreign investment has responded to these various public policies.

2.4.1 Tax policies

A variety of factors influence the desirability of the investment location. Investors make their investing decisions in two stages. The first is based on fundamental determinants such as market size, availability of skilled labor, raw material and infrastructure. In the second stages those countries that pass the first stage criterions are evaluated on the bases of tax rates, incentives, grants or loans. Early literature attempted to empirically test this perception that tax policies are secondary in nature for attracting foreign investment. Two basic approaches were used survey of international investors and time-series econometric analysis.

Among the first survey studies Barlow and Wender (1955) interviewed 247 US companies regarding the factors that drove them to investing abroad. Of which 10 percent of the companies stated favorable taxes in host countries to be a determinant of FDI, while 11 percent of the sample companies were of the view that incentives offered by the host country’s government induced investment. Overall results put these factors forth in place of importance to investors, after currency convertibility, guarantee against expropriation and the political stability of the country.

Later Robinson’s (1961) survey of 205 companies validated these findings. The most important result that came out of this survey was the difference of opinion between the business community and the government regarding the factors that influenced the investment decisions. While the governments believed that tax concessions were the most attractive policy incentives, investors did not hold the same opinion.

In recent years, these surveys have explored the question of tax policy effectiveness on FDI in more detail; Emst and Young (1994), JETRO (1995) and Deloitte and Touche (1997). And all these surveys reinstate the same conclusions that tax policies do matter for attracting investment but they are not the most influential factor.

Econometric research carried out on tax policy affects made use of time-series data and most of these studies have yielded the same results as the surveys. Root and Ahmed (1978) analyzed 41 developing countries during 1966-1970, by dividing them in unattractive, moderately attractive and highly attractive economies based on their annual per capital FDI inflows. Different corporate tax rates across countries were found a significant variable explaining this division. However tax incentives were not found as effective discriminating factors.

Tax concessions were also found as insignificant factors affecting FDI by Agodo (1978) in his analysis of 33 US firms that had investment in 46 manufacturing units in 20 African countries.

A primary limitation of these studies is the omitted variables bias that arose from the correlation of FDI flows with variables such as trade and financial liberalization that are omitted from the equation. Followed by the issue of defining the changes in tax policies and which taxes to include in the regression; corporate taxes, trade taxes etc. Sometimes these tax measures can be misleading for various reasons; they do not capture the effect of tax rebates offered to foreign investors on certain types of investments or the tax treaties that are signed between host and home countries to avoid double taxation of profits.

However the relative little importance of tax policy found in the literature does not mean that it does not have any impact on FDI at all. The Public Policy Journal (2003) issued by the World Bank states that Foreign Direct investment to the tax haven regions; Caribbean and South Pacific grew five folds in 1985-94, and over the past two decades Ireland’s tax incentives have also been acknowledged as the major factors in attracting investment. Moreover, in recent years there is growing evidence being found that in well integrated markets such as the European Union, North American Free Trade Area and the Association of Southeast Asian Nations, tax incentives are influencing the decisions of foreign companies to invest.

Explanation for this trend is that the impact of taxes on foreign investment differs with the multinational companies. Investors usually have alternative methods for financing and structuring their investments. And there is strong evidence that these alternatives have important tax implications. Impact of tax rates on investment is higher on export-oriented companies than market seeking. Rolfe et al. (1993) in a survey analysis of US firms found that start-up companies prefer incentives that reduced their initial expenses while the firms planning to expand prefer incentives that were aimed at their profits. Another study by Coyne (1994) reveals that small investors are more responsive to tax incentives than large multinationals who receive special tax treatments by the government of the host country.

On the whole there are several tax instruments available to the host country’s governments that influence the location decisions of MNCs. Except that the optimal policy varies with each country’s economic and political situation. In addition a major drawback to tax incentive policies is that there is a high cost and loss of revenue associated with it, and sometimes it is difficult to quantify whether the benefits of FDI were higher than the cost incurred by the government in attracting it or not.

2.4.2 Government Spending

Under the fiscal policy measures, next to tax policies is the level of government spending in the host country. And while taxes were not found to be significant variables in determining the FDI inflows, infrastructure has an important to play. Government’s investment spending determine the quality of infrastructure and since it is publically provided Khadaroo and Seetanah (2008) state that the costs to a business a greatly reduced and leading to maximization of profits. Other empirical studies conclude that availability of infrastructure facilities not only reduce the cost of production but also improve the productivity of private firms (Quere et al., 2007; Morrison and Schwartz, 1996). Erenberg (1993) in his study discusses the idea that not only would firms’ operate with less efficiency if infrastructure was not publically provided but would also result in duplication and wastage of resources since MNCs will have to build their own infrastructure.

The quality of infrastructure affects FDI inflows through two channels. First better quality decreases transaction costs and increase the access to local and global markets that in turn encourages foreign investment. Second it facilitates exports that eventually attract inward FDI.

What is important here is the impact of infrastructure facilities on foreign investment differs across developed and developing countries. Sekkat and Varoudakis (2007) found infrastructure to be a significant variable in attracting investment from abroad, much more than openness and investment climate in developing countries. On the other hand Bae (2008) states that it is an indicators to attract FDI in developed countries rather than a motivator.

Various empirical studies also establish the importance of infrastructure as a determinant of foreign investment; such as Kok and Erosoy (2009) by conducting panel and cross sectional analysis on 24 developing countries, Belak et al. (2009) for Central Eastern European Countries and Sekkat and Varoudakis (2007) for Africa, South Asia and Middle East.

2.4.3Level of governance

While tax policies and infrastructure facilities have their share in stimulating FDI flows, it also depends upon the environment of the host country in which the MNC has to operate. Strong political and institutional structures are essential to ensure consistent rate of return to investors. Wei (2000a, 2000b) carefully studies the relationship between the levels of corruption and investment, and found a significant negative result.

Developed countries have strong institutions and firm laws thus implying good governance level and a save business environment, while in the developing or underdeveloped countries there are high cases of corruption and institutional failures. So more FDI flows towards developed economies compared to developing ones, however the marginal increase in investment resulting from the improvement in the governance level is high in developing countries. Thus a policy that is aimed at attracting investors from abroad must motivate its government to tackle widespread corruption that may exist at any level or sector of the economy.

2.4.4 Educational policies

Multinational companies exploit the differences in factor prices across countries. They do this by locating their skill-intensive processes in countries with abundant skilled labor and unskilled labor-intensive processes in countries with low average wages. Zhang-Markusen (1999) hypothesized that foreign investment will not take place even if the wage of unskilled labor in a country is very low and he found that MNCs need a certain human capital to operate in a market. Statistics from the World Bank (2000) show that underdeveloped countries that produce around 4% of the world’s total production, with 11% of the total population living there received less than 1% share of the total FDI across the world. Addison and Heshmati (2003) state that FDI to less developed countries is concentrated in the mining and quarrying sector, as a result of which they fail to reap the benefits of foreign investment towards economic growth.

There is contradictory evidence on the relationship between human capital and foreign investment. Cheng and Kwan (2000) estimated the effects of various determinants of FDI in 29 regions of China during 1985-1995 and found the effect of education to be positive but statistically insignificant. Blomstrom, Lipsey and Zeyna (1994) did not find any positive association between these two variables. And neither did Hanson (1996) who took adult literacy rate as a proxy for education. Then there were Noorbakhsh et al. (2001) who found stock and flow measures of human capital to be positive and statistically significant, and becoming even more significant over time. Nunnenkamp and Spatz (2003) used average years of education of total population as a measure of human capital and showed that from mid 1980s to the late 1990s education became an important variable. The underlining factor that accounts for the difference in results is that for efficiency-seeking FDI education is an important determinant whereas it is not for market or resource-seeking MNCs.

2.4.5 Trade policies

Trade policies determine whether FDI is a substitute for trade or complementary to it. If investors invest in a foreign country to avoid trade barriers such as high tariffs, FDI acts as a substitute to trade and local production and export changes to foreign production and sales. In case when there are no trade barriers FDI becomes complementary to trade and investors can then exploit any host country’s resources and use them to produce goods in home market and then export them back to the host countries’ at higher prices.

Bolling, Neff and Handy (1998) in their study of FDI in the food industry of Western Hemisphere argue that liberalization plays an important role towards the growth of investment. They suggested that FDI and food exports were complementary to one another.

2.4.6 Privatization policy

Theoretically not much has been discussed regarding the relationship between privatization and FDI but empirical studies have been carried out to develop an understanding on this issue. Gani (2005) provided strong evidence that both variables are positively related, by using annual data from 1990-99 on eight African and nine Latin American and Caribbean countries. Another analysis on Latin America by Baer (1994) established that as the state presence in the economy went down more foreign capital came in. UNCTAD (2002) mentions that along with macroeconomic stability and fewer trade restrictions privatization too has induced FDI inflows globally over 1990s.

2.5 Tax compliance by MNCs, efficiency of tax administration system and corruption

Where developed countries have a broad tax base and efficient administration, the developing countries face problems like administrative, political and social constraints in setting up a strong public finance system and the lack of tax policy management. Thus developing or transition economies are more vulnerable to tax evasion by individuals and companies. This can then account for the difference in the ability of developed and developing countries to mobilize their resources.

2.5.1 Reasons for low levels of tax compliance

The willingness to pay taxes varies across the world. Empirical evidence indicates that higher tax rates increase the tax burden and decrease the disposable income of individuals (Alligham and Sandmo, 1972; Chipeta, 2002). But tax burden is not the only factor that affects the tax taxpayer’s willingness to pay, in fact the tax systems have a role to play as well.

High levels of corruption and low transparency and accountability of public institutions cause citizens and companies to distrust the government and tax system, thus increasing their willingness to evade taxes (Kirchler et al., 2007). The underlining causes to this are that the citizens cannot be certain if their taxes are being utilized to finance public goods or not. Similarly when corporations are not provided with improved infrastructure or tax concessions based on their previous tax payments their motivation to comply with tax laws fall. Particularly for MNCs that are being taxed at home as well as in the host country and no double tax avoidance treaties are signed the likeliness of tax evasion by these corporations increase.

There is a huge difference in time required in developed countries to prepare and pay taxes compared to the developing countries. On average in the OECD countries it takes about 210 hours, exceeding to 1080 hours in Bolivia and Brazil respectively (World Bank, 2008). Everest-Philips (2008) found 1500 different local taxes, licenses and fees in Yemen. This was a worrisome situation for businesses in terms of high tax administration cost rather than the tax burden. Taxpayers therefore prefer to evade taxes if overall the cost of compliance is higher than the cost to bribe the tax auditors.

2.5.2 Causes of corruption in tax administration

A range of factors contribute towards the corruption in the tax administration system. First due to the complexity of tax laws and procedures the corruption level is increased and tax payers are exploited as they are unaware of their rights due to lack of necessary information. According to Pashev (2005) lack of clearly defined duties of public officials, high degree of discretionary power and inadequate check gives these officials the monopoly power to demand illegal payments from businesses in order to interpret ‘favorable’ rules for them. Furthermore in many middle income countries tax payers are willing to bribe the tax collector in order to ease on their tax liabilities.

Purohit (year unknown) points out political leadership to be a cause of corruption, because corruption at higher levels facilitate corrupt activities at lower levels of administration.

2.5.3 Combating corruption in tax administration

It is essential to try and eliminate corrupt activities at all levels in the tax administrations system. The initial step would be to redefine tax laws in a more simplified manner. The new tax system should aim at having a broad tax base, i.e. have as many tax payers as possible in the tax net.

Then to reduce the chances of a tax official of accepting bribery it will be useful to adopt incentive and performance based wage polices such as in Singapore and Hong Kong (Mookerjee, 1995). Also setting up independent anticorruption organizations can help curb corruption. Heilbrunn (2004) and Vittal (2003) found satisfactory results in investigating corrupt acts by such organizations in India and Singapore. Success of these organization have led governments all over the worlds to setup such similar organizations.