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There is a large literature documenting that high host-country corporate taxes deter foreign direct investment. However, some recent papers have questioned the robustness of this result in developing countries. In this paper we investigate one possible reason: the presence of a trade-off between taxes and good governance. We find that taxes and governance interact and that taxes and corruption are substitutes so that the impact of taxes alone on FDI will be lessened when corruption is also present. Bribes and weak tax enforcement tend to reduce formal tax payments by more than the bribe, and bribery becomes the more important cost for multinationals. Since corruption tends to be more prevalent and tax administration weaker in developing countries, this helps explain why in general corporate taxes are less relevant in explaining FDI location in the developing world. The substitutability result also suggests that when taxes are high, the impact of corruption on FDI location is lessened. The reason would seem to be that when there are excessive taxes, paying a bribe may allow a business to avoid the constraints imposed by excessive government, an argument suggested in the previous literature. This does not mean that such an economy is more efficient, however; as Shleifer and Vishny (1993) argue, bribe payments may be much more distortive and costly than taxation.


International Center for Public Policy Working Paper Series #2011, Andrew Young School of Policy Studies, Georgia State University.

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