Today, we continue to examine the effects of corporate income taxes on investment. Dr. Larry Summers, a Harvard professor and currently an economic adviser to President Obama, recently wrote about this. (Summers has announced he will return to Harvard at the end of the year.) In 2009, he published an article with Dr. James Hines of the University of Michigan. Here’s their review of the effects of taxation on foreign direct investment, followed by a translation into plain English.

”How Globalization Affects Tax Design.” Tax Policy and the Economy 2009 23:1, 123-158.

A substantial body of research considers how taxation influences the activities of multinational firms. This literature considers the effects of taxation on investment and on tax avoidance activities. With respect to investment, tax policies are obviously capable of affecting the volume and location of foreign direct investment since, all other considerations equal, higher tax rates reduce after-tax returns, thereby reducing incentives to commit investment funds. This literature identifies the effects of taxes through time-series estimation of the responsiveness of foreign direct investment to annual variation in after-tax rates of return and cross-sectional studies that exploit the large differences in corporate tax rates around the world to identify the effects of taxes on foreign direct investment. The first generation of these studies, reviewed in Hines (1997, 1999), reports tax elasticities of investment in the neighborhood of −0.6. What this means is that a 10% tax reduction (e.g., reducing the corporate tax rate from 35% to 31.5%) should be associated with 6% greater inbound foreign investment. More recent evidence suggests that foreign direct investment is even more tax sensitive than this…

For example, Altshuler, Grubert, and Newlon (2001) compare the tax sensitivity of aggregate capital ownership in 58 countries in 1984 to that in 1992, reporting estimated tax elasticities that rise (in absolute value) from −1.5 in 1984 to −2.8 in 1992. Altshuler and Grubert (2004) offer evidence of a −3.5 tax elasticity of investment in a sample of 58 countries in 2000. (p. 131)

Translation: Investment dollars are mobile and they will tend to flow to the investment projects offering the best after-tax rates of return.  Higher tax rates reduce the incentive to invest in a particular location.  Tax rates, then, affect a location’s ability to attract foreign investment dollars.

Economists have spent a lot of time calculating just how that fact plays out in a company’s decisions of where to invest in the world. People who look into this have used two complementary approaches. The time-series data approach attempts to figure out how much the level of foreign direct investment changes over time in response to changes in tax rates. (By “foreign,” we mean from outside the country.) The cross-sectional data approach, by contrast, compares tax rates across different countries, at the same time.

In the first generation of research, economists concluded that reducing the corporate tax rate by 10 percent meant that the level of foreign investment went up 6 percent. More recent research has concluded that the relationship is even stronger, suggesting that a 10 percent decrease in tax rates would increase foreign direct investment by 15, 28, or even 35 percent.

That’s the word from Summers and Hines. Now, do you remember Simeon Djankov and his co-authors, whom I wrote about in the first article in this series? Using their international data set they estimate that reducing the tax rate by 10 percent would increase the amount of foreign investment by 8.35 percent.

Dr.  Claudio Agostini, in another peer-reviewed article entitled, “The Impact of State Corporate Taxes on FDI Location,” (published in Public Finance Review 2007; 35; 335), found similar negative effects of corporate income tax rates on foreign direct investment in the 50 states. He concluded that the elasticity of foreign direct investment is –1. What that means is that a 10 percent reduction in the corporate tax rate is associated with a 10 percent increase in investment in that state.

What this quick overview of three different articles demonstrates is that there is good evidence that higher corporate income tax rates reduce foreign direct investment. In the terms of economists, the findings are “robust,” meaning different researchers using different types of data from different countries and different time periods find similar results.  Now, “robust” findings are significant for academics, who take pride in being able to be confident rather than tentative in their research.

But these findings have day-to-day consequences for the rest of us, too. Less foreign direct investment in a country or state means less money used to create jobs and in turn, incomes.