Playing easy or playing hard to get: When and how to attract FDI

Abstract

We show the observed variation in corporate tax policies depends on each country’s institutional quality in tax collection using a model of heterogeneous multinationals that can shift income using debt and transfer prices. Countries with weak institutional capacity are either worse off attracting foreign direct investment (FDI) or their optimal policies collect no tax revenues from foreign subsidiaries. Countries with moderate institutional capacity can gain from under-utilizing their ability to collect taxes, since the benefit of attracting more FDI outstrips the cost of less tax revenue. Countries with strong institutions benefit from attracting FDI that generates corporate tax revenues.