Withholding Tax Effects on the Investment Decision of Multinational Firms. Michael Riedle* University of Tuebingen. February 2016

Transcription

1 Withholding Tax Effects on the Investment Decision of Multinational Firms Michael Riedle* University of Tuebingen February 2016 Abstract: Using a large international firm-level panel data set, we investigate the impact of corporate taxation on foreign direct investment. In this paper, we also theoretically and empirically analyse foreign corporate taxation. In particular, we examine non-resident withholding taxes. The impact of foreign country taxation is estimated to be sizable, as is consistent with the findings from the existing literature. Moreover, our results provide evidence which shows that withholding taxes have a remarkable additional effect on the investment decision. We find that a ten percentage point increase in the foreign corporate tax rate is associated with a 15.8% decrease in the affiliate s fixed assets. Furthermore, we show that a ten percentage point increase in the withholding tax rate reduces the affiliate s fixed assets by 4.4%. Keywords: Corporate Taxation, Double Tax Treaties, Empirical Analysis, Foreign Direct Investment, Multinational Firms, Withholding Taxes JEL Classification: F23, H25, H32 * University of Tuebingen, Mohlstrasse 36, D Tuebingen, MichaelRiedle@gmx.de,

2 1. Introduction The global economy has experienced fundamental changes over the last decades. Through the process of globalisation a new type of company has evolved from national companies: the multinational enterprise (MNE). As a result, it is possible to note and quantify a rise in foreign direct investment (FDI). The inward FDI stock has increased from a level of billion USD in 1990 to billion USD in 2014 (source: United Nations, 2015). 1 Taking economic policy into account, attracting FDI helps national economies realise welfare gains. FDI is directly linked to new growth opportunities, higher wages, higher employment and higher tax revenue (see, e.g. Becker et al., 2012). To attract FDI, a country s tax policy and corporate income tax rate are crucial. Hence the race to the bottom of the corporate income tax rate is verifiable (see, e.g. Devereux et al., 2008). Furthermore, our paper offers proof regarding a cut in corporate tax if we look at the global average tax rate. In 2000 the worldwide average for corporate income tax had amounted to 27.8% while it dropped to 22.5% in The effect of host country corporate taxation on its FDI has been researched extensively. The impact of foreign countries corporate taxes and particularly of their withholding taxes, on the other hand, has rarely been taken into consideration (see, e.g. Egger et al., 2006; Overesch and Wamser, 2009). The corporate tax burden of a foreign subsidiary of a MNE is in fact not limited to foreign corporate income tax. Moreover, if profit is distributed to the parent company, the respective foreign country may levy an additional withholding tax on distributed profits, which may be, in addition, subject to parent country taxation. Consequently, the parent company has to take a number of tax rates into account when investing in a foreign affiliate. The aim of this paper is to identify the impacts of foreign corporate tax and of dividend withholding tax in particular on the investment decision of multinationals. As mentioned above, there is a wide range of literature looking into the relationship between FDI and taxation. A MNE planning to invest abroad is facing two decisions. First it has to decide where it wants to invest and then it needs to decide on the level of investment depending on the chosen country. Past research papers have examined either the location decision or the investment decision which is tied to the location. However, some surveys 1 cf. United Nations (2015), Web Table 3. 1

3 analyse both stages. An overview of the empirical literature is given by De Mooij and Ederveen (2003), (2006) and (2008), Devereux and Maffini (2007) and Feld and Heckemeyer (2011). All these surveys conclude that taxation has a significantly negative impact on FDI. De Mooij and Ederveen (2003) find the median value of tax rate semi-elasticity to be Hence, a one percentage point increase in host country s corporate tax rate implicates, ceteris paribus, a decrease in FDI by of about 3.3% in the host country. Similarly, Feld and Heckemeyer (2011) broaden former meta-analyses and find lower median tax semi-elasticity for FDI, namely They show that studies based on aggregate data report significantly higher semi-elasticities compared to the studies using firm-level data. In spite of this, a great heterogeneity regarding the use of estimation approaches, data and tax measures makes it difficult to compare the results of different studies. The earliest empirical surveys on FDI and taxation use aggregated data. Hartman (1984) reports a negative relationship between domestic tax rates and aggregated capital inflows for the US with a semi-elasticity of Slemrod (1990) is the first to take the tax rates of the respective foreign country and prospective effective marginal tax rates (EMTR) into account. He observes a US corporate tax elasticity of Newer papers incorporate additional tax measures and control variables. Blonigen and Davis (2004) analyse the effect of bilateral tax treaties on inbound and outbound US investment. Yet they find little evidence of a positive relationship. In this context, they analyse the withholding tax burden on repatriated profits, expecting a negative coefficient. But they fail to detect a significant pattern. In contrast, Egger et al. (2006) present evidence of withholding taxes impact on multinational activity. For the withholding tax rate they report a semielasticity of Moreover, they differentiate between home countries of the MNE which apply different double tax relief systems. Where the credit system is applied, the semielasticity of withholding tax is and where the exemption system is used the semielasticity is even larger, to be specific. In addition, foreign corporate income tax reaches a negative semi-elasticity of Wijeweera et al. (2007) conduct a panel study on nine countries investing in the US. Their results show a negative relation between FDI inflows and corporate tax rate in the US. Moreover, they find the corporate tax rate sensitivity of FDI inflows to be higher if the investing country applies the exemption method instead of the credit method. Lejour (2014) investigates the impacts of bilateral and multilateral tax treaties on FDI stocks within the OECD. He concludes that tax treaties and FDI are positively related. Besides, he finds that the decreasing withholding tax rate, as negotiated and stipulated in tax treaties, has a 2

4 positive effect on FDI, with the semi-elasticity being Haberly and Wójcik (2015) support his findings by mentioning a positive relation between a zero withholding tax and FDI. All of these papers share one characteristic: They use aggregate data. However, the fact that FDI contains many different components complicates this approach. For instance they comprise M&A deals, which do not have any impact on real investment (as additional FDI would) because they are only financial transactions. Hence, aggregate data represents an imperfect approximation of real investment activity (see Feld and Heckemeyer, 2011). To mitigate this issue, researchers started to use balance sheet information data. Microdata enables to isolate real investment in (tangible) fixed assets, which is the commonly accepted proxy for FDI (see, e.g. Altshuler et al., 2001). Using firm-level data, Devereux and Griffith (1998) investigate the influence of taxes on the location of production. They find evidence for the anticipated negative relationship between effective corporate tax rates and the probability of affiliate location. Razin et al. (2005) and Buettner and Ruf (2007) basically confirm this finding. Barrios et al. (2012) examine, as other previous studies have done, the influence of host country taxation and additional parent country taxation on the location decision of MNE. Thereby they identify significant negative elasticities of the foreign and parent country corporate tax rate. Furthermore, they investigate non-resident withholding tax but find no significance. Going back to the investment decision, the most recent studies analysing foreign country taxation and, to a degree, withholding tax will be part of the following section. Becker et al. (2006) use the German tax reform in 2000 as a natural experiment, which allows them to analyse the impact of corporate taxation on FDI in Germany. With respect to the total capital stock, they find a semi-elasticity for the EMTR of around -4, which is a relatively high estimate. Overesch and Wamser (2009) apply a new estimation methodology to analyse FDI by using a count data model. They find a semi-elasticity of for the corporate tax rate. Quantitatively, an increase in the corporate tax rate reduces the number of foreign affiliates a German MNE holds by around 3. They further conclude that non-resident withholding taxes have a negative influence on the number of foreign held affiliates. This can be deduced from the semi-elasticity being -2.5, which indicates a weak significant relationship. Overesch and Wamser (2010) examine MNE investment activity by using firm-level data. They find a negative relationship between the effective average tax rate (EATR) and the location of a foreign affiliate as measured by the number of affiliates in total. In a second step, they use the EMTR to estimate the investment decision. In this context, a negative relation 3

5 between EMTR and fixed assets is also valid; the semi-elasticity is -0.9 here. Wamser (2011) then confirms previous findings concerning the impact of corporate tax rates on affiliates stock of fixed assets. Regarding dividend payment, withholding taxes are the only additional tax burden in this data set because Germany applies the exemption method for double tax relief. He finds a negative coefficient but it is without significance. In closing, he argues that the lack of statistical significance is caused by tax avoiding instruments such as conduit chains. Dressler and Overesch (2011), on the other hand, explore FDI in the context of tax treaties and profit repatriation. They confirm the negative impact corporate tax rates have on firm investment. Moreover, they examine withholding taxes and additional tax burdens called repatriation taxes, which consist of the withholding tax rate and also the MNE s home country tax rate, which is dependent on the double tax relief system. They determine that if repatriation tax goes up by 10 percentage points, it reduces investment in foreign affiliate s fixed assets by 4.3%. Similarly, they mention that the impact of withholding taxes lies almost within the same range. Adding to this, Becker and Riedel (2012) investigate cross-border tax effects on affiliate investment by using AMADEUS firm-level data. Once again they find that foreign corporate taxation has a negative influence on foreign affiliate investment. Additionally, they prove that increasing home country taxation fosters outbound affiliate investment. Among other things, Becker et al. (2012) highlight the negative relationship between foreign corporate tax rates and the investment in the total capital stock of affiliates. In a nutshell, the research on foreign corporate taxation is quite conclusive. Yet the effect of additional non-resident withholding taxes is not discussed very often. In addition it should be noted that their effect is not immediately obvious. Our paper contributes to the existing literature by clarifying the issue of dividend withholding tax s effect on the investment activity of a MNE. This analysis uses the global firm-level panel data set ORBIS from Bureau van Dijk, which contains the time period between 2004 and This data set allows us to analyse the investment behaviour of more than 73,000 parent companies located in 76 foreign target host countries all over the world. In this analysis, we estimate the relation between multinational affiliates capital stock and corporate and withholding tax rates of the respective foreign country and derive from it a robust negative relationship between both tax rates and the affiliate s capital stock. This result is in line with our theoretical predictions. 4

6 The layout of the rest of the paper is organized as follows: In the next section we show our theoretic considerations in a model. Section 3 then outlines the estimation methodology. Afterwards, section 4 provides information on the data. Section 5 presents the empirical results. Finally, section 6 briefly concludes. 2. Model 2.1. Basic model This paragraph outlines the theoretical considerations used as preliminary guiding principles for the empirical analysis to come. Our model analysis is inspired by Mintz (2004) and Wamser (2011). It should be noted that in our model the MNE has already decided on the location decision for the subsidiary. Thus the profit maximizing MNE in question has to determine how much it is willing to invest in the affiliate s capital stock, a decision which is conditional on the chosen location. The model basically includes two jurisdictions but can be adapted to incorporate several ones. The MNE M is located in the domestic country D and its subsidiary S in the foreign country F. Profits, as determined by output and cost of debt, are taxed at the corporate tax rate t D and t F, respectively. The firms i = M, S use the capital K i available for production. The production technology f(k i ), identical for both firms and dependent only on K i, is a strictly concave function; f (K i ) > 0; f (K i ) < 0. M raises the capital deployed for the production K M by accumulating debt. Additionally, M borrows capital on the bond market to finance its subsidiary. The company s cumulative debt B consists of K M and K S with the interest rate i being identical for all types of financing. Since there are no financing constraints, M can deduct the total interest expenses i B from its tax burden. The implication hereby is that M raises K S as debt and makes it available to its subsidiary in the form of equity. 2 Such a transfer is only appropriate if we adopt the assumption that the domestic country s tax rate is higher than the foreign country s tax rate, t D > t F. In consequence, interest expenses become tax-deductible in the high-tax country. 3 Finally, we assume that the MNE wishes to dispose of the total profits. This means the profits of M and the profits which are distributed by S. Hence, we stipulate that S has to distribute all of its profits to its parent M. This dividend payout is then subject to non-resident withholding tax t W in the subsidiary s host country. 2 The subsidiary is fully financed through equity. Additional debt financing in country F would be possible but does not influence the model s mechanism which concerns withholding taxes. 3 This applies only if we assume that fiscal financing constraints are not violated and M makes profits in order to be not tax-exhaust. 5

7 In a first step, the domestic country D applies the exemption method for double tax relief. The use of the credit method is shown afterwards. As a whole, the tax burden of the subsidiary s profits is determined by t F and t W. The sum of the MNE s profits is then expressed through π M = (1 t D ) [f(k M ) i (K M + K S )] + (1 t W ) (1 t F ) f(k S ) (1) The first two terms refer to the profits of the parent M in the domestic country where interest expenses are tax-deductible. Accordingly, the last part of the term expresses the profits of the foreign subsidiary. 4 The MNE maximises its profits with respect to K i to determine the optimal level of investment. This results in the following marginal conditions: π M K M = (1 t D ) [f (K M ) i] 0 (2) f (K M ) = i π M K S = (1 t D ) i + (1 t W ) (1 t F ) f (K S ) 0 (3) f (K S ) = (1 t D ) (1 t W ) (1 t F ) i Based on equation (2), we can determine M s demand for capital. Since the parent invests until the cost of capital equals the interest rate, the investment decision in the domestic country is not influenced by taxation. Equation (3), on the contrary, shows a distortion of the investment decision pertaining to the affiliate s capital stock, caused by taxation if (1 t D ) (1 t W ) (1 t F ) i. Due to the assumption that t D > t F and typically low withholding tax rates t W, we see a distortion of demand for capital. In effect, the affiliate s cost of capital is lower than the interest rate: f (K T ) < i (4) To sum up, the optimality condition for the domestic firm implies tax neutrality. With regard to foreign direct investment, on the other hand, it is optimal to raise investment in the foreign 4 Note that the cost of production is implicitly included in the function for the production technology. 6

8 affiliate s capital stock by using tax arbitrage opportunities within the international tax system so that the cost of capital is lower than the interest rate. To examine our research question, we model the impact of the withholding tax on the investment decision. dk S = dk S dt W = K S f (K S) dt f (K S ) t W (5) W (1 t D ) i (1 t W ) 2 (1 t F ) f (K S ) < 0 Equation (5) implies that an increasing withholding tax rate raises the cost of capital and thus reduces affiliate investment. The same is true for an increasing corporate tax rate t F. To put it briefly, our model suggests that increasing foreign taxation, corporate and withholding tax rates to be specific, reduces the level of foreign direct investment Relaxing assumptions Now we assume that the domestic country applies the credit method for double tax relief. 6 In that case, the profits the affiliate distributes are subject to the full tax rate of the parent country and the foreign country. But foreign tax burden can be credited against domestic tax burden. Assuming the indirect credit method is applied, the MNE can credit foreign withholding taxes and foreign corporate taxes against domestic taxes. We therefore amend the income equation above so that the multinational s profits are now determined by π M = (6) (1 t D ) [f(k M ) i B M + f(k S )] [t F + (1 t F ) t W ] f(k S ) + [t F + (1 t F ) t W ] f(k S ) The first term represents the total profits to which the domestic corporate tax rate applies. The second term expresses affiliate s foreign tax burden while the third one represents the amount of tax credit available. 5 Note here that from a theoretical perspective, a tax differential of t D < t F leads to unprofitable foreign investment if the exemption system is applied. 6 In the previously published literature the credit method is not modelled for the most part. Nevertheless, the credit method is still applied. According to PWC (2013), 6 out of 34 OECD member states use the credit system for double tax relief. If we take the generated revenue of the 500 largest MNEs as a basis, 41.1% of it can be traced back to credit countries 7

9 If we assume t D > (t F + t W ), the total foreign tax burden is creditable. 7 Hence, the following income equation becomes valid: π M = (1 t D ) [f(k M ) i B M + f(k S )] (7) Comparing this to equation (6), we realize that the second and third term cancel out and the whole tax burden of the MNE is determined by domestic corporate taxation. In this scenario, withholding taxes do not matter from a theoretical point of view. 8 As a next step, we reverse the assumption underlying the tax differential to (t F + t W ) > t D. The foreign tax rate now exceeds the domestic one. Tax credit is always limited to the volume of domestic taxation. Therefore, the tax credit cannot compensate for the whole foreign tax burden. Going back to equation (6), the second and third term do not cancel out. Owning a foreign affiliate leads to an additional foreign tax burden. In this case, the foreign tax burden, as determined by corporate and withholding tax rates, harms foreign investment of domestic firms. In summary, if the credit system is applied, withholding taxes have a split impact. On the one hand, if we assume (t F + t W ) > t D, a negative relationship exists between foreign taxation and investment. On the other hand, if t D > (t F + t W ) is valid, foreign taxation is not relevant in the case of a complete distribution of profits. Now we relax the assumption concerning the distribution of total profits. In the case of the exemption system and also the credit system, if (t F + t W ) > t D, withholding taxes are harmful to profit distribution. The repatriation of profits effectively results in an additional tax burden, which can be avoided by accumulating retained earnings. Hence, if we loosen the assumption of total profit distribution, the previously mentioned mechanism of withholding taxes changes. Furthermore, if the MNE already owns a foreign affiliate, withholding taxes foster the accumulation of retained earnings. 3. Econometric framework The purpose of our empirical analysis is to estimate the influence of foreign taxation on investment in an affiliate s capital stock. We use firm-level data taken from the ORBIS 7 Note that the NME is not in an excess credit position here. 8 The assumption that total profits must be distributed is still valid. 8

10 database. Because we have to take firm-specific heterogeneity into account, we use a linear panel data model. The generalized least squares (GLS) fixed effects model allows consistent estimates by considering the correlation of firm-specific and time-constant heterogeneity with the independent variables. Our estimation approach is described by the following equation: log K i,t = β 0 + β 1 t c i,t+β 2 t w i,t + β 3 X i,t + γ i + φ t + ε i,t (8) Here we expect, under reasonable assumptions, β 1, β 2 < 0, according to the theory. The dependent variable K i,t denotes the capital stock of affiliate i at time t. We proxy K i,t by the logarithm of fixed and tangible fixed assets and shareholder funds. t c i,t denotes the foreign corporate income tax rate, t w i,t the non-resident withholding tax rate. The matrix X i,t covers macroeconomic time-varying explanatory variables. In addition, we control for firm-specific heterogeneity γ i and time-constant components φ t. ε i,t represents the error term. Furthermore, we calculate robust and clustered standard errors. Beside parent-country-year fixed effects to control for unobserved effects of the parent s country, we include industryyear fixed effects for unobserved shocks in certain industries. According to Grubert and Mutti (1991) and Altshuler et al. (2001), we approximate foreign direct investments by using the affiliate s capital stock of tangible fixed assets. In accordance with Overesch and Wamser (2010) we also capture the stock of fixed assets to give an approximation of real investment. As withholding taxes are levied on dividend payout to equity holders, we extend previous literature by implementing shareholder funds as proxies for FDI. It should be noted, however, that we cannot attribute changes in equity stock to retained earnings or authorized capital increases. It is not even possible to approximate this because of the quality of the data. Before moving on to the empirical results, a brief data description is provided in the next section. 4. Data and descriptive statistics Our analysis relies on the commercial database ORBIS, compiled by Bureau van Dijk, which contains detailed accounting and firm structure information of around 8 million firms in 202 countries. The data is available from 2004 to 2013 but unbalanced in structure. Moreover, we only consider affiliates which are directly owned by a foreign parent company possessing more than 50% of the ownership shares. Besides, we exclude company observations where 9

11 crucial information (fixed assets, shareholder funds, parent information) is not reported. Also, the data set is restricted to public and private limited companies and we do not use firm observations for which unconsolidated data is unavailable. 9 Furthermore, we avoid a bias caused by outliers by dropping observations below the 0.1 percentile and above the 99.9 percentile. In addition, we omit affiliates within the financial sector (banks and insurance companies). The ownership information contains only static information, predominantly from the year Thus, the ownership structure has only a cross-sectional dimension. However, since we rely on previous research using this data set, we are not especially concerned about this fact (see, Becker and Riedel, 2012). We may include a few affiliates that have not been affiliates in the past years. This data problem is captured by the measurement error and therefore negligible; see Budd et al. (2005). In order to make use of the year- and country pair-specific withholding tax rates applicable, we merge affiliates balance sheet information with their group structure information. The withholding tax rates collected represent 30 economically relevant states, which are basically the OECD member states. 10 After matching parent companies to their foreign affiliates and merging the bilateral withholding tax rates, we receive an unbalanced panel data set. Hence, our basic data set includes 107,505 affiliates in 76 countries and 73,325 parent companies located in 173 countries. In total, 740,451 affiliate-year observations are available for 6.7 years, on average. Table 1 gives an overview of the distribution of subsidiaries and parent firms across the countries. As expected, it shows that most affiliates are located in Western and Eastern European countries. Apart from Europe, most subsidiaries are hosted in India and Mexico. 11 Looking at parent firms, most of them are based in Western European countries, as well as in countries known as a holding country, e.g. Cyprus, Luxembourg, Switzerland or the Netherlands. Besides, some parent firms are located in tax havens, e.g. British Virgin Islands, Cayman Islands, Hong Kong, Ireland or Liechtenstein The reported firms have to be active and no insolvency proceedings or similar have been opened. 10 Bilateral withholding taxes are collected for: Argentina, Australia, Austria, Belgium, Brazil, Canada, China, Denmark, Finland, France, Germany, Greece, India, Indonesia, Ireland, Italy, Japan, Luxembourg, Mexico, Norway, Portugal, Russia, South Korea, Spain, Sweden, Switzerland, the Netherlands, Turkey, the United Kingdom, and the United States of America. 11 Note that due to problems in the data set concerning the merge of financial data and ownership information the USA is underrepresented. 12 We define tax havens according to Gravelle (2015). 10

12 Table 1: Country statistics Country Subsidiaries percentage Parent firms percentage Australia Austria 3, , Belgium 2, , Brazil British Virgin Islands 0 0 1, Bulgaria Canada Cayman Islands China Cyprus , Czech Republic 4, Denmark 1, , Finland 1, France 7, , Germany 15, , Greece Hong Kong Hungary India 1, Ireland Italy 8, , Japan , Liechtenstein Luxembourg 1, , Mexico Morocco Norway 1, Poland 5, Portugal Romania 5, Russia 10, Singapore Slovak Republic 2, South Korea Spain 5, , Sweden 1, , Switzerland , The Netherlands 3, , Turkey Ukraine United Kingdom 10, , United States 0 0 6, Others 4, , Total 107, , In order to prepare the data set for regression analysis, we have to add further variables. First we incorporate foreign affiliates corporate tax rates as well as additional tax measures, the EATR and the EMTR. We include bilateral withholding taxes to determine the additional taxation on dividend distribution. Due to reasons relating to the interpretation of estimation 11

13 coefficients, we use statutory withholding tax rates instead of effective withholding tax rates. 13 Moreover, we factor in the foreign tax relief system of the parent s home country. Most of the taxation data is obtained from the University of Oxford Centre for Business Taxation and the Ernst & Young Worldwide Corporate Tax Guides (see table A1 for more details). In addition, we enhance our data set with predominantly macroeconomic indicators. These indicators are based on previous studies examining taxation and FDI; see e.g. Becker et al. (2012), Wamser (2011) and Overesch and Wamser (2010). Furthermore, we control for various country characteristics. We proxy the size of the market by GDP. We also control for GDP growth rate, GDP per capita and unemployment rate which capture the country s economic situation and its degree of development. The inflation rate and the interest rate express capital cost. Additionally, a country s population size serves as a proxy for the size of its economy and potential workforce. Political stability and the corruption perception index are indicators of legal certainty, the condition of governance institutions and corruption. The corruption index is obtained from Transparency International while all of the other country data is retrieved from the World Bank World Development Indicators; see table A1 for details. Table 2: Descriptive statistics Variable Obs. Mean Std. dev. Min. Max. Corporate income tax rate Withholding tax rate Tangible fixed assets a Fixed assets a Total assets a Shareholder funds a Pre-tax profit a GDP b e e e+10 Population GDP per capita b GDP growth rate Inflation rate Unemployment rate Interest rate Corruption index Political stability a in thousands of US dollars. b in thousands of US dollars, purchasing power parity in prices Effective withholding tax rates (= (1 t F ) t W ) lead to similar results concerning the direction of the effect; even the coefficients show little difference. Results can be provided upon enquiry. 12

14 After the data has been refined and enhanced, it is worthwhile to examine descriptive statistics and illustrate the distribution of the variables. Table 2 contains descriptive statistics for the outcome variable, tangible fixed assets, fixed assets and shareholder funds, as well as for the tax rates and covariates in matrix X i,t. In our sample, the average amount of fixed assets of the foreign subsidiaries is 24.2 million US dollars. Shareholder funds amount to 18.5 million US dollars on average. Besides, the mean pre-tax profits of the subsidiaries amount to 1.4 million US dollars. Furthermore, the mean foreign corporate income tax rate is 27.43% whereas the minimum is zero and the maximum is 40.76%. The dividend withholding tax rate is 2.05% on average whilst the minimum is zero and the maximum 35%. 5. Results The following section reports our estimation results. Throughout our analysis we deal with the foreign subsidiary as unit of observation. All specifications contain a full set of yeardummies; robust standard errors clustered at the firm level are calculated and then displayed in the results tables below the coefficients. Deviations from the standard design are reported below Baseline results Table 3 presents the result of the GLS fixed effects estimations. In these specification we use the subsidiary s stock of fixed assets as the dependent variable while the independent variables are the withholding tax rate, the foreign corporate tax rate and various controls. 14 Specification (1) shows a significant negative effect of the withholding tax rate and the corporate tax rate. Specification (2) contains additional affiliate country characteristics to ensure that our result is not driven by omitted variable bias. The incorporation of additional controls decreases the effect of the withholding tax and leads to a slightly higher corporate tax effect. The calculated coefficient for the withholding tax rate is , meaning that a ten percentage point increase in the withholding tax rate reduces affiliate s fixed assets by 4.38% on average. Moreover, we find a negative coefficient for the corporate tax rate of Both coefficients are statistically significant on a one percent level. Regarding specification (3), we reestimate the relationship using different control variables. The magnitudes of the estimated coefficients we get here are very similar to specification (2). 14 Control variables measured in absolute terms enter the estimation equation in log form. Relative control variables remain unchanged. 13

15 Table 3: Fixed assets (1) (2) (3) (4) (5) Variable FIAS FIAS FIAS FIAS FIAS Withholding tax rate *** *** *** *** ** (0.159) (0.158) (0.157) (0.158) (0.350) Corporate tax rate *** *** *** *** *** (0.105) (0.106) (0.106) (0.107) (0.176) GDP 1.878*** 1.949*** 1.634*** (0.068) (0.069) (0.147) Population *** *** *** (0.156) (0.157) (0.246) GDP growth rate *** *** *** *** (0.080) (0.080) (0.080) (0.081) Inflation rate *** *** *** *** (0.130) (0.129) (0.131) (0.233) Unemployment rate 0.873*** 0.881*** 0.900*** 0.868*** (0.119) (0.119) (0.119) (0.193) Interest rate 0.290** 0.323*** 0.320*** (0.121) (0.122) (0.122) (0.163) Political stability 0.080*** 0.082*** 0.080*** 0.071*** (0.013) (0.013) (0.013) (0.019) GDP per capita 1.843*** (0.070) Corruption Index (0.006) Constant 6.933*** *** *** ** (0.033) (3.220) (0.737) ( ) (4.226) Observations 700, , , , ,710 R-squared Number of subsidiaries 104, , , , ,545 Firm-FE Yes Yes Yes Yes Yes Year-dummies Yes Yes Yes Yes Yes Industry-year-FE Yes Parent-Country-year-FE Yes Dependent variable: log of subsidiary fixed assets (FIAS). Robust standard errors, clustered for subsidiary level reported in parentheses. In specification (5) standard errors are clustered for parent countries. *** indicates statistical significance at the 1% level. ** indicates statistical significance at the 5% level. * indicates statistical significance at the 10 % level. The GLS fixed effects estimation uses a full set of year-dummies in all specifications. In addition specification (4) includes industry-year fixed effects and specification (5) controls for parent-countryyear fixed effects calculates clustered standard errors for parent countries. Withholding tax rate stands for the statutory non-resident withholding tax rate, Corporate tax rate for the statutory corporate income tax rate, GDP for the log of GDP, Population for the log of population size, GDP growth rate for economic growth rate, Inflation rate for the inflation rate, Unemployment rate for the unemployment rate, Interest rate for the interest rate, Political stability for the log of the political stability index, Corruption Index for the Corruption Perception Index and GDP per capita stands for the log of GDP per capita. 14

16 With respect to the control variables, the results in table 3 reveal that a larger foreign market, as measured by the GDP, positively affects affiliate s fixed assets. Contrarily, the population size and GDP growth rate exhibit a negative relationship towards investment. The reason for this may be that the data was mainly gathered in Europe where the population size remains mostly the same and economic growth is relatively low. Foreign investment, however, is sizable. Also higher inflation rates are associated with lower investment. Due to the increasing cost of capital and economic uncertainty, this now seems reasonable. Proxying the degree of development by the unemployment rate we get a positive coefficient. This could be misleading but further specifications then show a more obvious negative impact. Still, this effect has not become immediately clear in the existing literature (see Becker et al., 2012). Surprisingly, the interest rate shows a positive effect. Yet it is not very robust here as it reverses in the following specifications. Moreover, we then show that higher political stability and legal certainty increases investment. Another variable reflecting the economic development is the GDP per capita: In this case we find a significant positive relationship between higher GDP per capita and affiliate s fixed assets. In specification (4) we include a full set of industry-year-dummies to control for industryspecific characteristics over time, which does not affect our results. Lastly, in specification (5) we implement parent-country-year fixed effects to account for unobserved parent country features. Furthermore, standard errors are now clustered with regard to the parent countries. We notice a considerably higher influence of withholding taxes on investment whereas all other coefficients almost remain constant. We further proceed by reestimating the investment decision, including the affiliate s stock of tangible fixed assets as dependent variables and shareholder funds, respectively. Specification (1) and (2) from table 4 refer to tangible fixed assets. For the corporate tax rate, we find similar coefficients. Besides, the coefficient of the withholding tax rate in specification (1) has slightly declined. Quantitatively, an increase in the withholding tax rate by one percentage point reduces the firm s tangible fixed assets by 0.4%. Furthermore, a one percentage point increase in the corporate tax rate reduces tangible fixed assets by 1.63%. In specification (2), we adjust for parent-country-year fixed effects and in addition standard errors are clustered with regard to parent countries. We find that the effect of the corporate tax rate is still sizeable, whereas we cannot measure an impact of the withholding tax rate. Specifications (3) and (4), which use equity as the dependent variable, indicate stronger effects of taxation. The semi-elasticity for the withholding tax is and for the corporate 15

17 tax rate -2.14, respectively. In specification (4), we once again control for unobserved parent country characteristics, including parent-country-year fixed effects and standard errors, clustered for parent countries. Regarding the controls, apart from the unemployment rate and interest rate, all coefficients show similar effects. Now, the unemployment rate is negatively related to the investment volume of the MNE. The same is true for the interest rate except for the last three specifications in which it is not significant. Table 4: Tangible fixed assets and shareholder funds (1) (2) (3) (4) Variable TFAS TFAS SHFD SHFD Withholding tax rate ** *** *** (0.162) (0.374) (0.147) (0.333) Corporate tax rate *** *** *** *** (0.106) (0.188) (0.100) (0.167) GDP 1.215*** 1.053*** 1.622*** 1.333*** (0.069) (0.131) (0.064) (0.101) Population *** *** *** *** (0.156) (0.233) (0.143) (0.194) GDP growth rate *** *** *** *** (0.078) (0.079) (0.081) (0.110) Inflation rate *** *** *** *** (0.131) (0.176) (0.132) (0.195) Unemployment rate *** *** *** *** (0.126) (0.168) (0.113) (0.112) Interest rate ** ** (0.120) (0.171) (0.117) (0.165) Political stability 0.048*** 0.034* 0.080*** 0.073** (0.013) (0.019) (0.012) (0.029) Constant *** * ** (3.259) (5.436) (2.914) (3.665) Observations 637, , , ,660 R-squared Number of subsidiaries 95,374 95,374 98,694 98,694 Firm-FE Yes Yes Yes Yes Year-dummies Yes Yes Yes Yes Parent-Country-year-FE Yes Yes Dependent variable: log of subsidiary tangible fixed assets (TFAS) and shareholder funds (SHFD) in specification (3) and (4). Robust standard errors, clustered for subsidiary level reported in parentheses. In specification (2) and (3) standard errors are clustered for parent countries. *** indicates statistical significance at the 1% level. ** indicates statistical significance at the 5% level. * indicates statistical significance at the 10 % level. The GLS fixed effects estimation uses a full set of year-dummies in all specifications. In addition specification (2) and (4) include parent-country-year fixed effects and calculate clustered standard errors for parent countries. Withholding tax rate stands for the statutory non-resident withholding tax rate, Corporate tax rate for the statutory corporate income tax rate, GDP for the log of GDP, Population for the log of population size, GDP growth rate for economic growth rate, Inflation rate for the inflation rate, Unemployment rate for the unemployment rate, Interest rate for the interest rate and Political stability stands for the log of the political stability index. 16

18 In summary, we present a considerable effect of corporate taxation on foreign investment for all approximations. Furthermore, we note that these quantitative estimates are also in line with findings in the literature available (see, e.g. De Mooij and Ederveen, 2008; Feld and Heckemeyer, 2011). In addition, we identify that withholding taxes have a remarkable additional effect on the investment decision of MNEs Robustness checks In this section we use several robustness checks to validate our results above. First, we implement the EMTR and the EATR as additional tax measures. Table 5: Effective tax rates 15 (1) (2) (3) (4) Variable FIAS FIAS SHFD SHFD Withholding tax rate * *** *** (0.158) (0.158) (0.148) (0.148) Effective marginal tax rate *** *** (0.056) (0.048) Effective average tax rate *** *** (0.130) (0.120) GDP 2.030*** 1.893*** 1.755*** 1.650*** (0.070) (0.070) (0.067) (0.067) Population *** *** *** *** (0.177) (0.177) (0.166) (0.166) GDP growth rate *** *** *** *** (0.084) (0.084) (0.086) (0.087) Inflation rate *** *** *** *** (0.136) (0.136) (0.137) (0.137) Unemployment rate 1.284*** 1.295*** (0.123) (0.124) (0.116) (0.117) Interest rate * ** (0.124) (0.125) (0.119) (0.120) Political stability 0.068*** 0.113*** 0.063*** 0.114*** (0.013) (0.013) (0.012) (0.012) Constant *** *** ** * (3.602) (3.612) (3.384) (3.386) Observations 683, , , ,070 R-squared Number of subsidiaries 100, ,802 96,096 96,096 Firm-FE Yes Yes Yes Yes Year-dummies Yes Yes Yes Yes 15 Note that EMTR and EATR are on a country and year basis. We do not look at firm specific EMTR. 17

19 (Table 5 continued) Dependent variable: log of subsidiary fixed assets (FIAS) and shareholder funds (SHFD) in specification (3) and (4). Robust standard errors, clustered for subsidiary level reported in parentheses. *** indicates statistical significance at the 1% level. ** indicates statistical significance at the 5% level. * indicates statistical significance at the 10 % level. The GLS fixed effects estimation uses a full set of year-dummies in all specifications. Withholding tax rate stands for the statutory non-resident withholding tax rate, Effective marginal tax rate for the effective marginal tax rate, Effective average tax rate for the effective average tax rate, GDP for the log of GDP, Population for the log of population size, GDP growth rate for economic growth rate, Inflation rate for the inflation rate, Unemployment rate for the unemployment rate, Interest rate for the interest rate and Political stability stands for the log of the political stability index. Whilst column (1) and (2) of table 5 show fixed assets as dependent variable column (3) and (4) refer to equity. Now, we refer to the results of the EMTR as it is the relevant measure for the marginal investment decision from a theoretical point of view. The negative coefficient indicates a significant negative relationship between the EMTR and the dependent variables, fixed assets and equity, respectively. While the impact of withholding tax on shareholder funds is quite sizable, we find a diminishing and insignificant effect on fixed assets. Reestimating with the EATR as exogenous variable, virtually a measure for the location decision, we confirm the immediately preceding results. We find a strong impact for the EATR and the withholding tax both cases. In the theoretic part we differ between the double tax relief system applied; the exemption method and the credit method. Therefore, we split our sample into two groups: parent firms hosted in countries applying the exemption method and parent firms located in countries applying the credit method. 16 The results are shown in table 6. In specification (1) and (3) we use MNEs of exemption countries and the dependent variable is shareholder funds. In specification (3) we add parent-country-year fixed effects to account for the characteristics of the parents home countries. Also, we cluster standard errors for the parents countries. The results referring to the corporate tax rate remains quantitatively unchanged compared to table 3 and table 4. If we look at the effect of the withholding tax rate we find a considerably higher impact on affiliate s equity. Now, a one percentage point increase in the withholding tax rate decreases the stock of affiliate s equity by 0.74% and 1.4%, respectively. Concerning exemption countries our results confirms the result of Egger et al. (2006) who also find a higher effect of withholding taxes on investment of exemption countries. 16 We do not distinguish between the indirect and the direct credit method. As well, we state countries as exemption countries, even if they only exempt 95% or 97.5% of foreign profits. 18

20 Table 6: Double tax relief system of the parent country (1) (2) (3) (4) Variable SHFD SHFD SHFD SHFD Withholding tax rate *** 1.253*** *** (0.169) (0.455) (0.405) (0.460) Corporate tax rate *** *** *** *** (0.114) (0.229) (0.205) (0.203) GDP 1.690*** 1.294*** 1.372*** 1.107*** (0.074) (0.162) (0.132) (0.265) Population *** *** *** * (0.165) (0.378) (0.221) (0.569) GDP growth rate *** *** *** *** (0.088) (0.220) (0.107) (0.394) Inflation rate *** *** *** *** (0.152) (0.298) (0.217) (0.322) Unemployment rate *** *** (0.126) (0.313) (0.134) (0.526) Interest rate 0.467*** (0.132) (0.325) (0.155) (0.360) Political stability 0.034** 0.145*** *** (0.014) (0.029) (0.032) (0.015) Constant (3.449) (7.267) (4.440) (5.832) Observations 484, , , ,268 R-squared Number of subsidiaries 78,936 19,678 78,936 19,678 Firm-FE Yes Yes Yes Yes Year-dummies Yes Yes Yea Yes Parent-Country-year-FE Yes Yes Double tax relief system Exemption Credit Exemption Credit Dependent variable: log of shareholder funds (SHFD). Robust standard errors, clustered for subsidiary level specification (1) and (2) and clustered for the mothers country in specification (3) and (4) reported, in parentheses. *** indicates statistical significance at the 1% level. ** indicates statistical significance at the 5% level. * indicates statistical significance at the 10 % level. The GLS fixed effects estimation uses a full set of year-dummies in all specifications. Withholding tax rate stands for the statutory non-resident withholding tax rate, Corporate tax rate for the statutory corporate income tax rate, GDP for the log of GDP, Population for the log of population size, GDP growth rate for economic growth rate, Inflation rate for the inflation rate, Unemployment rate for the unemployment rate, Interest rate for the interest rate and Political stability stands for the log of the political stability index. In addition, the data are distinguished in two groups concerning the double tax relief system applied by the parent country; credit system and exemption system. In specification (2) and (4) we reestimate the impact of foreign taxation on a firm s equity with the subgroup of countries applying worldwide taxation and therefore the credit system. As well, in specification (4) we implement parent country characteristics in the same way compared to specification (3). Both specifications indicate a similar impact of the foreign corporate tax rate compared to the estimates of the exemption group and to the basic results above. In contradiction to the exemption sample, we find a positive and quantitatively large 19

21 effect of withholding taxes on investment if the parent country applies the credit system. The positive coefficient of the withholding tax rate is questionable because if the MNE is not in an excess credit position it can credit foreign withholding tax burden against domestic tax burden. Therefore, we expect a declined effect of withholding taxes, which we cannot confirm in specification (2). But when we implement parent country characteristics, we find the expected decline of the withholding tax impact on FDI in specification (4). This is in line with the theoretic model. Thinking on the positive relation between withholding tax rate and equity in specification (2) one reason may be the accumulation of retained earnings to prevent foreign profits from taxation. Therefore, the foreign subsidiaries have higher retained earnings for internal financing. But because of the data quality we are not able to distinguish between internal and external financing to examine the mentioned mechanism concerning retained earnings. To reduce heterogeneity within the data set we split it into subgroups concerning the size of the parent company owning a foreign subsidiary. Thus, we can separate the impact of taxation on investment activity depending on firm size. We use a definition inspired by Bureau van Dijk to classify the groups: small-, medium- and large-sized parent companies. 17 We expect a lower tax sensitivity of large firms compared to small- and medium-sized firms. We think that it is more likely that larger firms use international tax planning activities than smaller firms. We reestimate specification (2) of table 3 for all three subgroups. Table 7 presents the results. Again, we can confirm that the corporate tax rate exerts a negative and significant effect on the subsidiary s fixed assets. Compared to medium companies, large firms are less responsive to corporate taxation. Concerning the withholding tax rate we estimate negative coefficients for the investment of medium and large companies. Unfortunately, we find weak significance for medium companies only. Specification (3) represents the group of small-sized parent companies. Here, we find no effect of withholding taxes on investment. This may result from the fact that small-sized companies are in fact relatively small, e.g. when we consider the balance sheet total. We presume that these companies put their whole effort in production and their main business activities instead of doing tax planning activities. Thus, we think that they do not optimize their investment activities with respect to taxation. So, we cannot find any effect of withholding taxes. This 17 Categories, if the companies match at least one of the following conditions: Large company: Revenue >=100 Mio. ; balance sheet total >=200 Mio. ; employees >=1000 or listed. Medium company: Revenue >=10Mio. ; balance sheet total >=20Mio. ; employees >=150. Small company: Revenue >=1Mio. ; balance sheet total >=2Mio. ; employees >=15. 20