A Continuing Debate on the ‘Race to the Bottom’ and Tax-Avoidance Policies of MNE's

Abstract

The issue of tax avoidance has once again come to prominence in public debate (IMF, 2014). The change in government policies in the UK, in Europe and a host of other countries across the world has been leaning towards lowering of corporation tax in order to attract multinationals investment in their territories. The debate as to how this lowering of tax, or the new consciousness of the MNEs in their tax planning as a tool for strategic management and competitiveness can shape the future of the local economies, and whether the perceived benefits of inward FDI is still a reality that surpass the negative impacts that such investments may have on local economies and the development and growth of local SMEs are issues that this paper aim to cover. The methodology of this paper is mainly a desk based review of policies and theories of taxation and inward FDI. The literature on theories of taxation in general and corporate taxation in particular will focus on the history of corporate tax and its development, and offers a comparison of the corporation taxation systems in Europe and the US. The paper will then re-examine the perceived positive and negative externalities of the MNEs FDI on local economies against actual benefits confirmed by secondary evidence.
The paper is structured in three sections. In the first section, a review of taxation as an economic concept is presented; the history of corporation tax in the UK is reviewed and evaluated; a change towards lowering of corporate tax and the arguments in favour of a lowered tax regime will be examined. This second section reviews the impact of inward FDI primarily from a conceptual point of view and then moves into a systematic review of the literature on the evidence of potential benefits of inward FDI as presented by local governments as justification for favourable policies to entice MNEs to choose their investment locations. The last section will offer a debate on government-multinational interaction and proposes a conceptual framework for assessing the local impacts of national policies by proposing testable hypotheses. It would not be within the scope of this paper to test these hypotheses but it is hoped that by offering such propositions a wider debate on the future role of taxation as a means for achieving welfare goals of sustainable societies.

Full text

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International Business Conference 2015
“Contemporary issues in international business theory” and Rugman Memorial”
13-14 June 2015
Rugman-Related: MNE-Government in the Context of FDI
A CONTINUING DEBATE ON THE ‘RACE TO THE BOTTOM’ AND TAX-AVOIDANCE
POLICIES OF MNES
Herman Belgraver, The Queen's University of Belfast Management School, Riddel Hall, 185
Stranmillis Road, Belfast, Northern Ireland | United Kingdom, BT9 5EE Tel: +31 (0)6 1887 4094, e-
mail: hbelgraver01@qub.ac.uk
Mahtab Akhavan Farshchi, Senior Lecture, London South Bank University, 103 Borough Road,
London, SE1 0AA. Tel: +44(0)2078157597; email: m.farshchi@lsbu.ac.uk
INTRODUCTION
The issue of tax avoidance has once again come to prominence in public debate (IMF, 2014). The
change in government policies in the UK, in Europe and a host of other countries across the world has
been leaning towards lowering of corporation tax in order to attract multinationals investment in their
territories. The debate as to how this lowering of tax, or the new consciousness of the MNEs in their
tax planning as a tool for strategic management and competitiveness can shape the future of the local
economies, and whether the perceived benefits of inward FDI is still a reality that surpass the negative
impacts that such investments may have on local economies and the development and growth of local
SMEs are issues that this paper aim to cover. The methodology of this paper is mainly a desk based
review of policies and theories of taxation and inward FDI. The literature on theories of taxation in
general and corporate taxation in particular will focus on the history of corporate tax and its

2
development, and offers a comparison of the corporation taxation systems in Europe and the US. The
paper will then re-examine the perceived positive and negative externalities of the MNEs FDI on local
economies against actual benefits confirmed by secondary evidence.
The paper is structured in three sections. In the first section, a review of taxation as an economic
concept is presented; the history of corporation tax in the UK is reviewed and evaluated; a change
towards lowering of corporate tax and the arguments in favour of a lowered tax regime will be
examined. This second section reviews the impact of inward FDI primarily from a conceptual point of
view and then moves into a systematic review of the literature on the evidence of potential benefits of
inward FDI as presented by local governments as justification for favourable policies to entice MNEs
to choose their investment locations. The last section will offer a debate on government-multinational
interaction and proposes a conceptual framework for assessing the local impacts of national policies
by proposing testable hypotheses. It would not be within the scope of this paper to test these
hypotheses but it is hoped that by offering such propositions a wider debate on the future role of
taxation as a means for achieving welfare goals of sustainable societies.
Keywords: Taxation theories, Corporate Taxation, Tax Planning, Tax Avoidance, Knowledge
Spillover, Externalities, Government Policies, Local SMEs, FDI
SECTION ONE – CORPORATE TAX
Introduction
The role of multinationals in negotiating income taxes and import/export duties with domestic and
foreign governments has been well documented in academic literature (Rothchild & Curry Jr., 1978).
Countries, both developed and developing, are competing for foreign direct investments (FDI) by
offering a reduction in or exemption from taxes and duties (Devereux, Griffith, & Klemm, 2002;
Devereux, Lockwood, & Redoano, 2008; Hartman, 1982, Lent, 1967; Levy & Sarnat; 1975, Morisset
& Pirnia, 2000) assuming that inward FDI provides the host government with “direct” and “indirect”
benefits, i.e., externalities (de Mello, 1997) such as foreign capital infusion (Blomström & Kokko,
1998; Görg & Greenaway, 2004; Lent, 1977; Lent, 1967; Levy & Sarnat, 1975), reduced structural

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unemployment in the case of labour intensive industries (Blomström & Kokko, 1998; Driffield &
Taylor, 2000; Levy & Sarnat, 1975), and “indirect” effects such as productivity growth (de Mello,
1997, Görg & Greenaway, 2004), export growth or learning how to export (Aitken, Hanson, &
Harrison, 1997, Blomström & Kokko, 1998; Buckley, Clegg, & Wang, 2002; Görg & Greenaway,
2004; Wei & Liu, 2006), managerial knowledge and techniques (Aitken & Harrison, 1999;
Blomström & Kokko, 1998; Fosfuri, Motta, & Rønde, 2001; Zhang, Li, Li, & Zhou, 2010), and
knowledge or technology spillovers (Blomström & Kokko, 1998, Liu, 2002). The perceived benefits
of inward FDI have therefore justified favourable policies towards foreign MNEs in most countries
where a “race to bottom” has meant that countries have pioneered or followed each other in reducing
corporate taxation. In the rest of this section we review theories of taxation and the role taxation has
historically played to overcome market failure. The changes in the taxation policies are then reviewed
on an international level and then specific attention is paid to the changes in the UK corporate taxation
and other policies regarding FDI. The section will conclude with a review of arguments that are
presented by respective governments to justify their favourable inward FDI policies. The evidence is
also presented of the impact that such policies have had on the distribution of wealth in the UK and in
general across the world.
Base Erosion and Profit Shifting and the public scrutiny
The growing trend in “base erosion and profit shifting” (BEPS) practices has undermined the
credibility of the tax system in the eye of all taxpayers. BEPS relates to instances where the
interaction of different tax rules leads to some part of the profits of the MNEs not being taxed at all, as
well as arrangements that achieve no or low taxation by shifting profits away from the jurisdictions
where the activities creating those profits take place (OECD, 2014). In a recent report by OCED
(2014) it was stated that developing countries often face policy and other conditions that impact their
abilities to address base erosion and profit shifting. Among the contributing factors are: lack of
information, highly complex rules, lack of effective legislation and gaps in capacity which ‘may leave
the door open to simpler, but potentially more aggressive, tax avoidance than is typically encountered
in developed economies’ (Pp.2-3). Developing countries may be affected more severely by practices

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such as excessive payments to foreign affiliated companies in respect of interest, service charges,
management and technical fees and royalties as well as shifting profit through supply chain
restructuring that contractually reallocates risks and associated profits, to affiliated companies in low
tax jurisdictions. The pressure for attracting investment to such countries leads to offering tax
incentives, which may in turn erode the country’s tax base with little demonstrable benefit. Although
not considered “illegal”, the practice of BEPS ‘exploits unintended mismatches between the rules on
the taxation of MNEs put in place by different tax jurisdictions’ (ibid., p.8). OECD (2014) report
suggests that in other cases, avoidance is possible because internationally developed principles have
not kept pace with the global integration of the economy. Practices that artificially segregate taxable
income from activities that generate it are the key problem rather than the mere low or no taxation
(ibid.). In such environments it is likely for the MNEs to earn incomes from cross-border activities
where these remained totally untaxed. This issue has entered the public debate and it is argued that
the international nature of tax planning requires a bilateral and coordinated action by all countries.
The public scrutiny of the taxes paid by MNEs and the evidence suggesting that some MNEs pay
little or no tax anywhere in the world have led to the United Nations Committee of Experts on
International Cooperation in Tax Matters to establish a Subcommittee on BEPS in 2013. The concern
here is that BEPS is a not just a developing country problem, and instead this should be viewed as a
global problem because the impact of the tax laws and policies of one country can adversely affect
another country’s ability to collect taxes that are due (Financing for Development Newsletter, 2014).
The international legal systems have so far been ineffective in preventing tax base erosion and profit
shifting from occurring (Lambers, Mcharo and Nakajima, 2014: p.4). The bilateral taxation treaties
with legal loopholes have made strategic tax planning possible providing opportunities for BEPS.
“..exemption roles which were originally designed to prevent double-taxation, can be exploited in a
way to lead to double non-taxation” (ibid. p4). Furthermore, the arm’s length principle, commonly
underlying transfer pricing allocations, can be abused so as to separate income from the economic
activity that produces it and allowing profits to be shifted to low tax environments. Lambers, Mcharo
and Nakajima (2014) argue that international investment law, which regulates the conduct of host

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states, not investors has by definition little chance to address BEPS. OECD (1998) report on Harmful
Tax Competition: An Emerging Global Issue alarmed that globalisation has encouraged countries to
‘assess continually their tax systems and public expenditures with a view to making adjustments
where appropriate to improve “fiscal climate” for investment’. However, it warned that reduction in
taxation might initially spur investment, but a ‘race to the bottom’ will harm all countries in the long
run (ibid. P7). The negative spillover effects of reduced or zero corporate tax are namely:
• distorting financial and indirectly real investment flows which can undermine the integrity
and fairness of tax structures
• discouraging compliance by all taxpayers
• reshaping the desired level of mix of tax bases, such as labour, property and consumption
• increasing the administrative costs and compliance burdens on tax authorities and taxpayers
(Lambers, Mcharo and Nakajima (2014).
Taxation principles and theories of politics
Decision making in the public sector relies on a variety of instruments to achieve the objectives of the
state (Kaplow, 2010). The policy mix needs to be adjusted so as to emphasise the marginal costs of
different policies, ‘to the extent that such costs are relevant to their aims’ (Hettich and Winer, 2003).
In a democratic system taxation is viewed as a collective choice model and therefore, it is important to
consider the interdependence among policies rather than selection of individual policies.
The decision making process for the selection of the leaders of the state is influenced by social classes
and pressures from the social mechanism, its municipalities and institutions, their knowledge or lack
of knowledge when taking decisions. Two main theories that have affected the taxation policies are:
a) the ability theory and b) the benefit theory. In the ‘ability’ theory of taxation taxes are based on the
taxpayer’s ability to pay; taxes are seen as a ‘sacrifice’ that each tax payer needs to make. Sacrifice
can be on equal, proportional or marginal basis (Auerbach and Feldstein, ). The ‘benefit’ theory on
the other hand is only applicable when beneficiaries can be observed directly. In the benefit model
the government can neither support the poor nor take steps to stabilise the economy, and taxation in

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accord with the benefit principle would leave distribution of real income unchanged (Lindhal, 1919).
As early as in the beginning of the twentieth century, progressive taxation was heavily scrutinised.
Yarros (1899, P759) animatedly summarised the views of Mr. William Guthrie the author of the
Fourth Amendment about progressive taxation:
‘The government is pledged to protect all citizens in the exercise of their freedom and faculties, and if
some, through superior intelligence and industry, earn more than others, it is wrong and short-sighted
to punish them for their superior qualifications, and to tax them at a higher rate than others is to
discourage intelligence and weaken incentive to labour and thrift’ (P.759).
Yarros (1899) however argued that if the state’s role is only policing the argument by Mr.
Guthrie would be justified, but if the role of the state is in improving the finance, trade, education and
similar subjects then the theory of progressive taxation is not hard to accept:
‘if we follow the doctrine that the government is as an insurance company for the mere protection of
personal and property rights then we could with proprietary advanced system of taxation under which
cost would determine the premium’.
Another passage in Yarros (1899) paper refers to a statement by Professor Cohn:
The enjoyment of peace and civil liberty is unquestionably a privilege of very unequal value to
different members of the commonwealth. The fact that these advantages cannot be measured or
apportioned by no means prevents the rich and the poor deriving very widely different benefits from
them. One who is able to call his own, not merely a bare existence, but also an extensive estate, who
may be exposed to the violence of the foreign armies or domestic malefactors, not only in his person,
but in his property, is entitled, or, rather, he is in duty bound, to look upon the institutions which
secure him against these dangers as being contrivances of the same kind with those coparcenary dikes
which are constructed to protect his own and his neighbours’.
In a democratic system, political decision makers who are motivated by self-interest would
use fiscal instruments to shape policies. There are various theories helping us to understand the
behaviour of the policy makers. For example, the Median Voter model - which assumes perfect
information – suggests that voting takes place in accordance with true preferences of the voter who

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faces no uncertainty. The Probabilistic Voting assumes that political institutions exist that follow for
regular election and free entry of new political parties. ‘Voters choose between parties on the basis of
the policies that they propose to implement while continual pressure from the opposition faces each
party to adopt a fiscal platform that it believes will maximise its expected popularity or expected vote
in the next election… In contrast to the Median Voter theory, here parties do not know with certainty
how voters will cast their ballots. Voters switch their support from one party to another becomes
subject of a bidding war between parties leading to vote cycling over alternative platforms (Brennan
and Buchanan, 1980: 20). The Leviathan Model on the other hand assumes that state has unlimited
power to tax private activity and the reason for the use of this power is to redistribute income toward
government. According to Brennan and Buchanan (1980) the politics of majority rule are irrelevant in
determining tax structures. The Leviathan policy maker will not be concerned with the level of public
service that could be financed from a given level of tax revenue. The only adverse effect of taxation
that may concern him is the level of taxable economic activity because this determines the maximum
size of total revenues. In this model the shape of the tax curve is determined by the ability of the tax
payer to avoid or to evade taxation by altering their economic behaviour.
Taxation in the UK
This history of taxation in the UK dates back to Peel’s 1841 income tax (incomes above £150 or
£12,320 in 2015 prices); Gladstone and Disraeli later proposed tax deductions in 1853.
During the history taxation has been seen as ‘unjust, unequal and inquisitorial’ and many
politicians have objected to progressive taxation. The corporation tax was first introduced in 1965
and Income and Corporation Taxes Act 1970 was recently revised to Income Tax (Trading and Other
Income) Act 2005. The top rate of income tax dropped from 90% in 1971 to 25% in 1988 (Figure 1).
The current UK Government policies are presented in a recent document (HM Government, 2013).
The UK Corporation is now at its lowest it has ever been not only in the UK, but in the G7 and joint
lowest in the G20: ‘The UK has completely changed the basis on which it taxes overseas profits which
is moving from a system of worldwide taxation to a broadly territorial system where the focus is on
taxing profits in the UK’. The introduction of the Patent Box is believed to reduce the cost of

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commercially exploiting intellectual property while in addition the UK also offers generous and
flexible credits against the cost of R&D, with a new, internationally competitive ‘above the line R&D
credit introduced for larger companies. The UK Government believes that by the introduction of new
flexible and competitive rules for taxing the profits of multinationals – including a modernised
Controlled Foreign Company (CFC) regime, it can make the UK an attractive location for
headquarters, regional holding companies and global or regional business hubs. The new UK’s CFC
rules (applied from 1 January 2013) exempt profits earned in controlled overseas companies from UK
tax, unless they have been artificially diverted from the UK. In broad terms the report suggests that
the rules allocate 25 per cent of the net profits to the UK, giving an effective tax rate of five per cent
from 2015. Furthermore, multinationals moving to the UK are able to make use of a one-year
exemption, to allow any restructuring necessary for them to be able to take advantage of the other
available exemptions. In 2009 the UK introduced a complete exemption from tax on dividends in
almost all circumstances which unlike some other countries, is 100 per cent. There is no rule limiting
tax deductions for expenses and no holding or minimum underlying tax rate requirement. This report
also suggests that ‘The UK is unusual in not having an outbound dividend withholding tax and, under
the country’s wide treaty network, withholding taxes on interest and royalties are often reduced to
zero’.
Figure 1 – UK Tax rates 1971-2014
0%
10%
20%
30%
40%
50%
60%
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
2013
Small Profit Rate of Tax Standard Rate of Tax

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Source: http://webarchive.nationalarchives.gov.uk
Figure 2 – Corporate Tax rate 2014
Source: http://www.tradingeconomics.com/
Government policy, FDI and MNEs
The favourable corporate taxation policies are rooted in the philosophy that the inward foreign direct
investment (FDI) triggers technological spillovers, assists human capital formation (particularly when
FDI is in a developing country), contributes to international trade integration, and helps create a more
competitive business environment (OECD, 2000, P.5). Most empirical studies conclude that FDI
contributes to both factor productivity and income growth in host countries, beyond what domestic
investment normally would trigger (ibid. P.9). Figure 3 shows that as countries develop and approach
industrialised status, inward FDI contributes to their further integration into the global economy by
encouraging and boosting foreign trade flows.
0 10 20 30 40 50
Switzerland
Russia
Turkey
United Kingdom
South Korea
China
Indonesia
Netherlands
Canada
Germany
Australia
Mexico
Spain
Italy
Japan
France
Brazil
India
United States

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Figure 3 – The openness to FDI and trade
SECTION TWO – MNES AND HOST ECONOMIES
Introduction
The knowledge and productivity spillover effects have been focal points in the literature on
multinationals and local economies (Altomonte & Pennings, 2009; Blomström & Kokko, 1998, pp. 1-
2; Driffield & Love, 2007; Görg & Greenaway, 2004). When studying inward FDI, two main factors
have generally been identified as the justification of multinationals’ presence in local economies: a)
short-term effects: foreign capital infusion (Lu & Gao, 2011, p. 106), the reduction of unemployment
(Blomström et al., 1998, p. 1; Driffield & Taylor, 2000, p. 90; Levy & Sarnat, 1975, p. 431), and the
potential for creating new knowledge and innovation and, b) long-term effects: (vertical) productivity
improvements due to increased competition, improvements of the MNE’s backward supply chain to
attain the necessary quality inputs may improve related firms in other industry sectors (Aitken &
Harrison, 1999), the expansion of scientific knowledge which are claimed to have a long-term
productivity impact on the social development of a country (or region). It is also argued that in the

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short-run scientific knowledge may reduce economic growth due its focus on social (e.g., human
resources, medicine or environmental science) rather than economic knowledge domains (Schofer,
Ramirez, & Meyer, 2000). The productivity effects that are unrelated to knowledge such as volume of
production (Tian, Io Lo, Lin, & Song, 2011, p. 107) and exporting may reduce the fixed cost per unit
of production over time. Based on the current research we can conclude that the difficulty that we face
is due to a lack of a unifying model of spillovers in host economies when knowledge and productivity
are measured over time. We review these two factors from a theoretical perspective henceforth.
Inward FDI and the adaptive efficiency of the host economy
In the tradition of Institution economics, North (1990, p. 76) has argued that the institutional
characteristics of a country (in part) may determine the development of schooling, and on-the-job
training. In turn schooling and on-the-job training may also affect the human capital that is available
in a country. North (1990, p. 76) has further argued that knowledge shapes the “perception of the
world around us and in turn those perceptions shape the search for knowledge”. Therefore, the path-
dependency of “pure” and “applied” knowledge development (true knowledge or science) (Dierickx
& Cool, 1989) may be a determining factor in the long-term development of society and economy
(North, 1990, pp. 75 - 78). In contrast knowledge development based on ideologies may create
knowledge that fit that ideology but excludes knowledge that doesn’t fit the ideology. As argued by
Ruttan (2003, p. 18) “Cultural endowments, including religion and ideology, exert a strong influence
on the supply of institutional innovation. They make some forms of institutional change less costly to
establish and impose severe cost on others”. Knowledge created based on cultural endowments may
be ill equipped to adjust to shocks in society because it doesn’t allow for a search for all possible
problem solutions and the elimination of organizational forms (including political and cultural based
organizations) and solutions that do not work (North, 1990, pp. 80 - 81). Therefore successful
societies have adopted a search for “true knowledge” and have developed a form of adaptive
efficiency.
Based on the premise of the adaptive efficiency hypothesis (North, 1990) the effects of
inward FDI on the host society may (partly) be dependent on the willingness of society to acquire

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knowledge, the ability to unlearn unproductive old knowledge, induce innovation and is not risk
adverse (North, 1990). Inward FDI may provide the host society with, (1) new and innovative
organizational forms, (2) provide the host economy with new (innovative) knowledge, (3) managerial
skills, (4) technologies that it is unable to (cost effective) develop on its own. But MNE can also be in
search of knowledge that is developed in the host society because of its specific and path dependent
history. Thus, MNE’s stimulate and benefit indirectly from the knowledge and skills that may be
developed by society, and in the long-term the actions of MNE’s may direct the economic
development of a society (North, 1990, p. 79).
The development of a society or economy over time is not a given fact, because institutional
characteristics and their value maximising behaviour may pose both productive as unproductive
economic activities (North, 1990, p. 78), and hence adaptive efficiency may be an important
determinant that distinguish productive from unproductive economies (North, 1990, pp. 80 - 81).
“Adaptive” efficiency (Lo, 2004; Lo, 2005) and the rule of law are important determinants for long-
term economic growth and the ability of an economy to cope with imperfect markets and shocks in
these markets (North, 1990, pp. 80-82; North, 1998, pp. 87- 88).
In contrast to North’s view, “allocative” efficiency proponents presume that markets are
efficient, and the outcome of competitive markets is presumed to be a zero-sum perspective
(Atkinson, 2010, p. 4), suggesting that the resource allocation decisions can be made reliably without
distorting growth (Atkinson, 2010, p. 4). Hence products or services can be made in the right variety,
quality, quantity, and cost. In sum, the allocative efficiency may be a concern for short-term economic
growth, and may be more oriented towards business or technology cycles (Tassey, 2013, pp. 10 - 11),
while adaptive efficiency may be an issue to be considered for long term economic growth (North,
1990), and is oriented across business or technology cycles (Tassey, 2013, pp. 10 - 11). With the
above reasoning one can conclude that investment in (true) knowledge development may benefit the
economy as a whole in the long-term, and thus attracting knowledge-based foreign direct investments
may outweigh the short-term (allocative efficiency) inefficiencies.
The rule of law and the third party enforcement are a requisite for the economic development
of a society, because strong third party enforcement enables firms to create complex and international

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exchange agreements which may benefit the society by inducing new organizational forms,
knowledge, managerial skills, and technology exchanges (North, 1990). Smeets (2008) for example
argued that when the intellectual property protection is weak in a country the degree of knowledge
spillover is low. Thus a strong and enforceable intellectual property protection is a requisite for
societies to benefit from inward FDI.
Time-orientation of inward FDI policy measures
It is therefore important to understand and distinguish the development of different skills necessary
for short-medium-long-term economic development; i.e., management and marketing skills
(Blomström et al., 1998, p. 1) are necessary for the long-term national social development, and
productivity gains are necessary for medium-term economic growth. However, tax and duty
reductions may only have a short-term effect on localised economies. If the tax and duty reductions
are cancelled the MNE could leave the country short after that its fiscal advantages are no longer
available (Obwona, 2001). This is supported by institutional scholars such as North (1990) who
argues that economic development and the third party enforcement are two mutually reinforcing
economic factors. Thus, a requirement for inward FDI with the objective to benefit from knowledge
spillovers from the MNE to the local society is a reliable third party enforcement institutional
mechanism and strong intellectual property protection laws (North, 1990; Smeets, 2008).
As mentioned earlier the benefits of inward FDI cannot been seen in isolation from the policy
measures that are used to attract inward FDI. Based on a literature review we can segment the
different forms of policy measures and their longevity. Typical short-term economic effects are, for
example, i) the devaluation of the national currency to stimulate exports (Andreosso-O'Callaghan &
Lenihan, 2011, p. 336), ii) tax holidays because when they expire the firm has to pay the normal taxes
and duties and might move-out (Obwona, 2001), and iii) tax holidays do encourage exporting to the
host country but not establishing a local presence in the host country (Obwona, 2001) to name a few.
Thus devaluation of the national currency and tax holidays are predominantly short-term economic
development instruments.

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Medium-term economic measures are, for example, improvements in the functioning and
reliability of the legal system (Anonymous, 2011; Globerman & Shapiro, 2003; Keefer & Knack,
1997), creating a reliable infrastructure (i.e., information technology, utilities, transportation
facilities)(Anonymous, 2011; Stein & Daude, 2001, p. 12), and investing in the knowledge and skills
of the people (Anonymous, 2011).
Long-term economic measures are for example advanced forms of industrialisation (Cabral,
Vieira, & Rodrigues, 2014, p. 1447), but also apply to trade, and social development.
Short to long-term impact of MNEs on local economies
Long-term economic growth would accrue to a location based on the extent of time that the
multinational firm stays in that location and the extent of the MNE’s influence on the broader
economic development of that country (de Mello, 1997; Haskel, Pereira, & Slaughter, 2002, p. 24).
The rational and assumption behind this argument is that MNEs tend to protect their competitive
competences from spillovers to the domestic firms (Smeets, 2008), the training of employees and
mobility of these employees may take time, thus the workers’ mobility effect on the local economy
require a long stay of the MNE in the host economy.
The positive effects of inward FDI
In general do many studies that find positive externalities of inward FDI depend the following three
concepts. Firstly, knowledge, managerial skills, and technology spillovers occur due to workers’
mobility (Fosfuri, Motta, & Rønde, 2001; Görg & Strobl, 2005; Liu, Wright, Filatotchev, Dai, & Lu,
2010). Workers that are trained and educated by the MNE may (partly) disseminate this knowledge
when the move on to local firms which may as a result of the entry of the MNE in the domestic
market have increased the workers compensation arrangements. Secondly, (vertical) productivity
improvements may occur due to increased competition on the domestic market by the MNE, the MNE
might trigger productivity enhancing investments by the domestic firms and as a consequence
improve a region or society wide productivity enhancing investments. Thirdly, the MNE needs
supplies for its processes and local suppliers may be relatively more economical to source of supplies

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than other subsidiaries of the MNE are. But these local suppliers may not offer the qualitative
products that the MNE requires. Therefore the MNE might enhance the quality level of its inputs by
improving the products and processes of its local suppliers (Aitken et al., 1999) which may have a
relatively long term benefit for the economy. An example of the backward integration of a MNE is for
example the Toyota case as studied by Dyer and Nobeoka (2000), Toyota increased the quality level
of its suppliers by disseminating knowledge and offering free advise relating to the quality and
productivity improvements of its (other) suppliers.
The negative side-effects of inward FDI
So far this study has described the contextual environment that could make knowledge spillovers from
inward FDI possible. What lacks in this line of argumentation is an examination of the negative side-
effects of inward FDI.
For example, Fowle (1991, p. 27) has argued that in the case of an Australian partnership
programme the local firms became dependent on the multinational firm and the industry sector stayed
fragmented, and the domestic firms never became “full-fledged”. Spencer (2008) has also shown that
the negative (i.e., crowding out), or positive (i.e., knowledge diffusion) externalities depend on the
pursued strategy of the multinational firm. Altomonte et al. (2009) have disputed earlier findings
from Aitken et al. (1999) and Görg et al. (2004) that horizontal productivity spillovers are
inconclusive. Evidence from Altomonte et al. (2009) has suggested significant positive effects when
the first multinational firm enters a domestic market. The local firms benefit from the knowledge and
technology of the foreign firm, but by increasing inward FDI firms reach the technology frontier;
when a certain threshold of inward FDI is reached, further inward FDI may lead to a “crowding-out”
or “market stealing” effects, local firms are unable to compete with the multinational firm because of
the (international sourcing) efficiency advantages of the multinational firm and the sheer resources a
multinational firm can bring to bear.
In sum, inward FDI could provide benefits to the local economy but could also have
destructive effects on the local economy. These destructive effects of inward FDI is in most policy
issues a understudied issue.

16
Spillovers and absorptive capacity
Although, the benefits of technology spillovers are disputed by van Pottelsberghe de la Porterie and
Lichtenberg (2001), they argue that FDI can also have the reverse effect of technology stealing by the
multinational firm (Driffield & Love, 2003; Driffield, Love, & Yang, 2014; Fosfuri & Motta, 1999),
especially the negative horizontal effects of FDI (Javorcik, 2004; Jeon, Park, & Ghauri, 2013), and the
positive vertical effects of FDI (Javorcik, 2004; Jeon et al., 2013). The literature also suggests that
domestic firms have to be susceptible and receptive to knowledge spillovers to benefit from them, in
other words the firms’ absorptive capacity (Cohen & Levinthal, 1990; Smeets, 2008; Todorova &
Durisin, 2007; Zahra & George, 2002) is important when the goal for FDI is knowledge or technology
spillovers (Aitken, Harrison, & Lipsey, 1996). However, the absorptive capacity depends on the
differential in knowledge between the partners in an FDI alliance - if the knowledge gap is too small it
might lack the imputes to trigger learning, and if the knowledge gap is too large it becomes very
difficult to learn (Hamel, 1991). This means that the learning capacity is not universal as suggested by
the absorptive capacity literature but unique to an alliance relationship between to dyadic firms (Lane
& Lubatkin, 1998). Thus, absorptive capacity depends on the knowledge gap between the foreign and
domestic firms (Lane et al., 1998; Yeoh, 2009). If this knowledge is extrapolated to the institutional
environments - and as North (1990) has argued - knowledge development and economic development
are interdependent, the knowledge and technology spillovers are dependent on the relative economic
developments of both the foreign and domestic country. But at the same time FDI can cause a
crowding-out effect for the domestic firms that are not part of a joint venture with a FDI partner,
domestic firm tend to be unable to compete effectively with the location specific advantages and sheer
size that a multinational firm processes (Aitken et al., 1996; Aitken et al., 1999). In sum, the inward
FDI concept is one with many facets and there is a lack of a unifying framework that combines the
different facets of inward FDI and its benefits to the host economy together.

17
SECTION THREE – LOCAL POLICY DESIGN
Hypotheses and concluding remarks
In the first two sections we reviewed the role of taxation in a democratic society, highlighting the
decision making process and the role of policy makers in attracting votes through their choice of
policy instruments. The issue of progressive taxation as a means to redistribute the social achievement
in a fair and just manner was discussed. The emerging pattern in international corporate taxation was
identified as an issue that has captured the attention of the public in recent years more than any other
time in our recent history. The discussion in section two was focused on the perceived positive and
negative externalities as a result of inward FDI. We highlighted that these externalities take three
main dimensions: i) longevity (duration of the MNE’s activity in a given country in which the
externality may become effective; i.e., short, medium to long run); ii) content (knowledge creation or
productivity measures); iii) and absorptive capacity (e.g., dynamic efficiency as in North, 1990 and
Luo, 2004). The role of the state as the provider of the infrastructure where the private sector can
flourish is undoubtedly a premise that is hard to deny by any political orientation. The taxation as one
of the instruments used by policy makers needs to be further explored. Our conceptual framework is
presented in Table 1.
Figure 4. Proposed conceptual framework
Externalities/spillovers Short term Medium term Long term
Positive Private sector:
Employment in value
adding sectors
Private sector:
Growth of SMEs and
entrepreneurial activity
Private sector:
Productivity gains
Policy relevance:
Education of the
workforce
Policy relevance:
Training and
knowledge
infrastructure
Policy relevance:
Creation of absorptive
capacity

18
Negative Private sector:
Employment in low
value added sectors
Private sector:
Crowding out of local
firms
Private sector:
Policy relevance:
Policy relevance:
Policy relevance:
We therefore propose two hypotheses to be tested in our forthcoming study:
• Hypothesis 1 – Tax avoidance/evasion/reduction will negatively impact the long-term
knowledge creation in the host country where the MNE has invested due to lack of sufficient
investment in education infrastructure.
• Hypothesis 2 – Inward FDI is substantially encouraged in the medium term by low taxation
as a primary locational advantage for MNEs.
To be completed before the conference….

19
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24
Positive externalities Negative externalities
Short
term
F
o
reign capital infusion
(Blomström & Kokko, 1998; Görg &
Greenaway, 2004; Lent, 1977; Lent, 1967;
Levy & Sarnat, 1975)
Reduced structural unemployment in
the case of labour intensive industries
(Blomström & Kokko, 1998; Driffield &
Taylor, 2000; Levy & Sarnat, 1975)
Higher wage inequality
(Driffield & Taylor, 2000, pp. 90-92)
Protection of competitive competences from
spillovers to the domestic firms
(Roording & de Vaal, 2010, p. 6)
Crowding out or “market stealing” effects with
increasing inward FDI the technology
(Altomonte et al. (2009)
Mid
term
Productivity growth
(de Mello, 1997, Görg & Greenaway,
2004)
Export growth or learning how to
export
(Aitken, Hanson, & Harrison, 1997,
Blomström & Kokko, 1998; Buckley, Clegg, &
Wang, 2002; Görg & Greenaway, 2004; Wei
& Liu, 2006)
Backward linkages
(Blomström & Kokko, 1998, p. 2; de Mello,
1997, p. 9; Görg et al., 2004, p. 172)
Demonstration effect
(Blomström et al., 1998, pp. 15-16)
Export growth or learning how to
export
(Aitken, Hanson, & Harrison, 1997,
Blomström & Kokko, 1998; Buckley, Clegg, &
Wang, 2002; Görg & Greenaway, 2004; Wei
& Liu, 2006)
Export growth or learning how to
export by direct interaction with the
MNE or by the demonstration effect of
the MNE
(Aitken, Hanson, & Harrison, 1997, p. 128;
Blomström et al., 1998, p. 2; Buckley, Clegg, &
Wang, 2002, p. 639; Görg et al., 2004, p.
174).
Training of employees and mobility of these
employees
(Roording & de Vaal, 2010, p. 6)

25
Long
term
Productivity growth
(de Mello, 1997, Görg & Greenaway,
2004)
Backward linkages
(Blomström & Kokko, 1998, p. 2; de Mello,
1997, p. 9; Görg et al., 2004, p. 172)
Managerial knowledge and techniques
(Aitken & Harrison, 1999; Blomström &
Kokko, 1998; Fosfuri, Motta, & Rønde, 2001;
Zhang, Li, Li, & Zhou, 2010)
Export growth or learning how to
export by direct interaction with the
MNE or by the demonstration effect of
the MNE
(Aitken, Hanson, & Harrison, 1997, p. 128;
Blomström et al., 1998, p. 2; Buckley, Clegg, &
Wang, 2002, p. 639; Görg et al., 2004, p.
174).
Managerial knowledge and techniques
(Aitken & Harrison, 1999; Blomström &
Kokko, 1998; Fosfuri, Motta, & Rønde, 2001;
Zhang, Li, Li, & Zhou, 2010)
knowledge or technology spillovers
(Blomström & Kokko, 1998, Liu, 2002)
The acquisition of modern technology
and assumptions of workers mobility
(Aitken & Harrison, 1999; Blomström et al.,
1998; Liu, 2002)
(Fosfuri, Motta, & Rønde, 2001)
Technology gap (large or small)
(i.e. human capital) (Lapan & Bardhan, 1973;
Liu, 2002)
Asymmetrical dependence of the local firms on
the multinational firm
(Pfeffer & Salancik, 1978)
The acquisition or learning of managerial
knowledge
(Aitken et al., 1999, pp. 606 - 607; Blomström et al.,
1998, pp. 1 - 2; Zhang, Li, Li, & Zhou, 2010, p. 970).