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Labor Taxation and FDI Decisions in the European Union

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Abstract

This paper uses panel data on bilateral FDI stocks in the European Union to empirically analyze the impact of labor and corporate taxations on FDI decisions. While the effect of corporate taxes on FDI is well documented, the impact of labor taxes on FDI has barely been explored. This is surprising since labor taxation may influence FDI as well; the taxation of labor affects the production cost and the ability to attract and retain productive labor, and thereby it also, ultimately, impacts the return to the investment. By employing a Heckman two-step estimation model, which controls for possible sample selection bias due to many zero bilateral observations, we find that labor taxes do influence FDI decisions.

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Notes

  1. Several high-tax countries impose favorable tax treatment on foreign “experts” in order to attract and keep key personal.

  2. Austria, Belgium, Denmark, Germany, Greece, Finland, France, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden, and the UK are counted as the old EU members or the EU15. Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia are counted as the new member countries (NMCs).

  3. Tax reforms across countries have lowered statutory rates and broadened the base, resulting in substantially lower statutory rates and somewhat lower effective rates.

  4. Zero values can be due to no FDI stocks appearing, either because no FDI takes place or because it is too small to be reported.

  5. The assumption of fixed set-up costs distinguishes FDI from purely financial transactions.

  6. For other studies of FDI that employ a gravity framework, see, for example, Wei (2000), Stein and Daude (2007), Blonigen and Davies (2004), Bénassy-Quéré et al. (2005), Lahrèche-Révil (2006), Wolff (2007), Bellak and Leibrecht (2009), and Egger et al. (2009).

  7. Note that the implicit average tax rate is not the rate that applies to the top-bracket income earners but rather the overall average.

  8. The definition of the average and marginal tax rate was slightly changed in 2000, so that the years 1997–1999 and 2000–2007 use different definitions of these tax rates.

  9. For a theoretical discussion of trade costs and FDI, see Neary (2009).

  10. A more theoretically founded framework for FDI, provided by Carr, Markusen & Maskus (2001), includes distance and trade costs.

  11. The multilateral character of FDI, in combination with the impact of market access, is also related to the difficulty in defining the scope for agglomeration economies.

  12. As discussed in, e.g., Blonigen et al. (2004), market potential will have no effect on vertical FDI where the multinational enterprise (MNE) seeks the single lowest cost producer by evaluating all possible locations. On the other hand, in cases where several activities are to be outsourced by an MNE, the market potential of a specific location is likely to have a positive impact on the FDI decision.

  13. Following Wolff (2007) we regress the host country dummy on host country tax rates for both labor and corporate taxation. The host labor tax rate is highly significant and results in a R2 of 0.47. The host country corporate tax rate is also highly significant but results in a smaller R2 of 0.22.

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Acknowledgment

We thank participants and discussants at the International Institute of Public Finance Congress 2010, the 12th Annual SNEE European Integration Conference, 2010, ETSG, 2011, seminar participants at the Research Institute of Industrial Economics and Uppsala University, and especially one anonymous referee for very helpful and insightful comments. All remaining errors are ours.

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Authors and Affiliations

  1. Department of Economics, Lund University Sweden, Box 7082, SE-220 07, Lund, Sweden

    Åsa Hansson & Karin Olofsdotter

  2. Research Institute of Industrial Economics, Box 55665, SE-102 15, Stockholm, Sweden

    Åsa Hansson

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  1. Åsa Hansson
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  2. Karin Olofsdotter
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Correspondence to Åsa Hansson.

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Hansson, Å., Olofsdotter, K. Labor Taxation and FDI Decisions in the European Union. Open Econ Rev 25, 263–287 (2014). https://doi.org/10.1007/s11079-013-9282-8

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