find it difficult to distinguish the effects of investment promotion from those of investment incentives because there is a high correlation between the two variables. FDI incentives granted by competing countries from the same region divert FDI inflows while it is not the case for countries with similar income per capita. In other words, geographic distance matter to explain competition among countries while economic distance does not. Also the presence of investment promotion agencies in neighbouring countries has no impact on FDI flows whatever the definition of proximity. These results seem to suggest that competition over fiscal incentives takes place amongst geographically close countries suggesting the opportunity for those countries to coordinate their policies.

# **Box 3.    Tax Competition in Central and Eastern Europe**

Bellak and Leibrecht (2005) provide the first empirical application of effective average tax rates (EATR) at the bilateral level to explain FDI flows to the eight Central and Eastern European Countries. Their analysis is based on the OLI-paradigm, which explains the choice for FDI versus other routes of foreign market servicing, and a panel-gravity setting. They find that FDI is positively related to both source and host-market size as well as to progress in privatisation and that FDI is inversely related to the distance between home and host countries, and to the effective corporate income tax burden and to unit labour costs. The derived tax-elasticity is very robust and higher than those derived in earlier studies on CEECs, pointing to the importance of tax policy for company location decisions. The coefficient on the EATR is always statistically significant and in the –3.3 to -4.6 range. The relative importance of the effective average tax rate as a determinant of FDI must not be overemphasised as the results reveal that at least during 1995-2003 the EATR had no exceptional influence on FDI flows in those countries compared to other determinants.

Lahreche-Revil (2006) adds data on new members to her EU-15 sample and tries to separate the effects of corporate taxation in new members for 1990-2002. The analysis is run on _bilateral_ FDI data (i.e., on pairs of investing/recipient countries). Statutory rate, implicit tax rates and EATR are taken into account. The empirical investigation relies on a gravitational setting for FDI. FDI flowing from one EU-15 country to an EU-15 or to a new member state is explained by the size of the investor, the market potential of the host, the distance between both countries and additional gravity variables (contiguity, common language). Only implicit taxation can be shown to be a significant tax determinant of FDI flows while statutory and _ex-ante_ taxation fail to significantly explain location decisions. Tax differentials, when significant, only affect investment decision when the investor targets an EU-15 country with a potential non-linear impact. Taking into account competition between potential host countries for attracting FDI confirms that corporate taxation is insignificantly affecting FDI decisions only within the EU15 countries of the sample: on the whole sample, higher taxes in alternative potential locations tend to increase FDI in a given country, but this proves to be the result of the sensitivity of FDI flows going to the EU15 only, since FDI flowing to the new member states is not affected by tax changes in other potential locations.

The issue of tax competition is also examined with the use of a gravity model by Jakubiak and Markiewicz (2007). The estimation of basic equation suggests that traditional gravity variables and differences in statutory tax rates have directed FDI flows to and from new member states. It suggests that investors look at the nominal taxation when deciding about moving capital to and from the region, in addition to economic potential and distance. On the other hand, it is surprising that differences in effective taxation do not seem to matter. Perhaps the backward looking measure is the reason for that. Ordinary differences in tax rates do not seem to determine FDI flows. FDI remain determined by the economic potential of old member states, the economic potential of a destination country and the relative closeness that encourages FDI flows. However, the picture changes when distinguish for the economic potential of big vs. small countries which generates FDI. Moreover, statutory and effective corporate tax rates matter, although in an asymmetric way. If investors can pay lower taxes at home than in a destination country, it hampers FDI flows to such destinations. For effective taxation, the result is especially strong if flows originate in a new member state.

Source: Slavin (2007) 19