The impact of tax and governance on profitability inward foreign direct investment in Asia countries

This study examines the effect of taxes and regulatory environment on underlying profitability of inward investment as well as the volume of investment. The aim of this research has three main objectives. The first objective is to understand how indirect taxes combine with direct taxes to affect the underlying potential returns to different economic activities and, hence, the attractiveness of different sector inward investors. The second objective is to examine the role of direct contact between government and business through taxation and regulation in affecting the overall volume of inward investment relative to other determinants. The third objective is to investigate the view that tax and governance (bureaucracy) affect firm performance and, by so doing, impact on efficiency seeking motives for inward investment. To address the first objective is analysed using a net incentive effect (NIE) approach. NIEs use I-O data to measure or simulate the combined effect of different taxes and different measures on underlying profit. The finding revealed that, for some sectors, indirect taxes represent a substantially larger loss of revenues to investors than do direct taxes on profits. The findings also show that, unlike profit taxes, the burden of indirect taxation varies considerably between one sector and another. This distorts the returns to investment in one sector relative to another. To achieve second objective it follows a similar approach to much empirical research by using regression analysis to estimate the effects of various different locational determinants, including tax and bureaucracy, on overall stocks and flows of inward investment. For this objective this study uses country level data and two variants of regression analysis to investigate the governance effect on inward investment – OLS and panel-fixed effects. A Chow test is used for parameter constancy to establish whether it was valid to combine higher income and lower income countries into a single sample for Asia. The finding showed regulatory efficiency was consistently found to have a positive and statistically significant effect on inward FDI. For other governance variables the results tended to vary according to estimator. Taking the panel fixed effects estimator (as less prone to omitted variable bias) good governance was found to have a positive and statistically significant effect on inward FDI stocks for higher income countries but not for flows or stocks in lower income countries. The total tax rate was found to have a statistically significant effect on FDI inflows in lower income countries but not on inflows for higher income countries. Lastly, the third objective also employed regression techniques: in this case OLS and the LSDV estimators. Although the regression analysis is a useful first step some limitations are apparent. One key limitation is the role of firm heterogeneity. To address these limitations a propensity score matching approach is also used. The finding suggests that, for most specifications, neither taxes nor bureaucracy had a statistically significant effect on firm performance for the pooled sample of all three countries. This applies both to all firms (domestic and foreign) and to foreign firms only. However, repetition of the analysis on a country by country basis yielded some perverse results which suggest a positive relationship between tax and firm performance (Indonesia) or a positive relationship between bureaucracy and firm performance (Philippines and Vietnam). These findings raise doubts about the possibility of dual causality and bias with the regression estimates. Propensity score matching was used to provide a check on the findings of the regression analysis, which also extended the number of performance indicators to four. The results of the matching analysis were clear. For the pooled sample (all firms and all three countries), the sample of foreign owned firms and the sample of all firms for each individual country the results were the same: neither governance nor taxes had any statistically significant effect on firm performance.