beyond which core countries lie below this threshold. Most UE country pairs lie below this threshold so that more integration may come along with high tax gaps.

We conclude from this brief survey of the theoretical literature on intergovernmental competition and fiscal incentives that, contrary to common wisdom, there are various reasons why tax competition is not likely to lead to a race to the bottom. Public infrastructure that has a positive impact on firms’ productivity, as well as agglomeration effects, lessens tax competition.

# **II. Does FDI Respond to Fiscal Incentives in Developing Countries?**

Two main questions arise when it comes to analyze multinational firm decisions to engage in FDI. Why do firms choose to invest abroad and what causes them to invest in one country rather than another? These are often distinct questions since, in most cases, a decision is made to invest abroad first and only then does the multistage process of selecting the investment location starts (Harding and Smarzynska-Javorcik 2007). First a particular region of the world may be selected by the multinational firm, then a shortlist of potential host countries is drawn up. Finally, one country is chosen and a precise location is selected.

The purpose of this part is not to list the main determinants of FDI location in developing countries—this would drive us far beyond the purpose of our paper (for a survey on this topic, see Easson 2004). Our aim is rather to check whether corporate income taxation and fiscal incentives in host countries have an impact on FDI location. This question would not have been raised ten years ago since it was considered that tax motives played a secondary role in comparison to more traditional FDI determinants. But the increasing economic integration of regions (e.g., through regional trade agreements) has caused that tax incentives have become a decision factor of growing importance for FDI location.

According to the World Bank’s 2008 _Doing Business_ report, 20 non-OECD countries cut their corporate income tax rates in 2007 including Bulgaria (from 15 to 10 percent), Turkey (from 30 to 20 percent), South Africa (from 12.5 to 10 percent), Colombia (from 35 to 34 percent), Israel (from 31 to 29 percent) and Malaysia (from 28 to 27 percent). Asian countries have been very aggressive on the tax front. China’s new 25 percent corporate tax rate, down from 33 percent, came into effect in January. The Korean government has announced that it would cut its corporate tax rate from 25 to 22 percent, Taiwan is considering cutting its rate from 25 to 17.5 percent, and Hong Kong from 17.5 to 16.5 percent. In response to these developments, an advisory panel has called upon the Japanese government to cut its corporate tax rate to remain competitive and avoid discouraging foreign investment.

## _II.1. Are Fiscal Incentives Good or Bad for Developing Countries?_

Fiscal incentives do not require direct payments of scarce public funds and this is a major reason why they are widely used instruments in developing countries (see Easson 2004 for an extensive survey of tax incentives in both developed and developing countries). Fiscal incentives are defined as any tax provision granted to a qualified investment project that represents a favorable deviation from the provisions applicable to investment projects in general. Thus, the key feature is that it applies only to certain projects” (Fletcher 2002). All fiscal incentives will have an impact on the cost of capital, effective tax rates and, ultimately, 13