Ghana also uses Double Taxation Agreements (DTA) to rationalise tax obligations of investors who come from global tax sourced jurisdictions with a view to saving the investors the incidence of double taxation.
The dominant model of tax treaty negotiations in academic literature assumes rational choices on both sides (see here for a good example). Tax treaty negotiations generally entail the coordinated lowering of withholding taxes, which are levied by each country on overseas payments made by foreign investors. This is a shift away from taxation at the source of investment, towards taxation by the country of residence, which is thought to be more efficient.
Where the two countries in a negotiation have a relatively symmetric investment relationship, the lowering of withholding taxes has little impact on the amount of tax revenue that either state can raise, because each side is simultaneously a source and residence country.
But in an asymmetric pairing such as that between a developed and developing country, the developing country will favour source taxation, and the other residence taxation. The negotiation of a tax treaty generally requires that a developing country sacrifice some of its right to tax residents of the treaty partner on the income from their investments earned within its borders. At first sight this implies a reduction in its tax revenue, but it may be a rational choice for the country if a) other effects from the treaty lead to more tax revenue, or b) the overall effect on households in the country is positive, even if there’s a tax cost.
Why tax treaties might affect investment
The most important factor that is thought to lead to a) and b) is the promotion of foreign direct investment. Several arguments point in this direction:
- The elimination of double taxation and the other advantages offered to taxpayers – in particular a reduction in compliance costs – from the treaty are expected to encourage inflows of investment.
- If the tax treaty shifts taxing rights from the developing to the developed country, and the latter avails itself of these taxing rights, that may create an incentive for investors to reallocate capital to the developing country, where the tax cost is lower.
- In the case of developing countries, the conclusion of a treaty may have a signalling effect by indicating that the country is creating an encouraging environment for investment.
- Tax treaties also offer stability for investors in tax treatment, since in most instances unilateral changes to domestic law cannot override the treaty unless it is renegotiated.
In contrast, there are three arguments that suggest the above factors may not have such a significant effect:
- Double taxation can be, and usually is, relieved unilaterally by the home state of a multinational company. Typically this occurs either through exempting overseas profits from home state taxation, or by offering a credit against the home state tax liability for taxes paid overseas. Consequently, a tax treaty is not needed to eliminate double taxation (although there are still some cases, such as transfer pricing adjustments, where it can help).
- It will always be more cost-effective for a multinational to retain and reinvest profits in the source state, rather than repatriate and then re-export the capital from the home state; a tax treaty is therefore unlikely to have a significant impact on long-term investments, only on new investments.
- Tax treaties may discourage investment by closing off routes for tax evasion and avoidance, therefore increasing the tax cost to some investors.
Evidence for the effect of tax treaties on investment
The rational choice model of tax treaty negotiation by developing countries rests on the hypothesis that tax treaties increase inbound investment. (I’m leaving aside for a moment the main other part of the rational choice calculation, which is that the tax treaty saves developing countries money through administrative cooperation and information exchange. The same benefits can, in principle, be obtained through a Tax Information Exchange Agreement, without the need for a reduction in source taxation rights).
A number of papers in the academic literature have sought to examine this association. Unless otherwise indicated, they’re collected in this single book, published in 2009 . Blonigen & Davies find no significant association between foreign direct investment (FDI) activity and the negotiation of tax treaties with the US, and suggest a negative association when examining treaties negotiated between OECD states. These findings are corroborated by Egger et al and by Louie & Rousslang, the latter finding no change in the rate of return expected by US corporations investing in countries where a tax treaty has been negotiated.
Milmas & Kumar use a different methodology that allows for a lag of several years between the negotiation of a treaty and any effect on investment levels. They find a significant positive association between the presence of a tax treaty and inbound FDI activity into the US; for outbound investment, they find a less significant association which is positive for FDI stocks, but negative for flows. Neumayer finds a significant and positive relationship between the negotiation of tax treaties with OECD countries and inbound FDI for middle-income countries, but not for low-income countries.
So far, the evidence doesn’t look good for tax treaties and investment promotion in low-income countries. But the most recent intervention in this debate, published by Barthel, Busse & Neumayer in 2010 [pdf], uses a much more extensive dataset than previous studies, incorporating 30 FDI source countries and 105 host countries. This study finds a positive and significant association between the presence of a tax treaty and the stock of FDI, measured with a lag and over the long term, including for low-income countries.
This final study should not be considered the final word in the debate. It uses a dyadic approach (compares bilateral FDI between two treaty partners), as opposed to the monadic approaches (which use total investment figures for a country) or those focused on a single FDI source country. One possibility with this approach is that the increased inbound FDI from a treaty partner may not be new FDI: it may merely be rerouted FDI.
In general, all of the quantitative studies described here assume a simple model of investment flows from “home” to “host” country, rather than the more complex chains passing through “treaty havens” such as the Netherlands and Mauritius. A tax treaty with such jurisdictions is likely to change the pattern of investments from elsewhere; conversely, a new tax treaty with a true “home” country might lead to more direct investment links and fewer routed via treaty havens.
The question “does the size of a country’s tax treaty network affect overall investment levels?” most closely approximated by the earlier Neumayer paper, may therefore be a more appropriate one to ask.
The case of Ghana
A case-study approach may help to illustrate this. Ghana appears to have [pdf] eight tax treaties in force at present (internet sources disagree: many seem unaware of the 2008 treaty with Switzerland). These were signed in three waves: with the UK and France in 1993, with Italy, Germany, South Africa and Belgium in 2004-5, and with the Netherlands and Switzerland in 2008. A treaty with Mauritius was negotiated in 2009 [pdf], but has not yet been signed.
Arguably, the most recent wave of treaties is more likely to increase investment through these jurisdictions by investors based elsewhere than to increase FDI from investors based in these jurisdictions themselves. In addition to testing that particular assertion, the policy-relevant question for empirical research would be whether any increase in inbound investment through these jurisdictions after the treaty was concluded represented an increase in overall investment, or merely a redirection of investment from elsewhere.
Nice – the idea of ‘treaty havens’ seems a very helpful one.
There’s perhaps a finer-grain analysis that might be useful here too. Of the two different FDI types you characterise – ‘true’ direct FDI between two countries; and FDI routed through a ‘treaty haven’ – the latter is counteracted in some tax treaties by anti-treaty-shopping or Limitation on Benefits clauses. My gut feeling (not empirically based) is that many newer European & North American tax treaties have such provisions; but that the treaty networks of ‘treaty havens’ often do not, perhaps deliberately.
All of which is to say that in determining its effect on FDI patterns, the *quality* of a country’s treaty network may be as important as its *size*. At the moment most assessments of tax treaties have focussed on cooperation/info-exchange measures, and especially on whether they are compliant or not with Art. 26 of the OECD Model. I’d be curious to know if the academic literature has sought to measure the quality of different countries’ treaty networks in other ways too – WHT rates, anti-avoidance clauses, substance rules, residency rules, and so on? Some kind of rankable index would be of real research interest, I’d have thought?
ps. I know – ‘direct FDI’, tautologous. So sue me.
Hi Mike, there are a couple of studies looking variously at withholding tax rates, PE thresholds and tax sparing clauses. Watch this space for more on that!
But yes there’s a growing list of things to watch out for in comparing treaties, and the database of which you speak is likely to be one of my next steps.
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