No. 160: Tax Complexity and Foreign Direct Investment

Countries pursue competitive tax policies to attract foreign direct investment. However, national and international tax reforms often lead to increased tax complexity, which may discourage investment. Yet tax complexity may also encourage investment by providing tax planning opportunities. This study uses a sophisticated measure of corporate tax complexity to examine its impact on firms’ cross-border investment. Analyzing a large set of firm location choices, we use a Poisson estimation with high-dimensional fixed effects to assess how different dimensions of tax complexity affect the establishment of new foreign subsidiaries. We find that the complexity of legislative, administrative, and judicial tax procedures (tax framework complexity) deters investment, mainly due to low guidance and audit complexity. In contrast, we find that complex tax regulations (tax code complexity), especially transfer pricing regulations, attract foreign direct investment on average. Further analysis reveals that multinationals with substantial cross-border investment activity as well as firms with a history of international presence or exposure to tax havens are hardly affected by the costs of tax framework complexity. The benefits of tax code complexity also vary across firms, with manufacturers benefiting the least. Our results provide novel evidence that tax complexity imposes both costs and benefits on firms, with small and medium-sized firms and less mobile ones being particularly disadvantaged. Taken together, our results suggest that it is the complexity of the tax framework that primarily reduces a country’s attractiveness as a destination for foreign direct investment, underscoring the importance of simplification of and certainty in tax procedures to encourage investment.