Foreign direct investment with tax holidays and policy uncertainty

• Author: Alcino Azevedo,Artur Rodrigues,Paulo J. Pereira
• DOI: http://doi.org/10.1002/ijfe.1688
• Date: 01 April 2019
• Published date: 01 April 2019

Received: 25 November 2017 Revised: 5 July 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1688

RESEARCH ARTICLE

Foreign direct investment with tax holidays and policy

uncertainty

Alcino Azevedo1Paulo J. Pereira2Artur Rodrigues3

1Aston Business School, Aston University,

Birmingham, UK

2CEF.UP and Faculdadede Economia,

Universidade do Porto, Porto,Portugal

3NIPE and School of Economics and

Management, University of Minho, Braga,

Portugal

Correspondence

Artur Rodrigues, NIPE and School of

Economics and Management, University

of Minho, Braga, Portugal.

Email: artur.rodrigues@eeg.uminho.pt

Funding information

FCT, Grant/AwardNumber:

POCI-01-0145-FEDER-006683 and

POCI-01-0145-FEDER-006890; ERDF

JEL Classification: F21; G31; H25

Abstract

We study foreign direct investment agreements that entitle firms to a lower tax

rate during a tax holiday period. Our model considers both finite and uncertain

tax holiday period settings. Weshow that the tax holiday duration may have, for

small tax rate reductions, a nonmonotonic effect on the investment timing. For

sufficiently high tax reductions, a longer tax holiday speeds up investment. A

higher tax reduction during the tax holiday and a lower uncertainty are shown

to have a monotonic effect on the threshold, hastening investment. However, in

case of a finite tax holiday, for exceptional high salvage values, a higher uncer-

tainty can speed up investment. We show the usefulness of our model to design

an optimal incentives package that prompts investment.

KEYWORDS

FDI, real options, tax holidays, taxation policy, uncertainty

1INTRODUCTION

Governments use corporate tax incentives to enhance for-

eign direct investment (FDI). The offer to a foreign firm of

a more attractivetax rate is often enough to make an invest-

ment profitable, or the relocation of a business to another

country optimal. For instance, amongst the EU countries,

Ireland is well known for its aggressive corporate tax pol-

icy, which attracts FDI.

An FDI agreement can be seen as a contract between

a country and a foreign firm through which, over a

given time period, the two parties are entitled to a set

of financial benefits and obligations. The benefits for the

firm are usually given through subsidies, guarantees, or

lower tax rates, whereas the obligations are normally

required through the promotion of new jobs, investment

in human capital, establishment of business partnerships

with local firms, or, as we will consider, the commitment

to remain in the country, not divesting during a given time

period.

We develop a real options model that determines the

optimal time to undertake an FDI when there is a tax

holiday period over which the firm agrees not to divest.

This means that, after investing, instead of the (usual)

divestment option, the firm holds a forward start option

to abandon the investment, which can only be exercised

after the expiration date of the FDI agreement. By consid-

ering this constrain on the divestment option, we depart

from the previous literature. We believe that this is a

realistic setting, because it is not plausible that a coun-

try offers a tax holiday to a foreign firm without any

constrain.

Our model considers two settings: a finite and a random

duration of the tax holiday period. In the former case, the

firm is offered a tax reduction lasting for a certain period

of time, whereas in the latter, the tax reduction is offered

as permanent but is perceived as reversible by the firm, as

aresultofataxpolicychange.

Typically, FDI agreements hold during relatively long

time periods, over which investments can face veryadverse

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