No. 160: Tax Complexity and Foreign Direct Investment

Countries increasingly use tax policy to compete for foreign direct investment (FDI), yet national and international tax reforms often make tax laws and regulations more complex and may thereby discourage investment. Drawing on a multidimensional measure of corporate tax complexity, data on newly established foreign subsidiaries, and Poisson estimations with high-dimensional fixed effects, this study examines how complexity in tax regulations (tax code complexity) and in legislative, administrative, and judicial tax procedures (tax framework complexity) affect FDI location choices. The findings reveal a dual nature of tax complexity: framework complexity consistently deters FDI, whereas, surprisingly, code complexity is on average associated with higher FDI, in particular when complexity stems from regulations on transfer pricing, royalties, and interest. Cross-sectional analyses show that tax framework complexity barely affects multinationals with extensive cross-border investments, prior host-country presence, or exposure to tax havens, but disproportionately discourages small and medium-sized groups. The benefits of tax code complexity are weaker for manufacturing firms than for service firms. Overall, the results suggest that it is chiefly the complexity of the tax framework, especially in tax audits and tax guidance, that undermines a country’s attractiveness for FDI, highlighting the policy importance of simplification and increasing certainty in tax procedures.