Taxes and agglomeration: determinants of FDI in an enlarged European Union

Work in progress – please do not quote This paper empirically analyzes the impact of tax rates and agglomeration economies on FDI, using aggregate and sectoral panel data on bilateral FDI flows and stocks in the European Union. The novelty of the paper it that it explicitly deals with agglomeration forces and how these may explain differences in tax policies between new and old members. In theory, we would expect agglomeration advantages to be larger in countries that previously have received large amount of FDI. As agglomeration economies give an opportunity to have higher taxes, deviations in tax rates across countries could then be explained by differences in the stock of FDI. At the same time, the two-fold nature of FDI suggests that higher taxes deter new flows of FDI. This could then explain why new member countries without large stocks of FDI are likely to pursue a more aggressive tax policy in order to attract new investments. The paper makes use of new data on effective corporate tax rates for the new member countries. These data are available for 7 new member countries and covers the period 1995 to 2005. In addition, the empirical analysis closely follows the underlying model where the foreign direct investment decision is seen a two-step procedure: first, whether to invest or not, and second, the amount of FDI to invest. This set-up of the investment decisions is crucial in order to understand the impact of different tax rates on the extensive and intensive margin of FDI.