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Research topic

How Taxation Influences The Foreign Direct Investment In Developing Economies.

Research topic

Governments of both developed and developing countries are always eager to bring in foreign direct investment in their respective countries. The need for FDI is of more importance in case of developing countries as they most often suffer from capital deficiency in their economy. FDI not only brings in capital but also technological progress, better managerial techniques and blueprints in the developing countries. FDI investment generates employment and income together with development of market, establishment of economic institutions in these counties whose spill over effect spreads across the economy in the form of positive externality (Margalioth n.d).

However, FDI in any country is subject to several conditions. The carriers of FDI are multinational corporations (MNC) who will invest only when they foresee encouraging return from the same. For this they take a few factors into their consideration to assess the investment environment of the country with investment potential. One such factor is taxation system of the country. How the government taxes the business is a factor that is believed to be impacting the investment decision (Sayd and Marimuthu 2012).

Knowing the underlying psychology of the MNCs governments of developing countries cut tax rate on investment and offer other tax benefits to these companies to lure them. However, most developing countries likely to have a weak and cumbersome tax design wrapped in stringent and non-transparent administrative rules. These make tax compliance a time consuming and inconvenient task. MNCs, therefore, find such tax incentives unattractive and don not consider it as a major factor while deciding on FDI in a developing country (Morisset and Pirnia n.d).  

Taxation: A system using which the government collects revenue from business and household for making its expenditure is called taxation. The governments can encourage or discourage economic decisions by altering levels of taxes.

The taxation system of developing country like India is broadly classified in to Direct Tax and Indirect Tax. Direct taxes are those whose burden falls directly on the entity being taxed. They include Income tax, Corporation tax, Capital gain tax, Wealth tax. Indirect taxes are those which are paid by someone, but its burden can be partially or wholly shifted to other person through business transactions. They include Excise duties, Sales tax, Goods and Services tax (Chakraborty 2016). In 2013-14 the tax-GDP ratio of India stood at 17.4 percent. The same ratio in sub-Saharan Africa in 2010 was 20 per cent (EPS 2013).

Taxation and Foreign Direct Investment (FDI)

Taxes impact economic growth in developing countries in many ways. Studies by Alegena (2014) to determine the effect of tax incentives on economic growth of Kenya showed that there was a negative relation between GDP growth rate and tax incentives. Another study in 2016 by Eugene Abigail which examined the impact of tax incentives on economic growth of Nigeria, demonstrated that taxes have a significant effect on Nigeria's economic growth. Especially it was the indirect taxes that had the robust positive effect on the economic growth of the country while the direct tax had weak impact on growth (Thaçi 2018).    

Foreign Direct Investment (FDI): Investment by one country into another mostly through private agents like companies, individuals instead of government is known as foreign direct investment or FDI. Foreign direct investment is the source of employment, growth and income along with exposure to foreign capital, technological progress, improved managerial practices.

India post 1991 pursued a policy of liberalization and welcomed foreign direct investments. These investments have been key to drive growth economic activities through technology transfer, creation of employment, and improved access to managerial expertise. The exposure to global capital, product markets and distribution network restructured the Indian market. FDI in India has helped the country to achieve some degree of financial stability, growth and development. Even in the wake of financial crisis 2008 and its subsequent global recession India was able to retain its FDIs and attracted more capital flow compared to many developed countries (Marimuthu 2012).   

Developing Countries: Development is a concept which is difficult to define. There are no universally accepted criteria for classifying countries according to their level of development. International agencies like UNDP, IMF and World Bank use their separate criteria to make distinctions and group countries according to their level of prosperity. The term “Developing Countries” is used mostly by UNDP to indicate those countries which are below the 75 percentiles of the Human Development Index distribution. The world Bank defines developing countries as those countries which have per capita income level of $4, 035 or less (A4ID 2018). The primary characteristics of developing nations include low level of industrialization together with low level of income, lower life expectancy, lower educational attainment, and high rates of fertility. Most of the countries in Africa, Asia, South America, Central Europe, and East Europe exhibit these features and hence are considered as developing.     

Studies have investigated the role of foreign direct investment in growth of developing countries. It has been found that FDI is not driven by a single factor but is a function of multiple factors including market size, market growth, human capital, trade openness, taxation, physical infrastructure (San, Cheng and Heng 2012). In their study San, Cheng and Heng (2012) delved deep into the relationship between corporate tax and US outward FDI in developing countries. They found that there exists a negative relation between the two in host developing countries.

Direct and Indirect Taxes in Developing Countries

OECD (2008) report on effects of tax on FDI stated that FDI falls by 3.7% with a 1 percentage point increase in the tax rate on FDI. However, other studies reflect decrease in the range of 0% to 5%. This variation is partly due to differences between the industries and the examined countries, or the time periods considered (OECD 2008). In the same report it has been further mentioned that some studies have shown increasing sensitivity of FDI against taxation. This is due to the enhanced mobility of capital resulting from removal of non-tax FDI barriers. In his discussion Margalioth (n.d) emphasised on the negative impact that taxation has in attracting FDI. In fact, international institutions like World Bank, OECD, IMF consider it a “Bad policy” to use tax incentives for luring FDI. The strongest argument against the tax incentives are that it distorts behaviour and brings in inefficiency and they are not effective rather are harmful and have very little impact of FDI decision. 

A study by Economou et.al (2016) revealed that in developing countries the taxation does not play a significant role in decision drawing FDI in those counties. The determining factors included market size, labor cost, and institutional variables.   Maria et al (2017) in their book titled Corporate tax incentives and FDI in developing countries elaborate the reason behind insignificant impact of taxation on FDI inflow in developing countries. They are of the view that in most developing countries the tax design is clumsy, weak, lacks transparency, and is full of administratively cumbersome paraphernalia. These make the tax incentive less attractive and inefficient.

Previous researches focused on capital income taxes mainly. Also, they did not exclusively consider developing economies. So, in this paper the idea is to explore what kind of tax policies developing economies should undertake in order to boost their growth through FDI. These developing economies depend a lot on inflow of foreign investments for their all-round economic growth. Therefore, the paper will throw light on the possibilities of adjustment in taxes and tariffs in order to promote these foreign investments.

The question that this research seeks to answer is: “How taxation influences the FDI decisions in India and Bangladesh?”. The reason behind choosing Bangladesh along with India are manifolds. First, both are democratic countries. Second, they are neighbours, and hence, a comparison can be made easily with ample availability of data and primary research. Third, India is a large country while Bangladesh is a small country in terms GDP, population, foreign trade and foreign investment. It would be interesting to study whether there is any effect of  taxation on a large country vis-à-vis a small country.   

Taxes' Impact on Economic Growth in Developing Countries

The hypothesis formed based on literature review is as follows:

  • There is no significant impact of taxation on FDI decisions in developing countries.

For simplicity of analysis the taxes considered are consumption tax, income tax, import tariff, business taxes (like property taxes, etc). The idea here is to study the impact of all these variables on FDI in respective countries. 

Further scope of this research will be to explore how FDI influences GDP and other associated economic parameters of these developing economies. This will give an idea on how the tax policy changes can affect the overall growth of economies.

Taxes on income (both wages and profit) can affect return on work effort. Labour supply could be inelastic and therefore incidence of tax will fall on workers in short run. In long run, supply elasticity is higher. When wage costs are high, companies will be less likely to invest in these economies. This is because with higher incidence of taxes companies will be left with lower profit and burden of higher overhead expenses. Again, with higher import tariff other economies will be keener to produce the good in the target economy itself in order to capture market share.

The study requires secondary data analysis. Both quantitative and   qualitative analysis may be used. A secondary study will help gather data on various developing countries’ FDI inflow, tax-GDP ratio, HDI rank needed to ascertain the level of development of the country (Johnston 2014). Moreover, there is no other option but to use secondary data for a study that involves collection and comparison of data across countries. The specific objectives behind this research are:

  • To identify a group of developing countries on which the study can be conducted.
  • Specify period of study

This study will use time series data for a period of 10 years for India and Bangladesh in relation to their FDI inflow and tax rates. For both the countries official data released by the government agencies of the respective countries can be used. Most data are available online through official websites of the governments. Online research will be done to collect the data. Besides, data can also be collected from websites of International agencies like IMF and World Bank. Regression analysis will be used to analyse the dataset. Here dependent variable is FDI in respective countries while the other tax variables are independent ones. The result will be  analysed in the light of existing literature review and subsequent conclusion will be drawn.

Confidentiality and Consent: Since secondary research method involves existing research data to find an answer to the research question, ethical concerns about them include data confidentiality and security (Tripathy, 2013). The data that will be used for this research are freely available in the internet, books or other public forums. That is why their use for further analysis is implied. There is no need to take usage permission separately. However, the ownership of the original data will be acknowledged (Grinyer 2009). 

Foreign Direct Investment (FDI) in India

Evaluation of data: Another point that will be taken care of is the evaluation of the data. Since the data used for this study was not collected to answer this research question, its adequacy and relevance must be ascertained. This will be done by scrutinizing the methodology of data collection, accuracy of the data, data collection period, purpose of data collection and the content of the data.

Access to data: The access of the data will be restricted to ensure that there is no unauthorized use of the data, accidental loss or destruction.

I would have expected you to come up with details. At least some idea of what you are going to do. You haven’t even decided on the countries you want to investigate, what kind of data you will collect, what time period you will look at…..

Criterion

Score

1 Background and academic context

50

2 Objectives and hypothesis

25

3 Research process

25

4 Bibliography

25

5 Feasibility (including access)

50

6 Communication and presentation

25

Total

33

References

Andersen, M. R., Kett, B.R. and Uexkull, E.von (2017). Corporate tax incentives and FDI in developing countries. Global Investment Competitiveness Report 2017/2018: Foreign Investor Perspectives and Policy Implications. [online] 77-99. Available at: https://elibrary.worldbank.org/doi/abs/10.1596/978-1-4648-1175-3_ch3 [Accessed 10th May 2018]

A4ID (2018). Understanding the developed/developing country taxonomy. [online] Available at: https://www.a4id.org/policy/understanding-the-developeddeveloping-country-taxonomy/ [Accessed 10th May 2018]

Chakraborty, M. (2016). India’s tax system: Increasing progressivity. Yojana November. [online] Available at: https://www.cbgaindia.org/wp-content/uploads/2017/04/Indias-Tax-System-Increasing-Progressivity.pdf [Accessed 10th May 2018]

EPS (2013). Taxation and developing countries. [online] Available at: https://www.odi.org/sites/odi.org.uk/files/odi-assets/events-documents/5045.pdf [Accessed 10th May 2018]

Grinyer, A. (2009). The ethics of the secondary analysis and further use of qualitative data. Social Research University of Surrey 56. [online] Available at:  https://sru.soc.surrey.ac.uk/SRU56.pdf [Accessed on 12th May 2018]

Johnston, M. P. (2014). Secondary data analysis: A method of which the time has come. Qualitative and Quantitative Methods in Libraries 3, [online] 619-626. Available at: https://www.qqml.net/papers/September_2014_Issue/336QQML_Journal_2014_Johnston_Sept_619-626.pdf [Accessed 12th May 2018]

Margalioth, Y. (nd). Tax competition, foreign direct investments and growth: using the tax system to promote developing countries. [online] Available at: https://portal.idc.ac.il/en/ilea/previousmeetings/documents/tax%20competition%20foreign%20direct%20investments%20and%20growth.pdf [Accessed 12th May 2018]

Morisset, J., Pirnia, N. (n.d). How tax policy and incentives affect foreign direct investment: A review. [online] Available at: https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.17.886&rep=rep1&type=pdf [Accessed 12th May 2018]

OECD (2008). Tax Effects on foreign direct investment. Policy Brief. [online] Available at: https://www.oecd.org/investment/investment-policy/40152903.pdf [Accessed 12th May 2018]

OECD (2002).  Foreign Direct Investment for Development. [online] Available at: https://www.oecd.org/investment/investmentfordevelopment/1959815.pdf [Accessed 12th May 2018]

San, O.T., Cheng, W.K.and T.B. Heng, (2012). Corporate tax and foreign direct investment in developing countries. International Journal of Business Management and Economic Research [online] 31(1). 471- 479. Available at: https://www.ijbmer.com/docs/volumes/vol3issue1/ijbmer2012030111.pdf [Accessed : 10th May 2018]

Syed, Azhar, Marimuthu K.N. (2012). An overview of foreign direct investment in India. International Journal of Multidisciplinary & Management Studies 2. [online] Available at: https://www.researchgate.net/publication/271729440_AN_OVERVIEW_OF_FOREIGN_DIRECT_INVESTMENT_IN_INDIA [Accessed: 10th May 2018]

Thaçi, L. and Gërxhaliu, A. (2018). Tax Structure and developing countries. European Journal of Economics and Business Studies [online] 10(1) Available at: https://journals.euser.org/files/articles/ejes_jan_apr_18_v10_i1/Lumnije.pdf. [Accessed 08th May 2018].

Tripathy, J.P. (2013). Secondary data analysis: Ethical issues and challenges. Iranian Journal of Public Health [online] 42(12). Available at: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC4441947/  [Accessed 09th May 2018].

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My Assignment Help. Essay: Taxation [Internet]. My Assignment Help. 2019 [cited 16 July 2024]. Available from: https://myassignmenthelp.com/free-samples/foreign-direct-investment-in-economies.

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