To increase foreign direct investment (FDI) in their country is a desirable policy goal for most policy makers. Yet, often the factors influencing the influx of FDI are not easily amenable to policy, either because they are unalterable, like natural endowment of physical resources, and cultural and geographic proximity to major source countries, or because changing them is a very long-term process, as in the case of the efficiency of political institutions, market size, or the education and productivity of the local labor force. However, there are still a number of measures which can be taken to compete in the rivalry for foreign investment: on the one hand, restrictions imposed on investors regarding, e.g., the profit repatriation can be unilaterally eased, red tape or corporate taxes can be reduced, and on the other hand, bilateral measures can be taken, such as concluding bilateral investment treaties (BITs) or double taxation treaties (DTTs). (1)
The question addressed in this paper is whether the conclusion of a DTT leads to more bilateral FDI between the two respective countries. If existent, this benefit could compensate for the costs attached to DTTs. In addition to the costs of negotiating and ratifying the contract and giving up some fiscal sovereignty, there could also be a loss in tax revenues for at least one of the signing parties. This is particularly important from the point of view of developing countries as most treaties favor residence-based over source-based taxation. (2)
We are, of course, not the first to analyze the effect of DTTs on FDI. However, our major original contribution to this literature is that we overcome two limitations of existing studies. These have either suffered from the absence of information on bilateral FDI, using instead aggregate FDI in a large and representative monadic country year sample (Di Giovanni, 2005; Neumayer, 2007), or, where they used bilateral FDI data, they have suffered from a small and unrepresentative dyad year sample (Blonigen and Davies, 2004, 2005; Coupe, Orlova, and Skiba, 2008; Davies, 2003, 2004; Egger et al., 2006). This applies in particular to the large number of developing countries, which are hardly covered in the estimations. Instead, we test the effect of DTTs on FDI in a dyadic country dataset, in which both developed and developing countries are very broadly represented over a long period of time. We find that DTTs increase the bilateral FDI stock between 27% and 31%.
The remainder of this article is structured as follows: the next section discusses the benefits and costs to the contracting partners of concluding DTTs. Section 3 presents trends in the development and coverage of DTTs, demonstrating that not only have DTTs become increasingly popular, but also their geographical coverage has extended to include many developing countries. Section 4 reviews existing studies which have examined the effect of DTTs on FDI and discusses their shortcomings. Section 5 explicates our research design. Section 6 reports results from the main estimations and robustness tests, while Section 7 concludes.
II. THE BENEFITS AND COSTS OF DTTs
Double taxation is generally defined as the imposition of comparable taxes in at least two countries on the same taxpayer with respect to the same subject matter and for identical periods (OECD, 2005). This may occur if one country claims taxing authority based on the residence or the citizenship of the taxpayer, while another country postulates taxing authority based on where the income originates. Another potential source of twofold taxation could be the fact that both countries claim either a certain taxpayer as a resident or that an income arises within its country (Doernberg, 2004). Also, different methods for the determination of the internal transfer price applied in two states can lead to a double taxation, e.g., a company has a production facility in two countries and delivers intermediate goods from the plant in country A to the factory in country B. …