Foreign direct investment and corporate income taxation under legal uncertainty

This paper analyzes the effects of legal uncertainty on foreign direct investment (FDI) in developed and developing economies. Legal uncertainty is modeled considering different aspects: the application of double tax agreements, the different types of legal systems existing and the level of corruption. The final effect of legal uncertainty on FDI is not clear in the literature. Whilst we would suppose that the existence of a double tax agreement should encourage foreign direct investment, the literature is surprisingly inconclusive and more often than not finds a negative or insignificant relationship. The impact of different legal systems on FDI is not straightforward in the various empirical results. As far as corruption is concerned most empirical findings underline a negative effect of corruption on FDI. We explain these different stylized facts by taking legal uncertainty into account. We will study a general equilibrium model of foreign investors who consider investing in a profitable developed or developing market. In such a context uncertainty arises due to the application of double tax agreements, due to different legislation in act and to corruption's issues. The entry decision will be undertaken strategically, taking the behavior of other market participants into account. Depending on the industry structure, firms may decide to enter until economic rents are zero in the low tax scenario. Companies that compete with each other may underbid each other, speculating that legal uncertainty resolves in their favor. This will lead to a race to the bottom between foreign direct investors and harmful competition. The analysis of the impact of corporate income taxation on FDI has been done thus considering the complexity of the context where foreign investors have to act due to legal uncertainty issues.