The Eclectic Theory of International Production

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Theoretical Framework

The Eclectic Theory of International Production

John Dunning first presented the eclectic paradigm theory in 1976. At its first stages, Dunning explained that there are three main determinants representing the tendency for enterprises to produce internationally: ownership-specific advantages, the desire to internalize these advantages, and the amount of profits that could be made by combining these assets with location-specific resources. Ownership-specific assets refer to the competitive advantages that firms have over other firms. Location-specific advantages refer to a country’s benefits (e.g. natural resources and technology availability). Dunning (1976) argued that the greater the ownership-advantages of a firm were and the wider the location-specific attractions of a country, the bigger the inclination towards internalizing the firm’s advantages in the country with these attractive resources. The theory later became to be known as the OLI paradigm, the initials representing the words Ownership, Location and Internationalization which, he argued, are the variables that shape a firm’s international activities (Dunning, 1980, 1988).

Deveroux’s Decision Tree

In the literature review by Michael P. Deveroux (2006) , the author presents a simple model decribing different desicions faced by multinationals when deciding on a new investment. The decision tree consists of four stages in which different types of decisions are made. Step one is the decision to invest at home and export the product or invest abroad. This decision can be influenced, among other factors, by the home country taxation system. If the company chooses to invest abroad, the second decision to be taken is the optimal location of the investment. It is in this stage (2nd) that host country taxes play an important role given that any MNEs would prefer to locate where production costs are lowest or productivity is highest. It is at this stage where MNEs face the decision of location and thus the stage at which the tax rate plays an important role. The fourth and fifth decisions are the level of investment to be done and the reallocation of profit among locations, respectively and are dependent on the tax rate conditional upon the chosen location. Stage two is the decision we try to analyze in this thesis, through the question of: Where will MNEs locate? And will the CIT influence their decision? Figure 3.2 shows the decision tree and the stages (Deveroux, 2006).

The relationship between taxes and FDI

Taxation can affect FDI inflows in different ways. According to Easson (1999), studies suggest that taxes are very important considering their direct impact on production costs and profits. Most research however, has been quite inconclusive on the exact relationship between FDI and changes in taxation; this could be due to the many other factors that affect FDI inflows into a country. Easson (1999) emphasizes on the importance of tax considerations while deciding where to locate, rather than decisions of whether to invest abroad or at home. Additionally, the type of investment may have an impact on the degree of the effect that taxes have on FDI. First of all, there are big differences between marketoriented and export-oriented investment, where the former is affected little by taxes compared to the latter. Moreover, according to Easson (2004), there is proof that the relevance of taxation varies depending on the type industry. In a study by Wilson (1993), the author finds that tax relevance varies significantly across industries. In the research, marketing and distribution centers and pharmaceutical and software companies were between medium and highly sensitive to taxes. While in the chemical industry taxes seemed to have no importance at all. “These differences seem to reflect the relative mobility of the investment and the range of choice of possible locations” Easson (2004).
Taxation is important for more export-oriented investment. Export-oriented FDI can be more sensitive to the host country tax burden than market-oriented FDI. It is also called “resource-oriented FDI” since the main reason for the investment is to have access to resources (natural or human). This type of FDI is more sensitive to taxes because the main factor that drives this type of investment is the cost of labour, raw materials, and other costs of operations, which in turn, are directly affected by taxes. In addition, the price of the products or services to be exported are also affected, the higher the taxes, the higher the prices (Easson 1999). A MNE seeking to locate on a place where there is big supply of skilled labour will consider labour costs which can be affected by taxes on labour.
Nevertheless, home and host country taxation are both relevant to FDI flows, we develop each of them below.

Host Country Taxation

Foreign companies can be, and in most cases, subject to the national tax system where they locate. The Corporate Income Tax (CIT), which varies from country to country, has been regarded as the most relevant and influential tax rate due to its direct relationship to profits. Company profits are directly taxed by the corporate tax rate and therefore any MNE looking to invest abroad will prefer a country where the CIT is lower. However, the CIT is not the only tax that can affect profits or production costs. Personal income taxes, payroll taxes and social security contributions, are other taxes that MNEs might be interested in knowing, before deciding where to carry on investment.
These taxes can have a substantial effect on labour costs. In many cases, foreign companies want to bring expatriates5 when coming into a new market in order to train local managers and employees. The cost of hiring these expatriates will differ if the country in which the investment is carried out has a higher tax rate on income and on employer payable taxes (social security contributions, payroll taxes, etc.). Thus, to some extent, these type of taxes can have an impact on the location decisions of MNEs.
Other host country taxes that could also influence, but about which less evidence has been shown, are: consumption taxes, custom duties and import taxes. These taxes could influence to the extent to which these are passed on to consumers (e.g. Value Added Tax). Custom duties and import taxes, however, would affect the consumer’s behavior on buying imported products which in turn might influence the decision of investing at home and exporting or producing abroad.
Foreign investors can be interested on the withholding taxes on dividends and interest. This could be the case of either home or host country taxation. Moreover, individual income tax and social security contributions are also important to consider, although they tend to have a minor effect, these type of taxes can have a large impact on labor costs, so is the case of Sweden.
Import taxes and custom duties can affect in two ways. If these are too high, it may perhaps create and incentive for MNEs to produce in a country rather than export to it. It could, however, also create a disincentive given that the initial cost of investment might be higher (Easson 2004). This are all taxes from the perspective of host countries, we now turn to the perspective of home countries.

Home Country Taxation

When we talk about home country taxation, we lie on the first stage of the decision tree presented earlier. Home country taxation comes into relevance when a company has to decide to either invest abroad or at home. The simplest of capital flows and taxation model suggests, “The tax rate in an open economy will cause a net capital outflow, and a lower aggregate capital stock. The lower capital stock may well have a negative impact on economic welfare of the residents of the country. It may therefore be natural to investigate the impact of capital taxes on the aggregate capital stock” (Deveroux, 2006, p. 7). Thus, it is important to investigate the impact of home country taxation in order to avoid capital flight, which in turn has a negative impact on the welfare.
Normally, governments tax their residents on their worldwide income. Any individual or company carrying out business in a different country, other than theirs, is subject to taxation in its home country. Consequently this has given rise to the problem of double taxation. Foreign companies are taxed by the host country and by the home country. This double taxation problem creates disincentives to invest and thus has influenced the creation of double taxation treaties. Double taxation is usually used in order to restrict companies from paying too little taxes, if the tax rates in the foreign country are too low it is only fair that foreign-sourced income is taxed and thus keeping capital export neutrality in the home country. (Easson, 2004) In some countries for example, such as Hong Kong, chaste territorial tax system is offered. Residents of Hong Kong are exempted from taxation of foreign-sourced income. This in turn, creates more transparency and less illegal or unfair transfer pricing amongst Hong Kong Multinationals, and consequently benefits their economy. In Sweden on the other hand, a crisis during early 1990’s caused a steep fall of the kroner. The crisis erupted primarily due to capital outflows from the country as citizens searched for tax havens to alleviate the high tax levels in Sweden (Banking Introductions, 2004). Additionally, although little evidence is presented about Swedish companies moving headquarters abroad due to high taxes in Sweden, it is inappropriate to disregard the possible influence that high taxation had on the decisions of these MNEs (e.g. Securitas, Autoliv and Esselte). Not to mention the relocation of Swedish richest man Ingvard Kampard to Switzerland (ITPS, 2008)4 .
By contrast, the ability of MNEs to shift profits freely across countries and control prices, through the exercise of transfer pricing, could have an influence on the extent to which home country taxation affects FDI flows (Deveroux, 2006).

Transfer Pricing

It is defined by Easson (1999) as “transactions in goods and services between related enterprises and, more specifically, the price charged in such transactions” (Easson 2004).
Transfer pricing can distort the results from research seeking to explain the impact of taxation on location decisions of capital. The ability of organizations to control prices, and therefore reduce the payable taxes, will provoke a weakening of the tax considerations taken by MNEs when deciding where to locate new investment. However, in a study by Bernard and Weiner (1990) on US firm-level data of oil imports seeking for a relationship between taxation and arm’s length and transfer prices, the authors find that there is no significant relationship between the controlling of prices and the tax liabilities (Deveroux 2006). Although, Deveroux argues, host country taxation may induce lower taxable income as companies try to find a way to shift profits to lower-taxed jurisdictions.

The Determinants

Since the 1950’s Western Europe has been an attractive area for US MNEs. Its lucrative market, technological advancements, skilled labour, efficient government policies and cultural proximity have been the main determinants of FDI inflows (Sethi et. al., 2003).
It is not appropriate to state that taxes are the only determinant behind foreign investment flows. If one wants to recognize the impact of taxation on FDI, it is necessary for all other possible factors to be included. For example, disregarding the infrastructure of a country, which is directly linked to government expenditure and taxes, might create a biased or misleading results on the true results (Deveroux 2006).
Based on the OLI framework, the most common variables used on other studies made on the impact of taxation on FDI were selected. Most developed economies share similar variables which are considered to be traditional determinants of FDI, for this reason, we have selected the variables that could differ more across these countries and thus influence the location decisions:
GDP
This variable is a proxy for market size. Market access has proven to be one of the main, if not the most important, determinant of FDI. The size of the market will determine the degree of possible profits hence, the relevance of the variable (Easson, 2004).
Skilled Labour
MNEs will be attracted to invest where human capital is larger given the higher productivity per labour cost unit. Moreover, technology intensive investment might require more advanced knowledge and thus the need for skilled labour. This however, may vary depending on the type of industry (Easson, 2004).
Labour costs:
For export-oriented investment, costs of production and low-cost qualified labour are of high importance (Lankes & Venables, 1997).Therefore, other things equal, MNEs will prefer to invest in a country where production costs are lower rather than higher because of effect on profits. Given this, the location decisions of an Enterprise will be influenced by the long-run production costs associated with investing in a certain country (Easson, 2004).
Economic Freedom
The Economic Freedom Index by The Heritage Foundation measures the degree of exertion of different factors that are rather important determinants of FDI. It measures the overall economic freedom in a given country. Higher values of the index mean better practice of all measurements and thus better possibilities for profitable investment.
The following are the targeted variables included in the index:
Trade Openness: countries offering lower barriers and easiness to move capital freely will be more attractive for foreign investors given that costs such as tariffs and duties will be lower (OECD, 2000).
Property Rights: Expropriation is a threat to any entrepreneur. The strength of the legal system over protection of new ideas is of high importance and of major concern to any investor. Weakness in this legal factor will have a negative impact on new investment and thus on FDI (Easson, 2004).
The role of infrastructure
A country with very good roads, water supply, power grids, telecommunications, etc. contribute to efficiency and higher labour productivity and thereby lower costs of production. (Bellak, Leibrecht, Damijan 2009). All this constitute part of a country’s infrastructure. Both taxes and infrastructure can have an impact of location decisions, one being negative and the latter being positive since it contributes to higher productivity.
It can be a confusing topic given that on one side an increase in taxes, all else equal, gives a lower post-tax net present value of any given investment. While on the other side, an increase in infrastructure contributes to labour productivity. Thus lower taxes or higher infrastructure can attract higher levels of FDI.
Bellak et. al. (2009) found that, infrastructure was a relevant factor or determinant of FDI location. Moreover, the authors also found that tax-rate elasticity of FDI was a diminishing function of infrastructure endowment. Thus one can be dampened by the other. In general, both of these variables have an inverse relationship to inflows on investment (Bellak et. al. 2009)

Table of Contents
1 Introduction
2 Background
2.1 Previous Studies
2.2 Inward FDI and taxes in Sweden
2.3 Benefits of FDI
3 Theoretical Framework
3.1 The Eclectic Theory of International Production
3.2 Deveroux’s Decision Tree
3.3 The relationship between taxes and FDI
3.4 The Determinants
4 Empirical Framework
4.1 Data
4.2 Dummy Variables
4.3 Model
4.4. Regression & Analysis
5 Conclusions
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