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How taxation influences the foreign direct investment in developing economies

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Added on  2021-06-18

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2.0 Background and Academic Context 2.1 Research topic Governments of both developed and developing countries are always eager to bring in foreign direct investment in their respective 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). The taxation system of developing country like India is broadly classified in to Direct Tax and Indirect Tax.

How taxation influences the foreign direct investment in developing economies

   Added on 2021-06-18

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1.0Working Title. How taxation influences the foreign direct investment in developing economies.2.0Background and Academic Context 2.1 Research topicGovernments 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 returnfrom 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 (Morissetand Pirnia n.d). 2.2 Key Academic Ideas. 2.2.1. 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.
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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). 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 ofNigeria, 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 growthof the country while the direct tax had weak impact on growth (Thaçi 2018). 2.2.2. Foreign Direct Investment (FDI): Investment by one country into another mostly through private agents like companies, individuals instead of government is known as foreigndirect 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 exposureto 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 developedcountries (Marimuthu 2012). 2.2.3. 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
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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, 035or 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. 3.0 How does this research relate to existing literature? 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 hostdeveloping 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 notplay 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
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