The Impact of State Corporate Taxes on FDI Location

Claudio Agostini and Soraphol Tulayasathien

ILADES-Georgetown University Working Papers from Ilades-Georgetown University, School of Economics and Bussines

Abstract: This paper examines the effects of state corporate income taxes on the location of foreign direct investment, taking into account the state governments' behavior when setting taxes. Ignoring the tax setting behavior of states may bias the estimate of the tax effects on foreign direct investment. States have a set of characteristics that influence investors' decisions, some of them are not observable by a researcher but states take them into account when they set taxes. States can also act strategically with respect to other states when setting taxes. The former behavior bias the estimated tax e ?ects because it creates correlation between the error term and the tax rate. The latter behavior directly implies an endogenous tax rate. We adapt a discrete choice model of differentiated products to estimate the tax effects. This approach allows us at the same time to control for the outside options of investors and to use instrumental variables to solve the problem of tax endogeneity. We find the tax elasticity to be consistently around -1.

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