Corporate taxes and the location of FDI in Europe: the importance of economic integration and project characteristics

Abstract

European countries face ever-increasing competition for Foreign Direct Investment (FDI). This paper studies how corporate taxes affect the location of FDI in Europe. Using firm-level data, we start by analysing the impact of the level and volatility of three tax rates on FDI: effective, statutory, and marginal tax rates. Next, we investigate how economic and monetary integration influences the effect of taxes on FDI. Finally, we focus on how the impact of taxes varies by project characteristics and sector: expansion versus new investment, industry versus services, high-tech versus low-tech manufacturing industries, and high versus low capital intensity firms. We conclude that stable taxes play a significant role in attracting FDI and, most importantly, that lowering taxes fosters FDI especially when the country has a high tax rate or is outside the euro area. There are some nuances in this relationship that are relevant to policymakers. Tax cuts are particularly important in stimulating foreign firms already in situ to expand their activities and in attracting industrial businesses. Finally, capital-intensive projects are less sensitive to taxes, but high-tech manufacturing projects have the same reaction to tax rates as other manufacturing projects.