Impact of economic volatility on corporate income tax rate the case of 20 asian countries

The former investigates directly the relationship of corporate income tax rates and economic volatility in terms of real interest rate, exchange rate, and growth rate.. 25 30 35 40Source

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS

PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF ECONOMIC VOLATILITY ON

CORPORATE INCOME TAX RATE:

THE CASE OF 20 ASIAN COUNTRIES

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

TRUONG HOANG YEN

Academic Supervisor

Dr NGUYEN HOANG BAO

HO CHI MINH CITY, JANUARY 2015

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS

PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF ECONOMIC VOLATILITY ON

CORPORATE INCOME TAX RATE:

THE CASE OF 20 ASIAN COUNTRIES

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRUONG HOANG YEN

Academic Supervisor

Dr NGUYEN HOANG BAO

HO CHI MINH CITY, JANUARY 2015

ABSTRACT

This paper examines the impact of economic volatility on the corporate income tax rate in the context of globalization and international taxation competition The impact is analyzed by two models, direct and indirect effect model The former investigates directly the relationship of corporate income tax rates and economic volatility in terms of real interest rate, exchange rate, and growth rate The latter applies a system of equations to examine simultaneously the determinants of tax rate and tax base The study finds out that economic volatility impacts negatively on corporate income tax rate and also negatively on foreign direct investment (FDI) inflows Moreover, corporate income tax rate affects negatively and significantly on FDI inflows, meanwhile FDI inflows influence corporate income tax rate with positive and significant impact

CONTENTS

CHAPTER ONE: INTRODUCTION 1

1.1 Problem statement 1

1.2 Research objectives and research questions 4

1.3 The structure of research 5

CHAPTER TWO: LITERATURE REVIEW 6

2.1 Theoretical literature 6

2.1.1 Roles of corporate income tax rate 6

2.1.2 Economic volatility 7

2.1.3 Foreign direct investment 9

2.1.4 Tax competition 11

2.2 Empirical literature 15

2.2.1 Economic volatility 15

2.2.2 Corporate income tax rate 17

2.2.3 FDI inflows 19

2.2.4 FDI outflows 19

2.2.5 Country size 20

2.2.6 Capital openness 21

2.2.7 Government expenditure 22

2.2.8 Productivity 23

2.2.9 Employment rate and demographic structure of population 23

2.2.10 Personal income tax rate 24

CHAPTER THREE: ECONOMIC VOLATILITY AND CORPORATE

INCOME TAX: DESCRIPTIVE AND DATA ANALYSIS 25

3.1 Variable measurements 25

3.1.1 Measurement of economic volatility 25

3.1.2 Measurement of corporate income tax rate 26

3.1.3 Measurement of capital openness index 26

3.2 Summary of variables description and data sources 28

3.3 Descriptive statistics 29

CHAPTER FOUR: METHODOLOGY AND RESULTS 33

4.1 Analytical framework 33

4.2 Direct effects 34

4.2.1 Model specification 34

4.2.2 Method specification 37

4.2.3 Results 38

4.2.4 Indirect effects 43

4.3.1 Model specification 43

4.3.2 Method specification 46

4.3.3 Results 48

CHAPTER FIVE: CONCLUSIONS AND IMPLICATIONS 53

5.1 Major findings 53

5.2 Policy implications 55

5.3 Limitations and suggestions for further study 56

REFERENCES 57

APPENDICES 63

A Graphs 63

B Tests 67

C Estimations 70

D Others 78

LIST OF FIGURES Figure 1.1 Average top statutory corporate income tax rate in 20 Asian countries 2

Figure 1.2 FDI inflows in 20 Asian countries 3

Figure 2.1 Theoretical framework 15

Figure 3.1 Corporate income tax rate, capital openness index and FDI inflows (1982-2011) 33

Figure 3.2: Corporate income tax rate, Real interest, Exchange rate, Growth volatility, and FDI inflows (1982-2011) 35

Figure 4.1 Direct effect framework 39

Figure 4.3 Method for Direct effect model 41

Figure 4.2 Indirect effect framework 49

Figure 4.4 Method for Indirect effect model 52

LIST OF TABLES Table 3.1 Variables description and data sources 29

Table 3.2 Descriptive statistics 31

Table 4.1: List of variables in direct effect model 38

Table 4.2: Direct approach in various methods with interest rate volatility 43

Table 4.3: GMM estimation with and without volatility in three proxies 47

Table 4.4: List of variables in indirect effect model 48

Table 4.5: Indirect approach with interest rate volatility through various estimators 53

Corporate income tax serves the economy with three vital functions Firstly, the corporate income tax rate is regarded as an effective way to raise tax revenues Secondly, corporate income tax is popularly perceived as fair charges for public goods and services consumed by companies Lastly, corporate income tax is considered as a reasonable substitute for personal income tax Because it is hard to administer personal tax on capital income, especially the gains which are retained in

a company (Bird, 1996; Devereux and Sørensen, 2006)

In high tax rate countries, governments have to allow some profit shifting because

of tax competition from lower tax rate countries (Becker and Fuest, 2012) Therefore, governments also restrain that process by competing in reducing the effective average tax rate and statutory tax rate (Devereux, Lockwood, and Redoano, 2008) During the period from the 1980s to the late 1990s, the average corporation tax rate decreased from nearly 40% to around 30%, specifically, in the European countries from 38% in 1990 to 33% in 2000 (De Mooij and Ederveen, 2003; Devereux et al., 2008) Figure 1.1 presents the dramatic downturn of average top statutory tax rate on corporate income of 20 Asian countries from more than 40% in 1982 to approximated 25% in 2011 Different from European countries, Asian countries decrease their statutory corporate income tax rate roughly after

25 30 35 40

Source: Author’s collected dataset

Figure 1.1 Average top statutory corporate income tax rate in 20 Asian countries

In order to attract more capital inflows, governments compete each other by reducing corporate income tax rate (Genschel and Schwarz, 2011), because a corporate income tax rate rise conducts to a decline in multinational investment (Hong and Smart, 2010) As illustrated in Figure 1.2, the inward FDI volume is increasing sharply and significantly From the roughly zero initial level in 1982, FDI inflows increase approximately to the landmark of 200 billion US dollars in

2011 Despite the crises in 1997 and 2008, this tendency still continues over time The combination of downward trend in corporate income tax rates and upward tendency in capital inflows illustrates the tax competition among countries for the purpose of capital attractiveness

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0 50 100 150 200

Figure 1.2 FDI inflows in 20 Asian countries

From another point of view, economic volatility is believed as a determinant of tax reform (Feldstein, 1976) It is considered as disincentive for investments because it distorts the location decision for investments to other stable economy instead of the volatile one In order to stimulate FDI inflows, the corporate income tax rates have

to be kept at a sufficient low level in order to reduce costs of capital and enhance investment incentives (Panteghini and Schjelderup, 2006) Consequently, the corporate income tax setting process is influenced by economic volatility (Ghinamo, Panteghini, and Revelli, 2010)

An enormous number of researches study tax competition among jurisdictions However, there is a lack of study investigating the tax competition under the impact

of economic volatility This subject is examined in the theoretical study of Panteghini and Schjelderup (2006), and the empirical studies of Slemrod (2004) as well as Ghinamo et al (2010) These studies contribute to the theoretical framework

of timing choices in the investment decisions of multinational enterprises This

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framework is regarded as the plausible explanation for the corporate income tax rate setting process under the influence of economic volatility Moreover, these studies also involve the effect of globalization on the relationship between corporate income tax rate and economic volatility Besides, the framework of timing choices

in the investment decisions of multinational enterprises is employed to illustrate the mechanism of capital mobility

Under the motivation from the works of Panteghini and Schjelderup (2006) and Ghinamo et al (2010), this research investigates the relationship of the top statutory tax rates on corporate income and economic volatility in terms of real interest rate, nominal exchange rate, and GDP growth rate This relationship is also examined with consideration of influences from globalization in terms of FDI flows and capital market openness The highlight of the paper is that the lag effects of public policies and investment decisions are taken into account

1.2 Research objectives and research questions

This study aims to investigate the corporate income tax rate setting process in scope

of 20 Asian countries from 1982 to 2011 The process is examined under the impact

of economic volatility in terms of real interest rate, nominal exchange rate, and growth Moreover, this impact is also assessed in the context of globalization, in particular, capital mobility in terms of FDI inflows into the country Based on these objectives, the goals of the study are to answer the following questions:

- Does economic volatility, in terms of real interest rate, nominal exchange rate, and growth, affect corporate income tax rates?

- How is the influence of FDI inflows on the relationship between economic volatility and corporate income tax rates?

o Does economic volatility affect FDI inflows?

o How do FDI inflows influence corporate income tax rates and vice versa?

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1.3 The structure of research

The research consists of five chapters The first chapter presents the introduction which points out the main objectives and the scope as well as the time period of the research The second chapter covers the literature review, which is composed of theoretical framework as the foundation of the study and empirical works on specific variables involved in the investigation in the research Measurements for each variables and data analysis are discussed in the third chapter The fourth chapter presents the analytical framework of the study and shows the particular models with their applied methods as well as the results for each model Based on the results obtained in the previous chapter, the fifth chapter demonstrates the findings and limitations of the research It also suggests the future directions and implications for policy makers

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CHAPTER TWO: LITERATURE REVIEW

The theoretical literature section introduces the roles of corporate income tax rate, economic volatility, and tax competition through various studies to illustrate the mechanism of their relationship Afterwards, the relationship between corporate income tax rate, economic volatility, and FDI Then the empirical literature section synthesizes numerous studies on economic volatility, corporate income tax rate, and FDI inflows as well as control variables This section aims to point out the benchmarks for the coming empirical models

2.1 Theoretical literature

2.1.1 Roles of corporate income tax rate

Corporate income tax rate is analyzed under three functions

Firstly, corporate income tax rate is regarded as an effective way to raise tax revenue without affecting economic behavior Corporate income tax is designed to charge on economic profits, particularly on economic rents with particular investments However, this function is only effective in a closed economy In case

of existing capital mobility, the choice for location of investments is distorted by high tax rates Therefore, Mintz (1995) concluded that the high tax rates may cause

a company to change their location of investments to another jurisdiction with lower tax rate.

Secondly, corporate income tax is perceived popularly as fair charges for public goods and services consumed by companies The government provides public supplies such as infrastructure and other public investments These supplies create a better economic environment in order to foster the economic growth To fund the public investment, according to Bird (1996), government levies on the profits of companies at a fair share of tax for the value of public goods and services the companies consumed

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Thirdly, Devereux and Sørensen (2006) pointed out that corporate income tax is considered as a reasonable substitute for personal income tax Because it is hard to administer personal tax on capital income, especially the gains which are retained in

a company However, this role is weakened in the context of capital mobility The owner of the capital gains may reside in a different country from where the company locates so that the individual capital profits are levied at the different tax rates This is the cause of poor substitute of corporate income tax for personal income tax In conclusion, capital mobility weakens the “backstop” role of corporate income tax for personal income tax though it does not eliminate completely the role

2.1.2 Economic volatility

Economic volatility, the instability in economic factors, especially in terms of uncertainty, is considered as an important parameter in the theory of tax reform (Feldstein, 1976) The fact of choosing particular tax rates not only influences social welfare, but also alters the information available for later decisions To that extent, changing a tax rate imposes a gamble that reduces expected utility Gamble argument implies that if value of information, regarding economic volatility parameter, is not taken into account, the variance in optimal tax may exert a smaller difference than normal Therefore, Eaton and Rosen (1980) debates that if ignoring volatility, estimates of optimal tax rates may be biased to incorrect results

Likewise, Barro (1989) examines the change of tax rates due to the effect of new information about government expenditure, total income of the nation, and so on Using the tax-smoothing approach, he derives that tax rate changes are due to business cycles and plans of government expenditure During recessions, tax rates descend to a lower level than normal During wars, tax rates ascend to a higher level than normal There is a correspondence between this insight and that of Sahasakul (1986)

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Dixit and Pindyck (1994) stated that volatility affects negatively on investment timing An increase in volatility implies the increase in both good and bad directions The increase in good direction causes no impact, but the increase in bad direction deters the investment decisions in order to wait for other information In other words, economic volatility reduces the current investment rate into a country Consequently, the government will reduce tax rates to alleviate the negative effect

Moreover, Panteghini and Schjelderup (2006) analyzed the taxation competition for foreign investments among countries They prove that an equilibrium tax rate exists

so that at that level, social marginal cost of taxation achieves the same value of social benefit That is the foundation for the conclusion that equilibrium tax rates will decrease as a result of expanding uncertainty in profit income The argument depends on the analysis of the effect of globalization process on taxation in which volatility is interpreted as consequence of deepening globalization, causing a great deal of unpredictable factors in the economy (Heckman, Agell, Gertser, and Friedrich, 2003) For given tax rate, raising volatility will lead to a rise in cost of capital because of higher risk in the investment This descends the expected profits

so that firms who have plans to invest tend to delay the investment decisions to wait for new information (Bernanke, 1983; Pindyck, 1991) Those who receive good news will invest, the remaining will cancel the investment plan Consequently, the total number of firms exerting investment decrease so that tax base reduces correspondingly Ultimately, the government will react by lowering the tax rate to counteract the negative effect of increased volatility

In conclusion, Koren and Tenreyro (2007) indicated that studying the volatility impacts brings two benefits Firstly, it assists governments in risk management by revealing the potential trouble areas In case a few high risk sectors bring about the volatility impacting widely on other sectors in the country, policies should concentrate on diversifying the economy and supporting financial institutions In case country specific shocks are the major sources of economic volatility,

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macroeconomic policies should be the main aim of policy makers Secondly, studying the volatility impacts helps to unfold the mechanisms of economic volatility not only to get rid of excess economic volatility but also to boost the ability of a country to deal with extreme shocks (Prakash, 2011)

2.1.3 Foreign direct investment

Bernanke (1983) pointed out that there are based on three important characteristics

of investment: irreversibility, uncertainty, and optimal investment timing1 The negative effect of investment timing depends on the Bad News Principle that volatility in terms of uncertain information retards the current rate of investment His central theory examines how the investment decision is affected by the new-arriving information (Keynes, 2006) To analysis this effect, Bernanke presumed two assumptions Firstly, real investments are strictly irreversible Secondly, new information that used to estimate investment return arrives continuously as cost of waiting or volatility Due to the irreversibility of investment, investors will have a tendency to defer his investment decision to wait for new information Because volatility increases the cost of waiting for new information, it discourages the investment

Similarly, Pindyck (1991) confirmed that increased uncertainty reduces investment

by analyzing two assumptions which Bernanke mentioned as the most important characteristics of investment expenditures The first is the irreversibility of investment The second is leaning toward decision postponement to wait for new information Because a firm cannot disinvest, but the investment is irreversible, so the expenditures are regarded as sunk costs Besides, the firm has an option to invest or not and to choose where to invest, called opportunity cost of investing Due to a postponement tendency on decision to wait for new information and the

1 These characteristics are confirmed in the studies of Pindyck (1991), Dixit and Pindyck (1994)

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high sensitivity of the opportunity cost of investing to changes in the future economic conditions, uncertainty impacts negatively and seriously on the expenditure and timing of investment This defines the dynamics in investment decision

Moreover, Hines Jr (1999) indicated that tax policies exert a strong influence on investment decision, particularly on the volume and location of FDI, due to the reduction of after-tax returns under the effect of higher tax rates And investment incentives suffer the negative impact as a result Moreover, based on the analysis of the cost of capital, Devereux, Griffith, and Klemm (2002) argues that the cost of capital will be exaggerated through an increase in effective marginal tax rate This effect conducts a diminution in capital inflow or an enlargement of outflow stock of capital This phenomenon is explained that an increase in the cost of capital is equivalent to an increase in required rate of return Therefore, under the effect of corporate income tax raising, investment incentives endure reducing In other words, lowering the corporate income tax rate enhances the incentive to invest

Similarly, Panteghini and Schjelderup (2006) confirmed the relationship that high taxes exert a negative effect on the probability of a country attracting FDI (Haufler and Schjelderup, 2000) A multinational firm can exploit this by locating capital in the country which offers the most favorable capital investment scheme Later, once

it starts to generate profits, it can shift some of its taxable profits to a country that offers low statutory tax rates This two-step strategy means that a multinational firm can save tax payments relative to domestic firms, but it also has the implication that national tax bases become more tax sensitive

On the other hand, Ghinamo et al (2010) explained the positive effect of FDI on corporate income tax rate The first reason relates to market openness The lower the economy’s openness, the lower is the incentive for inbound FDI This means that the government must set a lower statutory tax rate to attract multinational activities The second reason holds for volatility An increase in volatility is

2.1.4 Tax competition

Tax competition models originate from Tiebout hypothesis as the theory of efficient tax competition, based on theory of local public good provision Tiebout (1956) stated that competition for mobile households or mobile firms improve social welfare Assuming that landowners control local government, they aim to maximize the after-tax value of their land Therefore, they offer public goods as utilities financed by local taxes to attract individuals to reside on their land However, they fail because of many “utility-taking” regions As a result, such equilibria are efficient with the definition of efficiency: “a central authority cannot feasibly reallocate goods and resources in a way that makes some individuals better off without making anyone worse off.” (Wilson, 1999) To that extent, the fact that local taxes are kept low enough in order to tempt individuals to inhabit in the region, with the given public goods, will cause tax competition Based on this idea, Wildasin (1989) contributed departure of the existence of “fiscal externality” which occurs when a region gains capital at the expense of others by decreasing its tax rate

on mobile capital

In contrast with the intuition of Tiebout (1956), Oates (1972) debated that society is worse off in competition for capital between local governments For the purpose of attracting business investment, local governors may make an endeavor to keep taxes low by maintaining expenditure less than the level at that marginal benefits equal marginal costs It means taxation impact negatively on business investment by increasing marginal costs Because of these additional costs, public expenditure and

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taxes will be diminished to the level of a new equilibrium Consequently, none gain

a competitive advantage or, in other words, it conducts a wasteful tax competition

or inefficient tax competition This cause the “race to the bottom” in corporate income tax rates in recent decades

By the same token, Wilson (1999) confirmed the wasteful competition between independent governments, which cause the reduction in tax rates and levels of public expenditure for scarce capital Based on the Nash equilibrium concept, he defines equilibrium economy is a status where the objective function of the region’s strategy is maximized with the given strategies of other regions Particularly, the fact of choosing tax rate of a region in comparison with that of other regions influence the equilibrium of capital return Because an increase in the tax rate of a region causes a capital outflow that is considered to be a capital inflow to another region due to the assumption of scarce capital As a result, the region’s tax rate and public goods are set at inefficiently low levels in order to attract capital inflow

Based on the theory of tax competition, Panteghini and Schjelderup (2006) contributed an analysis the tax competition with regard to economic volatility They used a two-period model in which investments are regarded to be irreversible and multinational companies can shift their profit among countries At the first stage, governments set their tax rates At the next stage, multinational companies decide whether to do or deter their abroad investment operations The behaviors of multinational companies are based on the argument of timing investment

Eventually, two propositions derived from the two-period model of Panteghini and Schjelderup (2006) and analysis mechanisms of Ghinamo et al (2010) are applied

in this paper

The first is that an increase in FDI allows a higher tax rate setting Globalization means tighter integration or surge in market openness so that technical barriers are reduced This causes the reduction in investment costs On the other hand,

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globalization leads to lower transportation costs and increased skill-oriented technologies as well as widened information systems Moreover, the diminution in transaction and financial costs of e-banking services eases the ability of profit shifting These boost the average profitability in investments Eventually, FDI operations are stimulated by the reduction in investment costs as well as the increase in profitability Additionally, the growing number of FDI firms due to the increase in profitability enlarges the tax base of the country This also discourages the government to reduce tax rates

Secondly, increase in volatility motivates reduction in tax rates Globalization may raise the volatility and volatility dejects inbound FDI (Ghinamo et al., 2010) Based

on Bad News Principles (Bernanke, 1983), merely firms receiving good news exert their investment decisions, meanwhile firms with bad news deter their investment plans After the consideration time, firms will decide whether to invest or not Therefore, the number of FDI firms and the value of inward investments reduces The reduction in total FDI inflows leads to a decrease in the tax base To mitigate the negative impact, governments respond by lowering the tax rates This illustrates the dynamics in taxation setting

Four hypotheses are drawn based on the analysis on tax competition

o Hypothesis 1: whether economic volatility affects negatively on corporate

income tax rate

o Hypothesis 2: whether economic volatility affects negatively on FDI inflows

o Hypothesis 3: whether corporate income tax rate affects negatively on FDI

inflows

o Hypothesis 4: whether FDI inflows affects positively on corporate income tax

rate

FDI INFLOWS

CORPORATE TAX RATES

Transportation costs Market openness Technical barriers Investment costs

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2.2 Empirical literature

This section will give some justifications about economic volatility, which is measured by the standard deviation of real interest rate, nominal exchange rate, and growth, corporate income tax rate, and FDI inflows This section also explains the rationale of control variables, such as FDI outflows, country size, capital openness, government expenditure, productivity, employment rate, demographic structure of the population as well as personal income tax rate

2.2.1 Economic volatility

Volatility or uncertainty is studied in a great deal of economic researches In formidable contribution of Knight (1921) about the idea of the relationship of risk and uncertainty in economic analysis, both risk and uncertainty occur where there exists unknown future However, the risk is distinct from uncertainty in terms of probability distribution of possible future results It is affirmative in case of risk and negative in case of uncertainty Based on the theory of Neumann and Morgenstern (1947) about game and economic behavior, associating with Knight treatise, economists contribute a great deal of studies to explain profits, investment decisions, demand and supply of investments, etc (Arrow, 1951; Hicks, 1931; Keynes, 1936, 1937; Stigler, 1939)

Economic volatility might be reflected by means of changes in actual and unanticipated value The former is calculated in terms of variance (conditional/unconditional) or standard deviation and the latter is computed in the sense of residuals from an estimating model, according to Di Iorio, Faff, and Sander (2013) With the aim of investigating the time varying volatility with respect to actual changes, standard deviation is the suitable measure, as in similar strategy of Ramey et al (1994) and Aghion et al (2005) However, this costs considerable data loss Accordingly, in order to entirely make the most of the information in the data set, a kind of moving average of the standard deviation is computed through the

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value in the previous five years of the relevant variable This measurement approach seizes the general moments in economic volatility and the risk over time (Chowdhury, 1993; Cushman, 1988; Ghinamo et al., 2010; Koray and Lastrapes, 1989)

In this research, economic volatility is examined through variation in real interest rate, nominal exchange rate and productivity growth rate The two former variables reflect the behavior of government in monetary policy decision The latter shows the state of the performance of the economy in macro level

Real interest rate volatility

Irreversible investments are sensitive to volatility in many forms, for instance, uncertainty in future interest rates causes the increase in operating costs These costs alter the cash flows of a project, affect the return as well as the timing of investments Consequently, these reduce the investment stocks (Pindyck, 1991) Rodrik (1991) contributed the same explanation for the relationship, based on the analysis of the cost of capital He concluded that domestic real interest rates must be taken into account in estimating the presence of volatility

Ghinamo et al (2010) considered interest rate volatility as the crucial taxation factor in forming the financial structure of a firm Because of deductibility from taxable income, interest expenses are usually regarded as a tax shield by utilizing the internal and external credit market Multinational companies can utilize the debt shifting option in which incomes and tax burden can be shifted to the lower tax rate countries by using internal debt among affiliates Therefore, in order to obtain the optimal debt/asset ratio or internal/external debt structure, changes in external credit market of a firm or in external credit market of their foreign affiliates could affect the decision of investing in uncertain countries

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Nominal exchange rate volatility

Pindyck (1991) stated that exchange risk will descend direct investment He debated that exchange rate affects on investment decisions of both domestic firms and foreign subsidiaries However, according to a study of Diebold and Nerlove (1989), bilateral flows of direct investment have a positive relationship with uncertainty in exchange rate ARCH effects are used to capture the volatility clustering through movements of exchange rate volatility Also, A Dixit (1989) measures exchange rate volatility by ARCH model Meanwhile, Pindyck (1991) analyzes the cost of capital in terms of sunk costs of entry and exit to estimate the effect on investment

by volatility in exchange rate and prices

Growth volatility

Ramey et al (1994) mentioned that a higher economic volatility associates with a lower growth, with economic volatility measured by the proxy per capita annual growth rates Based on the precautionary motive for savings, they debated that a higher volatility should conduct an increase in saving rates This enhanced the investment rate, considered as a premise for growth rising Besides, Down (2007) measured the domestic and global volatility by calculating the standard deviation of growth rate in terms of purchasing power parity (PPP), and per capita real GDP He also implied that a reduction in economic volatility induces developments associated with remarkable growth as well as the welfare for the OECD countries

2.2.2 Corporate income tax rate

FDI inflows respond negatively to a higher corporate income tax rate In other words, to stimulate inward FDI, corporate income tax rate is used as an effective instrument Because a reduction in the corporate income tax rate will motivate the incentive of FDI inflows (Ang, 2008; Billington, 1999; Fedderke and Romm, 2006) Devereux et al (2002) illustrated the mechanism of the relationship that an increase

in tax rate will boost the cost of capital, that leads to a reduction in capital inflows

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and an increase in capital outflows Because of the higher tax rate, the cost of capital, considered as the required rate of investment return, will raise That conducts a disincentive of investment In a research of De Mooij and Ederveen (2003), tax rate elasticity have the mean value set at the value of around -3.3 As otherwise stated, if tax rate in the host country decreases 1 percentage point, foreign direct investment in that country will increase by 3.3%

Devereux et al (2002) classified the measurements of the corporate income tax rate into two groups of corporate income taxes The first group of measures bases on tax legislation, consisting of effective marginal/average tax rate, statutory corporate income tax rate, and so on This type is forward looking, seizing the influence of tax

on future anticipated profits from a specific investment The second is group of measures based on tax revenue, calculated on the basis of ratio of corporate income tax revenues on GDP or total tax revenues This type is backward looking, capturing the effect of tax on the incomes in any historical period of a firm's investment decision This research is for the purpose of analyzing the impact of corporate income tax rate on attracting the investment location decision of foreign investors Therefore, the former group is suitable for the goals of the research

Devereux et al (2008) examined the tax reaction function for exploring the investment stimulation created by the tax regime via three measures The first, effective marginal tax rate, is defined as tax rate on new investments In other words, the scale of a firm’s operation is determined through this measure The second, effective average tax rate, is defined as the proportion of tax payment on true economic profit Otherwise stated, the firm’s location is determined through this measure Finally, the statutory tax rate is adjusted by governments to contest for the inward location of firms

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2.2.3 FDI inflows

According to literature on investment and taxation, investment is influenced negatively by the uncertainty of the economy because uncertainty increase risk, causing the increase in the cost of capital (Panteghini and Schjelderup, 2006) However, Ang (2008) argues that macroeconomic uncertainty may motivate inward FDI He debates that foreign investors look for greater potential investment returns because the higher cost of capital refer to the higher required return on capital as compensation for the higher level of uncertainty

Besides, tax rate impacts negatively on investment In order to stimulate investment, local officials tend to reduce tax rates (Knight, 1921; Oates, 1972) Reversely, a country with high inbound FDI rate tends to raise its tax rates without affecting its tax revenue (Panteghini and Schjelderup, 2006)

2.2.4 FDI outflows

FDI outflows tend to rise along with the higher statutory tax rates in the home country proportionate to those in the target country (Buettner, 2002) With the same other factors, an increase in the statutory tax rates, especially corporate income tax,

in the home country will stimulate an increase in FDI outflows for various purposes With reference to the purpose of financial incentive seeking, the destinations of FDI outflows are tax havens In the period of 2004-2006, around 80% of the outward FDI flows from China penetrated into Hong Kong and Caribbean (Morck, Yeung, and Zhao, 2008) Based on the UNCTAD records, Rasiah, Gammeltoft, and Jiang (2010) point out that an enormous amount of these FDI outflows re-enters China with the intent to gain benefits from preferential treatments for FDI, regarded as

“round-tripping” phenomena

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2.2.5 Country size

In equilibrium, the larger country levies the higher tax rate (Haufler and Stähler, 2013) The reason is that larger country will have lower tax elasticity so that face fewer cost of public funds at the margin (Bucovetsky, 1991; Wilson, 1991) Similarly, Gordon and Hines Jr (2002) debated that wealthy countries set high corporate income tax rates Another explanation is contributed by Han, Pieretti, and Zou (2014) that smaller countries are more motivated in undercutting their rival in terms of tax rates as policy instruments to attract inward capital However, Barro (1989) argues that national income influences the tax rate setting, but the direction

of the revision of tax rates is unpredictable Likewise, Han et al (2014) state that the difference in size among competing countries affects ambiguously on downward tax rate competition, especially without taking into account the influence of capital openness In contrast, Prud'Homme (1995) argues that richer countries lower their tax rates thanks to their greater tax base with the same or lower tax rates than other countries Because the lower tax rates will gain businesses’ favor to settle there Hence, they will collect more taxes

With reference to the relationship between the country size and FDI inflows, Haufler and Wooton (1999) indicate that the larger country receives more inward investment Based on the new trade literature, the choice of location for investment

is explained that the larger countries are preferred to place firms due to the ability of charging a higher producer price Thanks to the large market, firms located in these countries could avoid trade costs The motivation to locate firms in the large market

is called the “home market bias” This insight is supported by the point of view of horizontal FDI or market-seeking FDI in which its production is for the purpose of serving the local market Therefore, market size, or country size in research scope

of country level, is one of the main determinants of FDI attractiveness with positive correlation (Kinoshita and Campos, 2003)

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2.2.6 Capital openness

International integration in literature spurs economic stability because international trade prods the markets to integrate into larger, deeper, and more stable ones This stimulates the incentive of investment, particularly inward FDI In some empirical researches, it is proved that international integration promotes domestic economic volatility rather than accentuates it To this extent, integration between markets is considered as the term of capital market openness or financial openness Chinn-Ito index is a popular measurement of this term which covers a great number of economies, denoted as KAOPEN The higher values of this index, the more openness of the economy in terms of cross-border capital flows (Aizenman and Sun, 2012; Chinn and Ito, 2007; M D Chinn and H Ito, 2008; Lane and Milesi-Ferretti, 2008)

There is an abundance of studies about financial liberalization so that there is a profusion of measures of financial openness called capital openness index This index is categorized into two types, de jure and de facto measures The former attempts to gauge regulatory restrictions on capital operations, meanwhile the latter tries to measure financial openness via price-based approach (Chinn and Ito, 2008)

It comes to two reasons for selecting a proper measure of capital openness index Firstly, this research focuses a longitudinal dataset, from 1982 to 2011, to seize the long-term capital flows This results in a consideration of choosing a measure of capital openness index, which is able to cover a duration of more than thirty years Secondly, this research’s theory is built up based on government behavior reaction Therefore the choice of measure should capture the regulatory restrictiveness in the country As a consequence, the Chinn and Ito (2008) index is the applicable measure to convey the concept of the capital openness index

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2.2.7 Government expenditure

Regarding taxation, Sahasakul (1986) states that if permanent government expenditure is changed, the tax rate should be revised correspondingly Therefore, government expenditure is a good variable to predict changes in tax rate, though the changes are explained by three controversies Firstly, Barro (1989) debates that how government expenditure is planned and managed would conduct revisions of tax rates However, it is unpredictable the direction of these revisions Secondly, Wildasin (1989) pointed out that the relationship between local public expenditure and local tax rates is negative based on the effects of fiscal externality arguments When local government increases tax rates, capital tends to run outwards This causes the cut in local public expenditure Lastly, Oates (1972) contributes the literature on tax competition, which illustrates the positive correlation between public expenditure and tax rates He infers that tax competition is wasteful because local governments attempt to stimulate investment by keeping taxes low, causing lower tax revenues, and holding public expenditure below the equilibrium levels due to the reduction in tax revenues Moreover, Wilson (1999) contributes to this perspective by the argument that governments involve in uneconomical international competition by means of cutting off public expenditure along with lowering tax rates

With respect to FDI, Calvo, Leiderman, and Reinhart (1996) argue that if FDI flows are poured in a country persistently, the domestic currency tends to appreciate Thus, the government would tighten fiscal policy in order to control the real appreciation of the domestic currency and simultaneously inhibit the economy from becoming too hot The common method of contractionary fiscal policy is to reduce public expenditure to respond to the proliferation in inward FDI From the same point of view, Albuquerque, Loayza, and Servén (2005) contend that government expenditure correlates negatively with FDI flows As a responding signal to an increase in tax rate, the rising in government expenditure impedes the inward FDI flows

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2.2.8 Productivity

According to De Mooij and Ederveen (2003), productivity reflects the attractiveness

of an economy for the location decision of FDI beside other human capital factors The rise in the pre-tax rate of return is achieved by an outflow of capital, which reduces labor productivity and hence the compensation received by the immobile domestic labor force Therefore, the burden of the tax will be shifted away from the owners of capital to the labor force (Arulampalam, Devereux, and Maffini, 2012) It leads to the biased valuation of labor productivity in the context of income shifting Bartelsman and Beetsma (2003) stated that for the purpose of tax burden reduction, income shifting among countries distorts the productivity measurement Because over-reported returns and under-reported inputs are employed in the low tax countries Therefore, the negative relationship between corporate income tax rate and productivity is expected

The productivity, which is measured by the growth rate of GDP per worker ratio (Ghinamo et al., 2010), determines the productivity of the labor force of a country Moreover, labor productivity also reflects proportionally the wage level in the country A raise in labor productivity should be returned correspondingly into an increase in wage growth (Sharpe, Arsenault, and Harrison, 2008; Wakeford, 2004) Additionally, Cushman (1987) reveals that growth in wages of the host country proportionally dejects FDI into that country

2.2.9 Employment rate and demographic structure of population

The variable employment rate measures the labor tax base composed of wages and salaries This index captures the importance of labor as alternative tax base which depends on personal income tax rate Meanwhile, demographic structure of the population as the proportion of young and elderly reflects the pressures on tax revenues These two variables reflect the fiscal needs of the countries Moreover, the young to population ratio reflects the labor force available for new and expanding investment However, the sign of the relationship between these

2.2.10 Personal income tax rate

Rosen (2004) used the concept of double taxation to illustrate the tendency of taxation reaction Virtually, the corporate incomes are taxed at first at corporate income tax level Next, when dividends are paid to shareholders, they are taxed at the personal income tax level This causes the rise of effective tax rate on the return

of corporate investments In case of higher personal income taxes, the shareholders tend to accumulate those incomes with the company in order to avoid these taxes

Meanwhile various researchers use the term of income shifting to demonstrate the relationship between corporate income tax rate and personal income tax rate (Gordon, MacKie-Mason, and Hubbard, 1995; Gordon and Slemrod, 1998) In effect, individuals have a tendency to bend the way of getting reported payments for the purpose of reducing their tax liabilities if the personal income tax rates are higher than corporate income tax rates For example, an employee receives qualified stock options instead of wage payments or a self-employed person accumulates his profits within the company and finances his consumption by the company’s expenses Therefore, a labor income might be reclassified into a business income This leads to the reaction of government to raise the statutory corporate income tax rate in attempts to keep up with the high statutory personal income tax rate (Slemrod, 2004) Otherwise stated, corporate income tax acts as a backstop to personal income tax

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CHAPTER THREE: ECONOMIC VOLATILITY AND CORPORATE INCOME

TAX: DESCRIPTIVE AND DATA ANALYSIS

Chapter three demonstrates the measurements of variables and analysis the dataset Based on reviewing the theoretical and empirical frameworks, multiple measurements applied in this paper are described before conducting the estimations Descriptive statistics of variables of interest will also be delivered More specific, detailed trends in the corporate income tax rate, capital openness index, FDI inflows, and interest rate volatility will be illustrated

Based on the theoretical framework mentioned in the previous chapter, a general model is presented to illustrate the impact of economic volatility as well as other variables on the corporate income tax rate

Ctax it = ρCtax i,(t-1) + V i,(t-1) β + X it φ + ε it (3.1)

Where Ctax is corporate income tax rate, V is a vector of interest rate, exchange rate, and growth volatility, X is a vector of control variables which is presented for

further detail in section 3.2

3.1 Variable measurements

3.1.1 Measurement of economic volatility

Economic volatility might be measured to seize the general moments in economic volatility and the risk over time (Chowdhury, 1993; Cushman, 1988; Ghinamo et al., 2010; Koray and Lastrapes, 1989)

Vt =

2 / 1

1

2 2

( /

K m

Where Vt is volatility, K is the relevant variable, m is the moving average order The moving average order is defined based on the time length of the dataset so that

m with 5 years is chosen to smooth the value of observations

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This measurement takes into account the temporal variation in the absolute significance of volatility or risk over time As mentioned in the previous section, three proxies, real interest rate, nominal exchange rate, and GDP per worker growth rate, are assessed with this formula to obtain economic volatility figure

3.1.2 Measurement of corporate income tax rate

Devereux et al (2008) examined the tax reaction function for exploring the investment stimulation created by the tax regime via three measures The first, effective marginal tax rate, is defined as tax rate on new investments In other words, the scale of a firm’s operation is determined through this measure The second, effective average tax rate, is defined as the proportion of tax payment on true economic profit Otherwise stated, firm’s location is determined through this measure Finally, statutory tax rate is employed by governments to contest for the inward location of firms

Because this research aims to investigate the taxation on corporate income in the circumstance of tax competition among countries, consequently, statutory tax rate is the proper measure Besides, the statutory rate assists in demonstrating the profit shifting and decision of investment location of MNCs, Ghinamo et al (2010) use this measure in their study as the dependent variable

3.1.3 Measurement of capital openness index

The Chinn and Ito (2008) index, called KAOPEN, reflects the capital openness with

a broad measure of capital controls of the country, updated in April 2013 Different from some researchers’ works which have used a ‘‘share measure” reflecting the segments of years in the sample with an opening country’s capital account, this index is constructed as a “finer measure” by employing the detailed information of

27

capital account restrictiveness in the AREAER2 publications (Kose, Prasad, Rogoff, and Wei, 2006) This index is a derivative calculated from four binary variables which are collected from the AREAER: (1) variable denoting the existence of

multiple exchange rates (k1); (2) variable denoting the limitation on the current account transactions (k2); (3) variable denoting the limitation on the capital account transactions (k3); and (4) variable denoting the required conditions of capitulating export proceeds (k4) (Forbes and Warnock, 2012) The variable k3 is recalculated as

a share of five-year values (the contemporaneous and the previous four year values)

SHAREk3,t = k3,t k3,t1k3,t52 k3,t3 k3,t4 

Then the KAOPEN index is computed as a composite measure by applying a principal component approach at the first standardized level of k1t, k2t, SHAREk3t, and k4t (Chinn and Ito, 2008)

2 IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions

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3.2 Summary of variables description and data sources

Table 3.1 Variables description and data sources

1 Corporate income tax rate Ctax Reflects the international tax competition The top statutory corporate income tax rate World Tax Database

KPMG Trading Economics

2 Interest rate volatility IntRateSd Affects operating costs of so influences the investments'

return

Standard deviation in the five previous years

of real interest rate

World Development Indicators

3 Exchange rate volatility XRateSd Affects costs of capital so influences the investments'

return

Standard deviation in the five previous years

of the growth of nominal exchange rate

World Development Indicators

4 Growth volatility GrowthSd Affects the saving rates so influences the investments' rate

into a country

Standard deviation in the five previous years

of GDP per worker growth rate

Penn World Tables

5 Country's size GDP Reflects the market size and the wealthy of a country Log of real GDP measured in expenditure-side Penn World Tables

6 Capital openness CapO Presents to what extent a country's capital market is open Chinn–Ito capital openness measure Chinn and Ito KAOPEN

7 Government expenditure GovExp Reflects the fiscal needs of a country Government expenditure as a share of GDP Penn World Tables

8 Productivity GDPpwgr Reflects the attractiveness of a country in terms of human

capital factor

Growth of GDP per person employed Based on Penn World Tables

9 Employment rate EmpRate Reflects the labor tax base and current labor force Total employment over total population Penn World Tables

10 Old old Reflects the pressures on tax revenues Share of population aged more than 65 World Development Indicators

11 Young young Reflects the pressures on tax revenues and the labor force

in future

Share of population aged up to 14 World Development Indicators

12 Personal income tax rate Ptax Reflects the taxation reaction which corporate and personal

income tax act as substitutes for each other

Top personal income tax rate World Tax Database

World Tax Indicators KPMG

Trading Economics

13 FDI inflows FDIi Reflects the capital mobility, also the motivation of public

policies

According to test’s result performed in Appendix B.1, multicollinearity is not a problem among the variables in this paper

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3.3 Descriptive statistics

This paper focuses on the period of thirty years, from 1982 to 2011, in an attempt to handle two goals First, this period covers the sharp surge in financial openness among countries in the world For example, the Chinn and Ito index shows that in average the financial openness index rises from -0.38 to zero over the period 1980-

2000 In effect, it implies an increase in free openness of capital due to the liberalization of foreign exchange regulations during the late 1980s Second, a long sample could capture the long-term capital flows without disproportionate effects of financial crises or the world business cycle (Gourinchas and Jeanne, 2013) The expansion of capital liberalization generates a proliferation in FDIs and multinational operations, accordingly, escalates the international tax competition, especially corporate income tax (Diamond and Zodrow, 2014) The top statutory corporate income tax rate in the 1980s was around 40% in average Afterwards, in the late 1990s, it has decreased to approximately 30% in average (Devereux et al., 2002; Lee and Gordon, 2005)

Table 3.2 Descriptive statistics

Corporate income tax rate 460 31.413 9.513 12.000 60.000 Interest rate volatility 424 3.401 3.557 0.132 25.525

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In the scope of this research, the highest rate of statutory corporate income tax is 60% in Pakistan in 1989 whereas the lowest one is 12% in Macau from 2005 to

2011 This causes the high fluctuation in this variable with a standard deviation up

to 9.5 In 2011, policy makers in Pakistan reduce this variable to 35%, nearly 50% reduction in this rate Therefore, the decrease in statutory corporate income tax may

be concluded to be the inter-region tendency

Concerning to FDI inflows, the lowest volume belongs to Lao in the period

1985-1987, 0.55 million US dollars while the highest one is of Hong Kong in 2007, 1,226,806 million US dollars Hong Kong is also the region which obtains the highest inward FDI in 2011, 1,184,511 million US dollars, though this value is lower compared to that in 2007 In 2011, Lao attracted 2,188 million US dollars of FDI inflows, increasing sharply compared to the initial value In general, this variable increases over time and so does its natural logarithm values

With the dataset of 20 Asian countries in the 1982-2011 period, Figure 3.1 performs the consistent increase of average FDI inflows over the period Meanwhile, the average top statutory rate of corporate income tax decreases from 40% in 1982 to around 25% in 2011 This might be the consequence of the escalation in the international tax competition, which conducts the race to the bottom in the tax rate setting process (Wilson, 1999; Zodrow and Mieszkowski, 1986) During the whole period, the average Chinn and Ito index of capital market openness, however, holds

on a steady level This explains the rise of the index right before 1997 and 2007 then the sharp downward turns after that It might be the defense mechanism of developing countries against the influence from the outside depressions3

In the context of globalization, the capital openness relaxation among territories motivates the global tax competition Hence, statutory and effective tax rates keep

3 The appendix 1 is a particular view of this index

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driving down (Devereux et al., 2008) Garretsen and Peeters (2007) used the volume of FDI inflows as a proxy measurement of global capital openness and detect a negative effect of it on average tax rates

Figure 3.1 Corporate income tax rate, capital openness index and FDI inflows

(1982-2011)

Figure 3.2 illustrates the fluctuation of economic volatility in comparison to corporate income tax rate and FDI inflows throughout the period 1982-2011 The average real interest rate volatility varies around a horizontal line, although it expanded the scale of variation from 1997 to 2008 These are the landmarks of the two great crises, the Asian financial crisis in 1997-1998 and the Global financial crisis in 2007-2008 Virtually, it is remarkable that an increase in interest rate volatility goes with a pronounced decrease in statutory corporate income tax rate and vice versa

However, exchange rate volatility does not vary much throughout the time period Because this index is calculated by the standard deviation of exchange rate growth, the variation of the exchange rate is reduced and the value of the index is smoothened by the moving average order with 5 years As a consequence, the index

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merely shows the tendency in the exchange rate volatility Based on the tendency performed in the graph, the exchange rate volatility has reverse impact on the corporate income tax rate as well as FDI inflows Similar conclusion does the growth volatility have

2 4 6 8 10

25 30 35

40

%

1980 1990 2000 2010

Year Corporate tax rate Interest rate volatility FDI inflows

0 2 4 6 8 10

25 30 35

40

%

1980 1990 2000 2010

Year Corporate tax rate Exchange rate volatiliy FDI inflows

0 2 4 6 8 10

25 30 35

40

%

1980 1990 2000 2010

Year Corporate tax rate Growth volatility FDI inflows

2 4 6 8 10

0 2 4 6 8 10

25 30 35

40

%

1980 1990 2000 2010

Year Corporate tax rate Exchange rate volatiliy FDI inflows

0 2 4 6 8 10

25 30 35

40

%

1980 1990 2000 2010

Year Corporate tax rate Growth volatility FDI inflows

Figure 3.2: Corporate income tax rate, Real interest, Exchange rate, Growth

volatility, and FDI inflows (1982-2011)

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CHAPTER FOUR: METHODOLOGY AND RESULTS

This chapter illustrates the analytical framework of empirical works in this research This framework demonstrates the two models representing the direct and indirect effects of economic volatility on corporate income tax rate by two approaches Each approach is analyzed through the specifications of the model and method At the end of each approach, Results will be performed to illustrate the specifications which have presented

4.1 Analytical framework

Based on the Bad News Principle of Bernanke (1983), economic volatility affects negatively on investment (Dixit and Pindyck, 1994; Pindyck, 2004) The Bad News Principle indicates the dependence of investment on economic volatility in terms of news in which bad news discourages investment, meanwhile good news is independent from investment timing Therefore, an increase in economic volatility pushes up the threshold of profit rate at which investment, particularly FDI inflows,

is undertaken (Zambujal-Oliveira, 2012) In other words, increased economic volatility defers FDI decisions (Ghinamo et al., 2010) That means the number of firms undertaking FDI reduces As a result, the overall tax base will decrease and become less stable over time (Panteghini and Schjelderup, 2006) To counteract the negative effect of economic volatility, governments will reduce tax rates, especially the corporate income tax rate, as an optimal fiscal policy in order to attract inward FDI This creates an international tax competition causing the “race to the bottom”

in tax rates (Devereux et al., 2002; Wilson, 1999)

Firstly, the effect of economic volatility in corporate income tax rate is estimated directly with the reduced form of a dynamic model, based on analyzing the tax base importance, fiscal needs of the country, the role of backstop for the personal income tax rate and the degree of capital openness of the country However, this approach does not reflect the mechanism in which economic volatility impacts on corporate

34

income tax rates as mentioned in a theoretical framework Moreover, this approach

is estimated by GMM method Despite the fact that this estimator can deal with simultaneity, lags used as instruments are considered as weak instruments This may cause inconsistence in results

Secondly, the indirect estimation of the impact of economic volatility in corporate income tax rate via analyzing the influence of foreign capital flows of countries with the structural equations model This model consists of FDI determination equation and corporate income tax rate determination as the timing of choices In the first period, policy makers choose the level of corporate income tax rate based

on the volume of FDI movements in the preceding period and other features of the economy In the meantime, the decision on investment of multinational companies depends on the economic status of the destination country, called the economic volatility and corporate income tax rate in the previous period and a set of control variables The indirect effect approach reflects the theoretical mechanism in which FDI inflows are considered a motivation for governments in the tax competition

4.2 Direct effects

4.2.1 Model specification

To evaluate to what extent the economic volatility of a country influences the corporate tax setting process, the corporate income tax rate determination is investigated under a direct approach as a reaction function with a dynamic model:

Ctax it = α 0 + α 1 CtaxL1 it + α 2 Volatility i(t-1) + α 3 lGDP i(t-1) + α 4 EmpRate i(t-1) +

α 5 GDPpwgr i(t-1) + α 6 GovExp it + α 7 young it + α 8 old it + α 9 Ptax it +

The variables are defined in the table below with Volatility consisting of IntRateSd,

XRateSd, and GrowthSd