Foreign Direct Investment in Europe: Tax Competition and Agglomeration Economies

This paper provides an empirical analysis of the impact of tax differentials and agglomeration economies on FDI. We use a panel of bilateral FDI flows for European Union member countries over the period 1986-2004. The paper departs from most previous work on FDI and tax competition as it incorporates several measures of agglomeration forces and examines how these may mitigate a race to the bottom in tax rates. As the strength of agglomeration economies may vary with the degree of integration–and as an additional aim of the current paper is the effects of European integration–we focus on countries within the European Union. Furthermore, as the market based measures of agglomeration forces could be difficult to differentiate from traditional explanations of FDI determinants, we include alternative measures of agglomeration associated with regional concentration and industrial linkages in production.