## Karl P. Sauvant and Lisa E. Sachs

Print publication date: 2009

Print ISBN-13: 9780195388534

Published to Oxford Scholarship Online: May 2009

DOI: 10.1093/acprof:oso/9780195388534.001.0001

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# The Impact of Endogenous Tax Treaties on Foreign Direct Investment: Theory and Empirical Evidence *

Chapter:
(p.513) 19. THE IMPACT OF ENDOGENOUS TAX TREATIES ON FOREIGN DIRECT INVESTMENT: THEORY AND EMPIRICAL EVIDENCE *
Source:
The Effect of Treaties on Foreign Direct Investment
Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780195388534.003.0019

# Abstract and Keywords

This chapter sheds further light on the question of how tax treaties affect outward foreign direct investment (FDI). The chapter is organized as follows. Section A outlines the general equilibrium model of trade and multinational firms for studying the welfare and FDI effects of tax treaties. The theoretical hypotheses are summarized in Section B. Section C presents the database, the econometric methods, and the empirical results. Section D discusses the results in the light of previous research, and provides an extension regarding the time pattern of accumulation of the treaty-induced effect on FDI.

# INTRODUCTION

There is a large body of theoretical and empirical literature viewing taxation as an important determinant of a country’s locational attractiveness for investors (see Hines 1999; Gresik 2001; de Mooij and Ederveen 2003, for comprehensive surveys). One of the most visible obstacles to cross-border investment is the double taxation of foreign-earned income. Double taxation arises if the same tax base (e.g., income or wealth) of a specific taxpayer (i.e., a person or enterprise) is taxed in two or more jurisdictions. Bilateral tax treaties, representing mutual agreements on the definition of tax liabilities, the assignment of taxing rights or the determination of withholding tax rates, are the most important way to circumvent double taxation of enterprises.

Worldwide, the importance of tax treaties has increased tremendously in the last decades. The number of treaties in force has risen from 100 in the 1960s to more than 2,500 today (see Easson 2000; Arnold, Sasseville, and Zolt 2002). Most of them are based on model conventions established by international organizations such as the Organization for Economic Co-operation and Development (OECD) or the United Nations, where the former accounts mainly for the interests of industrialized countries and the latter for those of less developed economies.

Apart from double taxation, tax treaties are usually motivated by additional objectives, depending on the specific economic and legal situation of the treaty partners. The preamble of the OECD Model Tax Convention on income and capital (henceforth OECD Model) emphasizes two major objectives: the alleviation of double taxation and the restriction of tax avoidance. The treaty partners are left (p.514) free to agree on one or both objectives.1 The U.S.–Canada treaty, for instance, focuses on “the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and on capital …” The coexistence of different aims highlights a fundamental conflict in tax treaty formation. As far as double taxation is concerned, tax treaties may on the one hand promote international production and investment activities. For instance, the assignment of taxing rights via tax exemption (Art. 23A OECD Model) or tax credits (Art. 23B OECD Model), or agreement on maximum withholding tax rates (e.g., for dividends paid from foreign subsidiaries), lower the overall tax burden of multinational enterprises. On the other hand, restricting tax evasion and tax avoidance, primarily through transfer pricing rules (Art. 9 OECD Model), anti-treaty shopping rules, or the exchange of information (Art. 26 OECD Model), may induce negative effects on international investment.

The conventional view of tax lawyers and administratives is that tax treaties are desirable to attract foreign investment. In contrast, Dagan (2000) argues that tax treaties are primarily intended to redistribute tax revenue (from poor to rich countries), or to lower administrative costs (e.g., via the definition of tax terms between contracting countries). Dagan concludes that double taxation should be more effectively eliminated by unilateral arrangements, which are less expensive and more flexible than tax treaties. In fact, some countries (e.g., Chile in the early 1990s) have not signed tax treaties but have unilaterally offered multinational enterprises a similar environment with respect to tax rules. However, there are several aspects of tax treaties that cannot be replicated by a country unilaterally. Most importantly, tax treaties reassure international investors ex-ante on how they are taxed with their overseas profits and this, in turn, may attract FDI.

Although international issues of taxation have been of growing concern in economics, tax treaties have attracted less attention so far. The majority of available studies examines theoretically the role of different tax assignment rules for international investment flows. There are three methods of international tax assignment: Under the credit method, foreign-earned profits are taxed in both the parent and the host country, but the taxes paid abroad are deductible from the domestic tax liability.2 Under the exemption method, in contrast, domestic and foreign profits are taxed separately within their jurisdiction.3 A third method, (p.515) though not proposed in the OECD Model, is the deduction method, which allows a deduction of foreign taxes from the domestic tax base. Bond and Samuelson (1989), relying on a model with a capital-exporting and a capital-importing country and discriminatory taxation (i.e., different tax rates for domestic and foreign-earned income), demonstrate that tax rates will increase in equilibrium if the treaty partners agree on a credit system instead of the deduction method. This, in turn, induces a decline in investment flows to zero at the extreme (see Hamada 1966) for an earlier contribution). Davies and Gresik (2003) show that this result no longer holds under the assumption that subsidiaries are able to finance their operations in the host country. Considering non-discriminatory taxation, Janeba (1995) finds that the home country sets its tax rate equal to zero, irrespective of the assignment of taxing powers. Davies (2003a), focusing on two-way capital flows, shows that there are always positive capital flows in equilibrium, regardless of which tax relief method is employed. In contrast to Janeba (1995), he finds that the home and host country set positive tax rates in equilibrium. In sum, the theoretical hypotheses with respect to the impact of tax treaties on international investment flows are ambiguous, so it remains an empirical question whether tax treaties promote or hinder foreign direct investment (FDI).

Empirical studies on the relationship between tax treaties and FDI are still scarce, and the available ones adopt methods that rely on the assumption that tax treaties are exogenous. Depending on whether a specification of FDI in logs or levels is chosen, previous studies find negative or no effects on FDI (Davies 2003b; Blonigen and Davies 2004a, 2004b; see Davies [2004] for an excellent survey). In this regard, Blonigen and Davies (2004a) indicate that empirical models of FDI should be formulated in logs rather than levels.4 However, based on such a specification recent research does not identify a significant impact of exogenous tax treaties on FDI (see Blonigen and Davies 2004a). For the average country-pair, the question then arises, whether implementing a treaty can be justified from an economic point of view.

This chapter sheds further light on the obviously relevant question of how tax treaties affect outward FDI, emphasizing two important issues that are not raised in previous research. First, it is reasonable to assume that new treaties are implemented only, if both treaty partners gain in welfare. Hence, tax treaties are endogenous from a general equilibrium perspective. Accordingly, it is a major concern under which conditions positive, treaty-induced welfare effects arise. Put differently, the determinants of tax treaties are at issue. Second, given that a treaty is implemented (i.e., given its positive welfare effects), the associated impact on FDI is of interest. Focussing on the double taxation aspect of tax treaties, we set up a two-country general equilibrium model of trade and FDI, which is (p.516) closely related to the knowledge-capital model of the multinational enterprise (Carr, Markusen, and Maskus 2001; Markusen 2002; Markusen and Maskus 2002). The model is parameterized and the hypotheses on the impact of tax treaties on welfare and outward FDI (rather than foreign affiliate sales) are derived from numerical simulations. Abstracting from the potential administrative cost-reducing effect of tax treaties and tax avoidance issues,5 we find that treaties often have positive welfare effects, but the associated effect on FDI can even be negative without tax evading FDI.

The simulation results for welfare motivate an empirical model to explain the probability of implementing new tax treaties. Further, given positive welfare effects, the results indicate under which circumstances one should expect negative FDI effects from implementing a treaty. In econometric terms, we estimate the average treatment on the treated, that is, the effect of a tax treaty on FDI between countries that have actually implemented a treaty. We construct a bilateral panel data set for tax treaties over the period from 1985 to 2000. Applying different matching estimators and focusing on differences-in-differences, we estimate a negative effect of newly implemented tax treaties of about −34% on changes in bilateral OECD outward FDI.

The remainder of the chapter is organized as follows. Section A outlines the general equilibrium model. The theoretical hypotheses are summarized in Section B. Section C presents the database, the econometric methods, and the empirical results. In Section D, we discuss our results in the light of previous research, and provide an extension regarding the time pattern of accumulation of the treaty-induced effect on FDI. The last section concludes with a summary of the main findings.

## A. A Numerically Solvable General Equilibrium Model of FDI and International Taxation

### 1. Households

There are two economies, referred to as countries 1 and 2 and indexed as {i, j} = {1, 2}. Both countries produce two goods, Z and X, Z is a homogeneous good produced at constant returns to scale by a competitive industry. X-goods are differentiated in the usual Dixit and Stiglitz (1977) fashion. We consider the following firm types: national firms (NEs) sell on the local market and export to the other country, where the number of national firms of country i is denoted by ni; horizontal multinational enterprises (MNEs) are running production plants in both countries, where hi denotes the number of horizontal multinationals headquartered in i; vertical MNEs are able to unbundle the headquarters and the production plant, where vi is the number of vertical multinationals with headquarters in i and production plants only in j. In contrast to horizontal MNEs, (p.517) vertical ones engage in goods trade. $X i j n$ are the exports of country i–based NEs to country j. Similar definitions apply for the other quantities, where the first subscript always denotes the home country of the firm whereas the second one refers to the country of consumption. Xic denotes the consumption of X in country i, being a constant elasticity of substitution (CES) aggregate of the individual varieties. Consumer preferences are assumed to be a nest of the homogeneous Z-good and the differentiated X-good. The symmetry of varieties within a group of goods allows us to formulate utility of country i (Ui) as follows:

(1)
$Display mathematics$
where α denotes the Cobb-Douglas expenditure share for differentiated products, and ε > 1 is the elasticity of substitution between varieties.

Iceberg transport costs (τ) impede goods trade in both sectors. In quantity terms, one unit of consumption of an X-variety in country j requires a firm in i to send (1 + τ) units. Similarly, one consumption unit of a foreign Z-good in j requires a firm to ship, that is, to produce, (1 + τ) units. For convenience, quantities of X are defined as (both NE and vertical MNE) firm-specific production for the respective foreign market, whereas Zij and Zji are normalized to represent consumed rather than produced quantities.

The consumer maximization problem can be solved in two steps. In the first step, each variety $X i j k , k ∈ { n , h , v } ,$ needs to be chosen so as to minimize the cost of attaining Xic, whatever the consumption of Xic is. In the second step, consumers allocate income between the Z-good and the composite X-good. Let $p j i k$ be the price of an X variety in country i produced by a type-k firm headquartered in country j. The price for the homogeneous good, qi, is indexed once, since all (indigenous and foreign) homogeneous goods consumed at a single location i must face the same price qi. Further, si denotes the price aggregator, defined as the minimum cost of buying one unit of Xic at prices of an individual variety:

(2)
$Display mathematics$
The first-stage budgeting problem leads to:
(3)
$Display mathematics$
where Ei denotes total expenditures of consumers in country i. Identical price elasticities of demand and identical marginal costs (technologies) within (p.518) a country ensure that the domestic price of a locally produced good is equal to the mill price for exports. Hence, mill prices of all goods produced in country i are equal in equilibrium (pi). Inserting these equilibrium conditions, the price aggregator si of differentiated goods consumed in country i can be written as
(4)
$Display mathematics$
The second-stage budgeting yields the division of expenditures between the two sectors:
(5)
$Display mathematics$
(6)
$Display mathematics$
where qi is the price of Z consumed in country i. The Z-sector is perfectly competitive, and we take qi as the numéraire.

### 2. Factor markets, production and income

Let ωKi and ωLi denote the factor rewards for capital and labor, respectively. Assuming that Z-production only uses labor (L), variable unit costs (i.e., marginal costs) cZi satisfy

(7)
$Display mathematics$
where ωLi is the wage rate of unskilled workers in i and ┴indicates that at least one of the adjacent conditions has to hold with equality. This implies
(8)
$Display mathematics$

There is monopolistic competition in the X-sector, where each firm produces under a Leontief technology, using both capital and labor. The country-specific unit input coefficients of capital and labor are denoted by aKxi and aLxi, respectively. Additionally, national firms and horizontal and vertical MNEs require capital to set-up plants αKni, αKhi, αKvi, and they employ labor to produce firm-specific assets and blueprints (a Lni, a Lhi, a Lvi) In line with the literature, we assume that firm- specific fixed costs are highest for horizontal MNEs, slightly lower for vertical ones, and lowest for exporters: aKniωKi + ωaLniωLi 〈 ωaKviωKi + aLviωLi 〈 aKhiωKi + aLhiωLi Specifically, we set a Lvi = a Lhi = 1+δ, a Kvi = 1+γ and a Khi = 2+γ without loss of generality. δ is the additional labor requirement to organize a multinational network, and 1 + γ are the fixed costs country i’s MNEs have to incur to set up a foreign plant in j. As mentioned above, horizontal MNEs also run domestic production plants, which is reflected in a Khi > a Kvi.

Factor market clearing in country i for capital Ki and labor Li requires

(9)
$Display mathematics$
(10)
$Display mathematics$
(p.519) Variable unit costs of producing an X-variety in country i are given by c Xi = aKziωki + αIziwLi. There is a fixed markup over variable costs, which is determined by the elasticity of substitution between varieties. Given that under CES-utility demand for all varieties is positive, we may write
(11)
$Display mathematics$
Free entry implies that firms earn zero profits, since operating profits are used to cover fixed costs. The corresponding zero-profit conditions determine the numbers of firms.

National firms in i have to bear fixed costs of $a K n i ω K i + a L n i ω L i 〈 a K v i ω K i + a L v i ω L i 〈 a K h i ω K i + a L h i ω L i$ and operating profits are taxed at the rate ti (i.e., country i’s corporate tax rate), which is applied to profits earned in country i.6 The profit condition for NEs, therefore, implies

(12)
$Display mathematics$

Vertical and horizontal MNEs are able to finance fixed costs via operating profits of both the domestic and the foreign activities. We maintain that the foreign subsidiary fully (and immediately) repatriates its profits to the domestic parent (see Hartman [1985] and Sinn [1993] for a discussion of alternative assumptions). Without a tax treaty, operating profits from foreign affiliates are exposed to double taxation. Let $t M i$ denote the tax rate of country i applied to foreign-earned profits of domestic multinational firms (i.e., the taxation of “permanent establishments” abroad indicated by superscript M), and $t M j$ the withholding tax on repatriated profits levied by country j. The conditions for the number of MNEs are thus given by

(13)
$Display mathematics$
(14)
$Display mathematics$

From the perspective of an MNE with headquarters in country i, tj is the corporate tax rate abroad, and, therefore, $( I − t i M − t j ω ) ( I − t j )$ is equal to the overall tax burden on foreign-earned profits under double taxation.7 Applying the exemption method in the tax treaty, $t i M$ becomes zero. In contrast, if both treaty (p.520) partners agree on the credit method, we have to replace $t i M$ by $t i M = t i M ′ − t j ω$ (assuming that $t i M > t j ω$ 8

All factors are owned by the households, so that consumer income (i.e., GNP) in country i is given by

(15)
$Display mathematics$

The equivalence of total factor income (Ei, Ej) and demand in each economy implicitly balances international payments.

### 3. The public sector

The only source of income for the public sector are taxes on operating profits of firms. Tax revenues for country i can therefore be summarized as:

(16)
$Display mathematics$

We consider three alternatives of public expenditure. First, governments pay lump-sum transfers to consumers. Second, governments use tax revenues to finance public infrastructure. By assumption, the production of public infrastructure only uses labor and lowers the capital needed to set up a plant (for this approach see Egger and Falkinger 2003; Kellenberg 2003). Let PIi be the amount of public infrastructure provided by government in country i. The capital needed to set up a national firm in i is given by

(17)
$Display mathematics$
where β is a scaling parameter. Similarly, the amount of capital needed to set up a plant for MNEs is lowered by the public infrastructure, therefore $a K v i = a K n i + γ$ + λ and $a K h i = 2 a K n i + γ .$

A third possibility is to finance a public good PGi, which directly enters the utility function of consumers (see, for example, Huizinga 1991; Lockwood 2003). (p.521) Again, it is assumed that the production of the public good only needs labor. The modified utility function in this case is given by:

(18)
$Display mathematics$
where β is the scaling parameter introduced above.

### 4. Model parametrization

For our simulations, we use the following parameter values. World factor endowments are set at L = 100 and K = 50. To study the effect of changes in the absolute bilateral country size, we triple both countries’ factor endowments. For the additional labor requirement to organize a multinational network, we assume δ = 0:01. Foreign-owned plants exceed the domestic capital requirement by γ = 0:1. The fixed input coefficients in the X-sector production are assumed at Lxi = 0:6 and Kxi = 0:4. We consider a value for the elasticity of substitution of ε = 4, which is similar to that one usually used in the literature (Markusen 2002). According to the United Nations World Trade Database, the share of manufacturing trade in the 1990s amounts to 70%–80% of total trade. Therefore, we assume an expenditure share for manufactures of α = 0:8. Motivated by the findings in Baier and Bergstrand (2001), the iceberg trade cost parameter is set at τ = 0:2. The scaling parameter used to model the importance of public expenditures for the capital usage in plant set-up is set at β = 0:4. Regarding tax rates, we assume $t i = t i M = t j = t j M = 0.25 ,$, and $t j ω = t i ω = 0.05$ in the case of equal taxes. In the alternative scenario with unequal tax rates we assume $t i = t i M = 0.25$ and $t j = t j M = 0. I .$.9

## B. Hypotheses

To analyze the impact of tax treaties on FDI, two issues are of special interest: (i) welfare effects of tax treaties—under which conditions are countries inclined toward implementing a bilateral tax treaty?; and (ii) FDI effects of tax treaties–does FDI rise or fall after implementing a tax treaty, given that the treaty increases welfare?

TAX TREATIES AND WELFARE: A bilateral tax treaty is implemented only if both countries gain in welfare.10 Figure 1 plots the signs of welfare effects of tax (p.522)

figure 1. WELFARE CHANGE AFTER TAX TREATY IMPLEMENTATION (TAX REVENUE IS SPENT TO FINANCE PUBLIC INFRASTRUCTURE)

treaties in the capital to labor endowment box of country i, in the case that governments spend their tax income on public infrastructure and countries levy identical tax rates.11 The welfare effect of a tax treaty is derived as the difference in the model outcome of two scenarios—one in which a treaty is effective, and a second one in which no treaty is implemented. The white areas in the figure indicate positive welfare effects of tax treaties. We see that positive welfare effects are more likely if relative factor endowments are dissimilar, and the difference in size (i.e., absolute factor endowment differences) is not too pronounced. The boundaries of the black area in the region around the center of the factor box are shaped like those of an ellipsoid. Hence, countries of more dissimilar size are likely to implement a treaty at smaller relative factor endowment differences, as (p.523) compared to equally sized economies.12 The welfare gains in both countries can be explained as follows: A tax treaty increases the number of firms in the capital-abundant country (specifically the number of horizontal MNEs), while the decrease in tax revenues and the induced reduction in public infrastructure provision does not produce countervailing effects of sufficient size due to the low capital price there. The capital-scarce country gains because it attracts more foreign plants. If the differences in country size become too large, there are no gains in welfare from implementing a treaty, irrespective of whether relative factor endowments are very different or not. Here, we have to consider two cases. If the differences in relative factor endowments are not big (i.e., the factor endowment points lie within the ellipsoid in center of Figure 1), the negative welfare effects of the treaty are driven by the reduction in tax revenue and the corresponding decrease in infrastructure. Dissimilarity in size and relative factor endowments (i.e., the black humps in the north-west and south-east of the factor box in Figure 1) implies negative welfare effects, since vertical MNEs in the capital-abundant country come into existence. This leads to a shift of production of the X-goods to the capital-scarce country. In sum, this suggests a nonlinear relationship between the relative factor endowment/country size differences and the likelihood of implementing a treaty.

We infer the robustness of these results with respect to the alternative modes of government expenditures mentioned above (i.e., tax revenues are used to finance a public good, or they are distributed as a lump-sum transfer to consumers). Qualitatively, our theoretical findings on the relationship between welfare gains and factor endowment/country size differences remain unaffected.

To study the impact of bilateral country size on the treaty-induced welfare effects, we triple the world factor endowments ceteris paribus. The result is illustrated in Figure 2. Now, there are islands with positive welfare effects along the main diagonal. Moreover, the black ellipsoid associated with non-positive welfare effects is narrower than in Figure 1. Hence, countries with similar relative factor endowments are more likely to implement a tax treaty, if both of them are larger. The reason for this lies in the rising dominance of horizontal MNEs in similarly endowed economies. If horizontal MNEs are prevalent in both countries, they will always gain from bilateral tax treaties. Notably, a change in world factor endowments does not affect the welfare effects of tax treaties under the alternative considered modes of public spending.

TAX TREATIES AND FDI: As mentioned in the introduction, the reduction of a multinational’s tax burden through the abolishment of double taxation should (p.524)

figure 2. WELFARE CHANGE AFTER TAX TREATY IMPLEMENTATION, TRIPLED WORLD ENDOWMENTS (TAX REVENUE IS SPENT TO FINANCE PUBLIC INFRASTRUCTURE)

promote FDI. In contrast, the treaty-induced restrictions on tax avoidance should lower FDI. In the theoretical model, we focus on the first issue. Nevertheless, as can be seen in Figure 3, even in this case a tax treaty may reduce FDI (see the black areas in the figure). The reason for a negative impact on outward FDI is that a treaty can lead to reduced tax revenues in the parent country. If governments use tax revenues to finance public infrastructure (thereby reducing the plant setup costs), a tax treaty induces higher fixed costs for MNEs. This effect may outweigh the direct FDI-enhancing effect of the reduction in tax burden due to the abolishment of double taxation. As a consequence, the domestic capital requirement for firm setup rises and the domestic price of capital relative to labor increases. The higher fixed costs for domestic MNEs reduce their competitiveness at the international goods market. In turn, they are partly replaced by foreign national firms. Even if governments use tax revenues to finance a public good, negative FDI effects can arise, but they are less likely under this alternative scenario. However, a negative effect on outward FDI does not occur under lump-sum transfers to consumers.

Figure 4 combines the information in Figures 1 and 3, and illustrates under which factor endowment configurations a treaty increases (reduces) a country’s outward FDI, given that a treaty will be implemented (i.e., increases welfare in both countries). In all non-black areas in the figure, countries are willing to (p.525)

figure 3. CHANGE IN COUNTRY 1’S OUTWARD FDI AFTER TAX TREATY IMPLEMENTATION (TAX REVENUE IS SPENT TO FINANCE PUBLIC INFRASTRUCTURE)

figure 4. CHANGE IN COUNTRY 1’S OUTWARD FDI AFTER TAX TREATY IMPLEMENTATION CONDITIONAL ON POSITIVE WELFARE EFFECTS (TAX REVENUE IS SPENT TO FINANCE PUBLIC INFRASTRUCTURE)

(p.526) implement a treaty. In the white area, country 1’s outward FDI rises, while in the dark gray area country 1 does not conduct outward FDI so a treaty does not affect its welfare. In the light gray area to the north of the diagonal, there is a positive effect on welfare but a negative one on country 1’s outward FDI. Changing the model parametrization we identify β and ε as the most important determinants of the light gray area. For instance, lowering β (i.e., lowering the cost-reducing effect of public infrastructure) leads to an increase of the light gray area. In this case, the aforementioned revenue effect would be even more pronounced. Similarly, increasing ε (i.e., intensifying competition) also induces an increase of the light gray area. In sum, even in a setting with a focus on the double taxation effects of treaties, there is no clear-cut theoretical prediction on the FDI effects of tax treaties.

ASYMMETRIC TAXATION: So far, we assumed identical tax rates in the two economies. With asymmetric tax rates, the results concerning the welfare and FDI effects of tax treaties do not differ much (see the corresponding figures in the supplement, available upon request from the authors). This holds true irrespective of whether the credit or the exemption method is applied. Accordingly, we conclude that the derived hypotheses are robust enough to warrant empirical implementation.

## C. Data and Difference-In-Difference Estimation of the Endogenous Tax Treaty Effect on Bilateral Outward FDI

We estimate the effect of tax treaties on bilateral outward FDI of the OECD economies in the period from 1985 to 2000. Bilateral FDI stock data at an annual basis are from the OECD (Bilateral Investment Statistics Yearbook 2003). Detailed information on the implementation dates of tax treaties is available from the International Bureau of Fiscal Documentation (IBFD; Tax Treaties Database 2002, Release 3). Tables A1 and A2 in the Appendix provide details for those newly implemented tax treaties over the covered period that are part of the sample used in the empirical analysis. In order to isolate the effect of tax treaties on bilateral FDI, we focus on the marginal effect of implementing a new treaty on the change in FDI. Our theoretical model suggests tax treaty implementation as an endogenous event. Hence, there is self selection. To take account of this endogeneity, the proper specification of the decision to implement a new tax treaty (i.e., selection into treatment) is essential.13 Further, a difference-in-difference approach is recommended to guard against time-invariant, endogenous, unobserved effects. Such time-invariant sources of bias arise, for example, if country (p.527)

Table a1. NUMBER OF OBSERVATIONS OF TREATED AND UNTREATED

Implementation year

Treated

Untreated

Total

1985

3

20

23

1986

1

31

32

1987

3

26

29

1989

3

34

37

1990

4

35

39

1991

3

40

43

1992

5

46

51

1993

4

56

60

1994

3

62

65

1995

10

57

67

1996

6

68

74

1997

6

73

79

1998

7

70

77

1999

6

60

66

2000

3

41

44

Total

67

719

786

pairs with newly implemented tax treaties and pairs without new treaties are geographically mismatched.

### SELECTION INTO TREATY FORMATION:

We compute differences between the average log FDI in the two-year period after a new treaty was implemented and the average log FDI in the two-year period before it was implemented. The same difference is calculated for the group of untreated country pairs. Finally, the formation of an appropriate control group is important. For each implementation year, we construct a biannual pre-treatment and a biannual post-treatment period (the latter includes the implementation year). Only those country pairs that did not sign a treaty until the end of the post-treatment period are valid potential control units. We select the country pairs in the control group according to their similarity in the propensity score of the selection equation (a probit model). The effects of new tax treaties on FDI are estimated by several matching estimators (see below). We focus on the tax treaty effect on outward FDI for those country pairs that have actually implemented a new treaty. Hence, these estimates reflect the average treatment effect on the treated.

As indicated in the summary of the theoretical hypotheses, the welfare effects from implementing a bilateral tax treaty at the beginning of period $t + I ( Δ T i j , t + 1 )$ are determined by the following measures of average absolute and relative bilateral factor endowments in period t: total bilateral country size (approximated by the log bilateral $G D P , G i j t = ln ⁡ ( G D P i t + G D P j t )$, the similarity in bilateral country (p.528) (p.529)

Table a2. NEWLY IMPLEMENTED TREATIES BETWEEN 1985–2000 (ONLY THE 67 TREATIES COVERED IN THE EMPIRICAL ANALYSIS ARE REPORTED)

OECD economy

Partner economy

Implementation year

Australia

Indonesia

1993

Austria

Australia

1989

Austria

South Africa

1997

Austria

Slovenia

1999

Sweden

1985

Brazil

1988

Inda

1987

Hungary

1995

South Africa

1997

Denmark

Greece

1993

Finland

Mexico

1999

France

Turkey

1990

France

Mexico

1993

France

Venezuela

1994

France

Panama

1996

Germany

Philippines

1985

Germany

Turkey

1990

Germany

Mexico

1994

Germany

Venezuela

1997

Iceland

1998

Iceland

Netherlands

1999

Iceland

Poland

2000

Italy

Bulgaria.

1992

Japan

South Africa

1998

Korea, Rep.

Philippines

1987

Korea. Rep.

Indonesia

1990

Korea, Rep.

Hungary

1991

Korea, Rep.

Brazil

1992

Korea, Rep.

Egypt

1992

Korea, Rep.

Ireland

1992

Korea, Rep.

Italy

1993

Korea, Rep.

China

1995

Korea, Rep.

Czech Republic

1995

Korea, Rep.

Spain

1995

Korea, Rep.

Romania

1995

Korea, Rep.

Mexico

1996

Korea, Rep.

Russia

1996

Korea, Rep.

South Africa

1997

Korea, Rep.

Portugal

1998

Netherlands

Mexico

1995

Netherlands

Venezuela

1998

Netherlands

Argentina

1999

New Zealand

Thailand

1999

Norway

Greece

1992

Norway

Australia

1995

Poland

Ukraine

1995

Poland

Hungary

1996

Portugal

USA

1996

Portugal

Bulgaria

1997

Portugal

Poland

1999

Portugal

Romania

2000

Switzerland

Mexico

1995

Switzerland

Thailand

1997

United Kingdom

Turkey

1989

United Kingdom

Mexico

1994.

USA

1985

USA

China

1987

USA

Mexico

1989

USA

Indonesia

1990

USA

Spain

1991

USA

Inda

1991

USA

Israel

1995

USA

Portugal

1996

USA

Thailand

1998

USA

Turkey

1998

USA

South Africa

1998

USA

Venezuela

2000

size (approximated by the log similarity index, $S i j t = ln ⁡ { I − [ G D P i t / ( G D P i t + G D P j t ) ] 2 − [ G D P j t / ( G D P i t + G D P j t ) ] 2 } ,$, the difference in relative factor endowments (approximated by the absolute bilateral log difference in capital-labor ratios, $| R i j t |$ with $R i j t = ln ⁡ ( K i t / L i t ) − ln ⁡ ( K j t / L j t ) ,$, and interaction terms of the latter two variables $S i j t × | R i j t |$ and $( S i j t × | R i j t | ) .$ GDP data in constant U.S. dollars are available from the World Bank (World Development Indicators 2004), and capital-labor ratios are computed in Baier, Dwyer, and Tamura (2002).14 We regress $Δ T i j , t + I$ on the initial level of these variables, that is, they are predetermined.

(p.530) Denoting the parameter estimates of the selection model by α’s, we expect the following coefficient signs from the above model. αG > 0 indicates that the probability of implementing a new treaty rises with bilateral country size. The direct effects of S and |R| reflected in the signs of αS and α|R| should not be interpreted without reference to the interaction terms. Starting from the center of the factor box in Figure 1, a smaller relative factor endowment difference |R| is necessary as S gets smaller to obtain a positive welfare effect. Since S 〈 0 by definition, we expect αSx|R| 〈 0. However, as S gets extremely small toward the lower left and upper right edges of the factor box, an increase in |R| is no longer associated with a higher likelihood of implementing a tax treaty. Accordingly, we expect α(Sx|R|) 2 〈 0, because S 2 > 0. Hence, including S x |R| and (S × |R|)2 in addition to the main effects S and |R| helps to capture this nonlinear relationship between country size and relative factor endowment differences on the one hand and implementing a treaty on the other hand. In addition to these determinants, we include the parent and the host government expenditure-to-GDP ratios (git, gjt) as two separate controls (World Bank, World Development Indicators 2004). These two variables indicate whether the parent and the host are high-tax or low-tax countries.15 If the objective of tax treaties is primarily to prevent double taxation, we would expect a negative sign for the coefficient of gjt. We report summary statistics for all variables in the Appendix (Table A3).

Formally, we specify selection into treatment (i.e., the probability of new tax treaty implementation) by the following probit model

(19)
$Display mathematics$
where α0 is a constant and $α ^ G > o .$. Due to the availability of data for FDI and the controls, the sample used in the econometric analysis spans the period from 1985 to 2000. After eliminating missing values, data for 67 newly implemented treaties can be used. Given the length of the period, this corresponds to about 4:5 treaties per annum (see Table A1 in the Appendix for more details on the time pattern of tax treaty implementation and the relative sizes of the groups of the treated and the untreated country pairs). Since (parent and host) countries tend to sign more than a single treaty over the observed time span and there is usually more than a single treaty signed in each year, we are able to include parent country (µi) and host country (νj) dummies as well as (p.531)

Table a3. DESCRIPTIVE STATISTICS

Variables

Mean

Std. dev.

Minimum

Maximum

Endogenous variables (changes):a

New tax treaties implemented

0.09

0.28

0.00

1.00

Log change in bilateral outward FDI

0.47

0.80

−3.17

5.97

Exogenous variables in selection equation (Initial period levels]:b)

Log bilateral GDP: Gj

27.75

1.33

23.42

30.27

Log parent-to-host similarity in GDP: Sj

−1.88

1.21

−6.20

−0.69

Absolute difference in log parent-to-host capital-labor ratio: |Rj|

2.28

1.83

0.00

11.90

Interaction term: Sij × |Rij|

−4.58

5.57

−39.40

0.00

Interaction term: (Sij × |Rij|)2

51.93

141.37

0.00

1552 44

Parent government expenditure- to-GDP ratio: g

18.66

3.85

9.75

25.84

Host government expenditure- to-GDP ratio: g

15.63

5.69

3.14

38.23

Notes: 786 observations. - a) Change between 2-year period after the treaty implementation and the 2-year period before the implementation. i.e., the treaty dummy is set at 1. if a new treaty was implemented and 0, else. The change in FDI is the log difference between the 2-year average of the period after and that one before the treaty was implemented.

time dummies (λt) to guard against the bias from omitted country-specific and time-specific effects.

Table 1 summarizes the parameter estimates of four different probit models. The first two reported models (referred to as the parsimonious ones) impose the restrictions $α ^ S × | R | 〈 o$, whereas the third and the fourth model relax them. The second and the fourth model include country and time dummies. The country dummies especially improve the model fit considerably. This indicates that the propensity of signing a new treaty differs systematically between countries. Further, the restrictions on α(Sx|R|) and α(Sx|R|) 2 to be zero are rejected at conventional levels of significance. Accordingly, we use the results from the fourth model in Table 1 in the subsequent analysis. The parameter estimates of this model lend support to our theoretical hypotheses. First, the likelihood of implementing a treaty rises with bilateral country size, reflected by $α ^ ( S × | R | ) 2 〈 o$ Further, 〈 0 and 〈 0 support our expectations regarding the functional relationship between relative and absolute bilateral factor endowment differences on the one hand and (p.532)

Table 1. SELECTION EQUATION (RATIFIED DOUBLE TAXATION TREATIES)

Explanatory variablesa

Parsimonious specification

Full model

Excl. Group effects Est. Coeff.

Incl. Group effects Est. Coeff.

Excl. Group effects Est Coeff.

Incl. Group effects Est. Coeff.

Log bilateral GDP: Gj

−0.04

3.66 **

−0.06

4.14 **

−0.76

2.25

−0.97

2.46

Log parent-to-host similarity

0.02

1.61 *

−0.05

2.24 ***

in GDP: Sj

0.34

1.96

0.39

2.56

Absolute difference in log parent-

0.03

0.06

0.02

−0.33 *

to-host capital-labor ratio: |Rj|

0.96

0.62

0.20

1.84

Interaction term: Sij × |Rij|

−0.03

−0.47 ***

0.29

3.06

Interaction term: (Sj × |Rj])2

0.00

−0.02 ***

0.71

2.80

Parent government

−0.04 ***

0.09

−0.04 **

0.06

expenditure-to-GDP ratio: g

3.42

0.68

2.23

0.48

Host government

−0.03 ***

−0.12 **

−0.02 *

−0.11 **

expenditure-to-GDP ratio: g

2.61

2.25

1.90

2.11

Number of country-pairs

786

786

786

786

Pseudo R2

0.04

0.25

0.03

0.27

Likelihood ratio tests (P>x2}:

Parent countries (18)

0.00 ***

0.00 ***

Host countries (31)

0 02 **

0.01 **

Time (14)

0.81

0.78

(a) t-values in italics below coefficients.

(***) significant at 1%;

(**) significant at 5%;

(*) significant at 10%

implementing a tax treaty on the other. Finally, the host country government expenditure variable enters significantly. A negative impact suggests that OECD countries tend to implement bilateral tax treaties more likely with countries that keep government expenditures low. Since a similar finding is obtained if we use corporate tax rates instead, we may conclude that parent countries use tax treaties to reduce the relative attractiveness of low-tax countries.

### TAX TREATIES AND FDI:

One branch of econometric literature on the estimation of endogenous treatment effects suggests propensity score matching techniques to infer the treatment effect on the treated (see Rosenbaum and Rubin 1983; Heckman, Ichimura, and Todd 1998; Vella and Verbeek 1999). We follow this (p.533) line of research and apply several different matching estimators to our difference-in-difference specification. For this, we need to compare the growth in FDI of those countries that implemented a treaty with those that did not but were similar in all other respects (as captured by similar propensity scores). A properly weighted sample of untreated country pairs serves as a group of control units.

We apply several different matching estimators. Nearest-neighbor matching estimators select one (one-to-one matching) or more (in our case, five) untreated control observations for each treated observation according to the propensity score, estimated in the above probit model. Each untreated observation potentially serves as a control for several treated ones. Under radius matching, all control units with a difference in propensity scores within a given radius are used. Kernel matching estimators make use of the whole sample of untreated observations, but they weight them according to the estimated kernel density weights. The obtained kernel estimates may be sensitive to the assumed density function and, more importantly, to the chosen bandwidth of the kernel. Local linear regression matching applies local linear weights rather than kernel weights. In general, there is a trade-off between exact matches at the danger of low precision (under nearest-neighbor, nearest-five-neighbors, small radius matching) and high precision at the danger of inexact matching (under wide radius matching or kernel matching).

For all matching estimators, it is important that the balancing property holds, that is, that the covariates are balanced between the treated and the control group. The balancing property is violated if the values of a covariate differ significantly between the treated and the matched control group. This is likely the case with many controls. Although the balancing property holds for our continuous variables according to t-tests, it is violated for the country and time dummies. However, associated problems can easily be avoided by using these dummies not only in the selection equation but also as controls in the treatment regression after matching. If the balancing property holds, the average treatment effect on the treated can always be estimated by regressing the dependent variable (in our case, the change in FDI stocks) on the treatment dummy and a constant in a weighted least-squares regression. The weights are determined by the chosen matching approach (for instance, in case of one-to-one matching all treated and control observations exhibit weight one and all other observations weight zero; under kernel matching, the kernel weights are used). If the balancing property is violated, the problematic controls should simply be included in the weighted least-squares regression in addition to the treatment dummy (see Blundell and Costa Dias 2002). In our case, this means regressing the change in log FDI stocks on the treatment dummy and the country and time dummies. The coefficient of the tax treaty dummy is an estimate of the average treatment effect on the treated.

Table 2 summarizes our findings for the various matching estimators based on the fourth probit model in Table 1. We report three sets of average treatment effects on the treated. The first one does not condition on the controls of the (p.534)

Table 2. THE IMPACT OF TAX TREATY RATIFICATION ON BILATERAL OUTWARD FDI (MATCHING ESTIMATES) (AVERAGE TREATMENT EFFECT ON THE TREATED)

Excl. country & time dummies

Incl. country & time dumnies

Incl. all controls of the probit

Estd. Effect

% change

Estd. Effect

% change

Estd. Effect

% change

Descriptive comparison (tax treaties exogenous)

0.002

-0.62

-0.18

-16.86

-0.19

-18.11

Standard error

0.12

12.34

0.12

10.24

0.12

10.12

One-to-one matching

-0.40**

-34.17

-0.53**

-42.44

-0.41**

-34.45

Standard error

0.17

10.81

0.20

11.63

0.17

11.32

Five nearest neighbor matching

-0.26*

-23.57

-0.30 **

-26.22

-0.30**

-26.58

Standard error

0.15

11.14

0.13

9.60

0.12

8.86

-0.21

-19.99

-0.21 **

-19.14

-0.21**

-19.15

Standard error

0.14

10.77

0.10

8.08

0.09

7.34

Kernel matching

Epanechnikov kernel: bandwidth = 0.06

-0.23 *

-21.35

-0.20 **

-18.75

-0.21**

-19.20

Standard error

0.14

10.75

0.10

8.05

0.09

7.28

Epanechnikov kernel; bandwidth = 0.01

-0.24

-22.45

-0.22 **

-19.90

-0.22**

-20.28

Standard error

0.15

11.51

0.11

8.73

0.10

7.83

Epanechnikov kernel; bandwidth = 0.8

-0.12

-12.15

-0.26 ***

-23.24

-0.24***

-21.82

Standard error

0.13

11.06

0.10

7.35

0.09

7.00

Gaussian kernel; bandwidth = 0.06

-0.21

-19.63

-0.21 **

-19.32

-0.21**

-19.26

Standard error

0.13

10.72

0.10

7.99

0.09

7.29

Uniform kernel: bandwidth = 0.06

-0.24 *

-21.71

-0.21 **

-19.60

-0.22**

-20.13

Standard error

0.14

10.73

0.10

7.91

0.09

7.17

Local linear regression matching

-0.22

-20.69

-0.18*

-17.16

-0.20**

-18.23

Standard error

0.14

11.09

0.10

8.54

0.09

7.55

Note: The tangible and intangible investment to sales ratios are logistically transformed; the selection probit equation includes firm size in terms of employment in 1993, the foreign ownership dummy, and the average exports to sales ratio 1997-1998. Tangible and intangible investment is measured in percent of sales and averaged over the periods 1999-2001. ** significant at 5%.

(p.535) probit, the second one includes the country and time dummies, and the third one includes all controls of the probit (dummies and continuous variables).

On top of the matching results, the descriptive comparison reflects the parameter estimate of a regression of the log difference in FDI on the change in the tax treaty dummy (all standard errors in Table 2 are heteroskedasticity-robust). In the absence of endogenous selection, this provides a consistent difference-in-difference estimate of both the treatment effect and the standard error. In contrast, the standard error of the tax treaty parameter estimated in a fixed-effects panel is likely downward biased (Bertrand, Duflo, and Mullainathan 2004). The covariates of the probit are jointly significant in the second-step weighted least-squares regression of the log change in FDI on the tax treaty dummy. Accordingly, we consider the third block of results in Table 2 as the preferred one. Note that the tax treaty coefficients cannot be interpreted at face value. Instead, one should take account of the underlying semi-logarithmic regression framework (see Kennedy 1981). We compute the percent changes in FDI associated with these estimates following van Garderen and Shah (2002). This obtains the corresponding percent change in FDI.

Treating tax treaties as an exogenous variable, we do not find any significant impact on FDI. However, the one-to-one matching estimates indicate that newly implemented tax treaties reduce FDI significantly. This points to endogenous selection into treatment leading to an underestimation of the tax treaty effect on FDI in absolute value. As long as we condition on the country and time dummies in the second-step weighted least-squares regression of FDI on the tax treaty dummy, tax treaty implementation is found to reduce FDI significantly. This effect must be interpreted as an average treatment effect on the treated. It indicates the change in outward FDI for two countries that have actually implemented a tax treaty. The general result of a negative tax treaty effect is neither affected by the choice of the matching procedure nor by different assumptions for bandwidth and density functions in case of kernel matching. The effect is highest under one-to-one matching in absolute value. There, the control units are closest to the treated ones (“exact” matching). The corresponding tax treaty effect is more reliable than that one estimated from “inexact” but potentially more efficient procedures such as kernel matching or radius matching. As we enlarge the control group by considering not only the nearest neighbor but also other control units, the weighted estimated impact gets smaller in absolute value. The smallest estimate is obtained from the local linear regression procedure. In sum, this indicates that the loss in matching quality from using more control units is relatively big as compared to the associated gain in efficiency in our sample.

## D. Discussion and extension

How do the obtained estimates relate to the results in previous research? As in Blonigen and Davies (2004a), a log specification in our sample leads to an insignificant tax treaty effect on outward FDI, if we assume that treaties are exogenous (p.536) (see the first line of results in Table 2).16 In contrast, we rigorously account for the endogeneity of tax treaties by specifying an empirical selection model, which is guided by the hypotheses derived in a general equilibrium model of trade and multinationals. In our case, ignoring self-selection leads to insignificant and much lower point estimates in absolute value. Further, the data are typically unbalanced and the implementation of new treaties is unequally spaced over time (i.e., the spell lengths before and after new treaties are implemented differ across country pairs with new treaties). This complicates the interpretation of the treatment coefficient, since the effect may implicitly reflect a weighted short-run and long-run impact. Only if the pre-treatment and treatment periods are of the same length for all treated and untreated country pairs in the sample (in our design, two years for each) is a difference-in-difference interpretation justified (see also Kyriazidou 1997).

Our estimates of the treatment effects on the treated in Table 2 indicate that the expectation of a negative effect of new tax treaties is justified as concluded in the inferior level-specifications in Blonigen and Davies (2004a, 2004b). However, our estimates underpin the importance of the endogeneity of tax treaties for an unbiased inference. In our sample of countries, we consider the one-to-one matching result of an expected reduction in FDI growth by 34% in the third block of results in Table 2 as most reliable among the reported results.

As mentioned above, we have so far required the pre-treatment and the treatment period to be of equal length (two years). If the treatment effects do not take place immediately due to adjustment costs, varying the window size of the treatment period may shed further light on the short-run versus long-run effects of implementing a new tax treaty on the treated. To assess the accumulation pattern of the tax treaty impact on outward FDI over time, we change the window size of (p.537)

figure 5. EFFECT OF TAX TREATIES ON AVERAGE BILATERAL FDI IN PERIODS OF DIFFERENT LENGTH AFTER RATIFICATION (POINT ESTIMATES AND 95% CONFIDENCE BOUND BASED ON EPANECHNIKOV KERNEL WITH BANDWIDTH 0.06)

the treatment period from two years to three, four and five years, respectively.17 If adjustment costs are important, the two-year window is closest to the short-run impact, while the others reflect the medium-run to long-run impact.18 In Figure 5, we display the percent-change of FDI associated with a new tax treaty for these different windows of the treatment period. To estimate the effects, we choose the one-to-one matching estimates. Accordingly, the outer left value of the black line reflects the corresponding estimate reported in Table 3. The point estimate is displayed in black and the upper and lower 95% confidence bounds appear in gray. The figure indicates that adjustment costs are important and the accumulated negative impact of bilateral tax treaties is higher in absolute value over the longer periods.

# CONCLUSION

Two primary goals of bilateral tax treaties are the elimination of double taxation of cross-border activities and the prevention of tax avoidance and evasion. Accordingly, the net impact of implementing a tax treaty on foreign direct investment is not clear-cut.

(p.538) This paper analyzes the influence of bilateral tax treaties on bilateral stocks of outward FDI, where we focus on the double taxation issue but not on tax evasion. We set up a general equilibrium model of trade and multinational firms to study the welfare and FDI effects of tax treaties. This model motivates an empirical specification to explain the implementation of tax treaties. The selection into treatment (i.e., a positive treaty-induced change in welfare) is considered as an endogenous event. Based on this selection model, we estimate the tax treaty implementation effect on FDI using various difference-in-difference propensity score matching approaches. In our sample of OECD outward FDI over the period from 1985 to 2000, we identify a significant negative and reasonable treatment effect on the treated, which is robust with respect to the matching estimator choice. A negative tax treaty effect on FDI can be explained by our general equilibrium model, if tax revenues are spent for public infrastructure to reduce plant setup costs. However, it may also indicate that the tax avoidance aspect of bilateral tax treaties is present in our sample.

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# Notes

## Notes:

(*.) This chapter was reprinted with permission from Canadian Journal of Economics. The chapter was originally published as “The impact of endogenous tax treaties on foreign direct investment: theory and empirical evidence”, Canadian Journal of Economics 39(3), 2006, 901–931. The authors are grateful to Ron Davies and the seminar participants at the 2004 IIPF Congress in Milan for helpful comments and suggestions. Financial support from the Austrian Fonds zur Förderung der wissenschaftlichen Forschung (FWF, grant no. P17028-G08) is gratefully acknowledged.

(1.) The aim of preventing tax avoidance was introduced recently in the 2003 revision of the OECD Model. In the 1963 and 1977 versions of the OECD Model, tax evasion was limited to fraud or criminal tax evasion (see Arnold 2004).

(2.) If the foreign tax burden is higher than the domestic one, the tax rebate is limited to the tax level of the home country. The limitation may be applied either for a single country (per-country-limitation) or for all countries (overall-limitation).

(3.) Consequently, this reduces the domestic tax base by the amount of foreign profits, which, in turn, lowers the overall tax burden in the presence of a progressive income tax system. In practice, this ‘splitting advantage’ is reduced via an exemption with progression.

(4.) Mutti and Grubert (2004) significantly reject level specifications versus log specifications based on a RESET test motivated by Davidson and MacKinnon (1993) in the context of taxation and FDI.

(5.) The related FDI-inhibiting effects of tax treaties are well understood (see Davies 2003b).

(6.) In terms of the OECD Model, national firms do not hold a “permanent establishment” (i.e., “a fixed place of business through which the business of an enterprise is wholly or partly carried on”; Art. 5 OECD Model) in foreign markets, and are therefore, not subject to taxation abroad.

(7.) Several OECD countries also apply various forms of unilateral methods to reduce the burden of double taxation, such as flat rates, deductions from the tax base or exemptions of foreign-earned profits. However, in most cases such practices do not completely eliminate double taxation.

(8.) If $t + I ( Δ T i j , t + 1 )$, a firm would accumulate an “excess foreign tax credit.” In this case, the credit is typically limited to $t i M$ yielding $t j ω = t i ω = 0$. Consequently, the overall tax burden under the credit method is equal to that of the exemption method (see Hines 1999 for further details) The credit method is applied, for instance, by the United States, the United Kingdom, Japan, Greece, Ireland and Spain, while the exemption method is used by Germany, France and Italy. We do not refer to the deduction method, since it is not proposed in the OECD Model and it is typically applied unilaterally (see Devereux and Hubbard 2003 for a welfare analysis).

(9.) The choice of these rates is motivated by the fact that withholding tax rates on cross-border payments of dividends are of similar size in most bilateral tax treaties.

(10.) Here, we rule out the possibility that the welfare gain of one party is used to compensate the welfare loss of the other. Further, it is reasonable to assume that marginal administrative costs of treaty formation rule out the implementation of a treaty at zero welfare gains.

(11.) Note that we focus on the endogeneity of bilateral treaties, leaving the unilateral setting of tax rates exogenous. Bond and Samuelson (1989), Janeba (1995), and Davies (2003) investigate the strategic tax rate setting under different assignment rules (i.e., credit, exemption, and deduction). The case of endogenous tax treaties under exogenous tax rates seems justified in the medium run. For instance, in the dataset used in the empirical analysis below, the number of newly implemented tax treaties is five times higher than that one of changes in the statutory corporate tax rates.

(12.) Graphically, imagine a relative factor price line with a negative slope. Two points on this line are relevant: the consumption point on the diagonal of the factor box, and a second point located at the border between the white and the black area. The segment of the factor price line between these two points is smaller for countries of dissimilar size than for countries with identical size.

(13.) Wooldridge (2002, 637) points out that endogeneity is an issue in panel data, if the treatment (in our case, implementing tax treaties) is correlated with time-varying unobservables that affect the response. The same argument applies for difference-in-difference analysis. However, this correlation takes place in a theoretical general equilibrium model such as the one outlined above.

(14.) We are grateful to Scott Baier for kindly providing the data.

(15.) Alternatively, we used corporate tax rates available from the Office of Tax Policy Research (World Tax Database). However, the results are insensitive with respect to this choice.

(16.) In a sample of OECD parent countries and a knowledge-capital specification using data over the period 1983–1992, Blonigen and Davies (2004b) estimate a significant negative impact of new tax treaties on levels of bilateral outward FDI stocks and flows. Their preferred specification is a model with fixed country-pair effects, and the identified tax treaty effect is extremely large in absolute values. In Table 5 of Blonigen and Davies (2004b), they report a new tax treaty parameter of −2597:6 in the FDI outbound stock specification in column 1. Given the average level of OECD outbound stocks of 3378:13 reported in their Table 2, this means that FDI stocks should be expected to shrink by almost 77%. In column 3 of Table 5, they run a fixed country-pair specification which includes the lagged FDI stock as a regressor. The reported new tax treaty parameter in this model is −2212:3 and the coefficient of the lagged dependent is 0:308, implying a long-run treaty effect of −3197:0, that is, a reduction in FDI stocks by 97%. These results are also consistent with the levels regressions in Blonigen and Davies (2004a), finding new treaty-induced reductions in U.S. FDI of 77% for outward stocks and of 88% for inward stocks. However, the effect on U.S. FDI in a preferable specification in logs is insignificant.

(17.) We are not able to consider longer periods because of the associated substantial loss of observations and, in particular, of tax treaty–implementing country pairs.

(18.) However, with an adjustment cost parameter of the size as estimated in Blonigen and Davies (2004b), more than 90% of the long-run impact would be already accumulated after only two years.