Does Cancellation of Preferential Tax Policy Reduce Foreign Direct Investment Inflows?

• DOI: http://doi.org/10.1111/cwe.12263
• Author: Chen Wang,Zhi Luo,Xun Zhang
• Date: 01 November 2018
• Published date: 01 November 2018

©2018 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 97–115, Vol. 26, No. 6, 2018

97

*Zhi Luo, Associate Professor, Center for Economic Development Research, Wuhan University, China.

Email: luozhi@whu.edu.cn; Chen Wang, Associate Professor, School of Urban and Regional Science,

Shanghai University of Finance and Economics, China. Email: wang.chen@mail.shufe.edu.cn; Xun Zhang

(corresponding author), Associate Professor, School of Statistics, Beijing Normal University, China.

Email: zhangxun@bnu.edu.cn. This paper was funded by the National Social Science Foundation of China

(No. 16ZDA006) and the National Natural Science Foundation of China (Nos. 71773084 and 71373186).

Does Cancellation of Preferential Tax Policy Reduce

Foreign Direct Investment Inows?

Zhi Luo, Chen Wang, Xun Zhang*

Abstract

In light of recent tax cuts by the US, should China reintroduce a preferential tax policy

to attract foreign direct investment? This paper investigates whether China’s 2008 tax

policy change affected inward foreign direct investment. In contrast to previous studies,

we break foreign investment down into suspect and real foreign investment using rm-

level data from 1998 to 2008 and conduct a difference-in-difference estimation to

determine the effect of the tax policy change on both types of foreign investment and

compare these to the effect on domestic investment. The results show that the 2008

tax policy change reduced the amount of suspect foreign investment and its effect on

real foreign investment was insignificant, indicating that foreign firms in China are

more concerned with the investment environment and economic stability than taxes.

Therefore, China should create a regulated business environment instead of readopting

supernational treatment for foreign enterprises.

Key words: foreign direct investment, preferential tax policy, suspect foreign capital

JEL codes: D24, H54, O18

I. Introduction

On 2 December 2017, the US enforced a massive tax cut policy to reduce its outward

foreign direct investment (FDI), attract cross-border FDI, create more jobs and

stimulate economic growth. The tax cuts present challenges to many other countries,

including China, because they may cause capital outow from these countries and FDI

inflows. In the face of the US tax cuts, should other countries do the same to attract

foreign investment? This issue is particularly important for China. Although China has

Zhi Luo et al. / 97–115, Vol. 26, No. 6, 2018

©2018 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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experienced rapid growth for nearly three decades, as a developing country it still needs

to attract substantial domestic and foreign investment to promote economic growth, and

particularly FDI, which will introduce advanced technology and management experience.

Indeed, China’s past experience indicates that adopting a preferential tax policy is

an effective way to attract FDI. Since the economic reform and opening up, the Chinese

government granted tax incentives to foreign-invested enterprises (FIEs, including

wholly foreign-owned enterprises, Chinese−foreign joint equity enterprises, foreign-

invested limited enterprises, and Chinese and foreign joint ventures) and established a

series of preferential policies to attract advanced technologies (Jiang, 2008; Xie, 2008;

Luo and Guariglia, 2012). Inward FDI became an important mechanism for China to

promote reforms and improve production technology (Sun et al., 2015).

However, the preferential tax policy in China also caused some distortions. FIEs

enjoyed supernational treatment, which prevented fair competition between different

types of enterprises. Moreover, the policy resulted in suspect FIEs – domestic enterprises

claiming to be FIEs to enjoy tax benefits. These distortions became more severe after

China joined the World Trade Organization (WTO) (Liu and Jia, 2008). Thus, in order to

deepen marketization reform, it became important for the Chinese government to cease

supernational treatment of FIEs (Murphy et al., 1992; Sacks et al., 2001; Lin et al., 2014).

In 2008, the Chinese government initiated reforms with the intention of abolishing the

supernational treatment of taxation enjoyed by FIEs and establishing a new preferential

taxation system based on industries and regions instead of investment type.

Did this reform have a negative impact on China’s inward FDI and therefore

will new reform impact future FDI opportunities? This issue deserves exploration.

The relationship between tax policy change in a host country and foreign investment

behavior has attracted intense review, but ndings are far from conclusive (e.g. Slemord,

1990; Grubert and Mutti, 1991; Wheeler and Mody, 1992; Hines and Rice, 1994; Mutti

and Grubert, 2004). Most studies estimate country-level tax rate changes on total FDI

inows. Slemrod (1990) and Hines and Rice (1994) found that tax rate change in the US

did not affect FDI inows, while others argue that such change has a signicant impact.

Using rm-level data, Stöwhase (2002) and Wamer (2011) showed that tax rate change

had a signicant effect on investment by multinational corporations. An (2011) found

that China’s 2008 tax policy change reduced FIEs’ total assets; however, this study

combined the effect of tax policy change on incumbents and entrants, and the effects on

incumbent foreign rms and entrants can be very different.

More importantly, as noted, one of the distortions caused by the preferential tax

policy was the rise of suspect foreign investment by domestic enterprises. We expect

that the tax policy changes had different effects on suspect and real foreign investment.