Taxation and the quality of institutions: asymmetric e¤ects on FDI

Economic integration has intensi\u85ed international competition to attract productive capital. This paper analyzes the e¤ect of both tax policies and institutional quality on the allocation of FDI two aspects that the economic literature has extensively investigated, though only in isolation. I build a simple two-country partial equilibrium model to study competition among governments vying for potential investors whose location choices are driven by both the quality of institutions and the corporate tax rate. It is shown that, provided \u85rms are sensitive enough to the quality variable, the jurisdiction providing better institutions is able to levy a higher tax on capital, and to attract more investment, compared to the low-quality/low-tax location. Empirical evidence using a di¤erence gravity speci\u85cation on FDI stocks to 63 economies supports the claim that the sensitivity of foreign investment to the tax rate varies signi\u85cantly between host countries with di¤erent levels of institutional quality