1Corporate taxation and FDI within the EU25

The influence of tax differentials on FDI location is a source of concern both in the EU15 and the NEM. EU15 countries fear that investment be diverted towards low-taxation, eastern European neighbors. As to the NEM, they have been experimenting a strong inflow of foreign capital during the transition period, as a result of both their rapid opening-up and the privatization process. With both processes now going to an end, the permanence of long-term foreign capital inflow is an important issue. The NEM could feel the temptation of attracting further FDI by tax incentives, as this is the only tool left once monetary policy is dedicated to entering the EMU, and fiscal policy is partly constrained by the Maastricht treaty. This paper investigates the impact of tax incentives on the location of FDI within the enlarged European Union. In order to capture the structural determinants of location choices, this issue is explored using a gravity framework, where the market potential of recipient countries is taken into account. Tax incentives are measured both by statutory and apparent taxation, and the whole empirical work is led on bilateral data. The paper shows that FDI does react to tax differentials within the EU25. This is especially the case when an ex-post measure of taxation that accounts for all possible allowances and exemptions, is used to measure tax differentials. This result is robust to the inclusion of other major determinants of FDI attraction, such as unit labor costs and/or the real exchange rate. Differentiating between positive and negative tax differentials seems to indicate that tax incentives are especially strong for FDI directed to the NEM. Moreover, a higher taxation in the competitors leads to an increase of FDI in the destination country. Hence, the risk of a tough tax competition to attract FDI does exist in the European Union. This risk is however limited by the prominent importance of non-tax factors in the location of FDI. 1