Improving infrastructure or lowering taxes to attract foreign direct investment?

The policy implications of this important result for a country seeking to attract FDI (especially countries currently debating the relative merits of cutting taxes versus increased spending, such as the United States) actually depend on the tax regime of the country. High tax countries should continue to invest in infrastructure, and do not have to participate in the “race to the bottom” in tax rates, as well-developed infrastructure will negate the potentially negative effects of high taxes on attracting and keeping FDI. Countries with an above average infrastructure endowment can – at least in part – afford to finance their infrastructure by taxing corporations. In other words, a policy of contributing to improvements in productivity investments in production-related infrastructure in fact compensates MNEs for higher taxes. The remaining policy issue for such governments is how much they should invest in infrastructure and which types of infrastructure should a country focus on. As mentioned above, information and communication infrastructure has been shown to be the most effective for attracting FDI, followed by transport infrastructure. Moreover, information and communication infrastructure is shown to be more important than corporate taxes as determinant of FDI (standardized coefficients of 0.45 and -0.25, respectively). Thus, it would be better to invest in information and communication infrastructure than lowering corporate taxes to attract and keep FDI. For low tax countries with an inferior infrastructure endowment, like many developing countries and transition economies, the importance of tax policy is still relatively important, since the infrastructure endowment does not compensate for the costs of high taxes. The silver lining, however, is that FDI does react to changes in tax rates, so such countries can adjust their tax policies to attract more FDI. In the short term, such countries will likely be most successful in attracting FDI by relying on a strategy of low corporate income taxes. In the longer term, however, these countries should harness the positive contribution of FDI in their countries to invest in improving their infrastructure. These results are of relevance to the current economic crisis, where countries have been scrambling to design stimulus packages that will increase investment, by domestic firms and foreign MNEs.