The effect of investing in foreign countries to pay lower taxes on economic productivity

An increasingly connected world and a strong digital economy have made it easier for multinational companies to have investments in multiple countries. This investment, where the company buys a controlling stake in a foreign company, is known as foreign direct investment.

Making multiple foreign direct investments in countries with favorable tax policies, also known as tax havens, is a common strategy used by multinational companies to pay lower taxes and increase profits. But this strategy is commonly believed to have negative effects on the economic productivity of the home country (where the company is based) and the host country (the foreign country the company invests in).

Now, a new study published in the Global Strategy Journal suggests that foreign direct investments across multiple countries does not always have to be a bad thing; the effects are more nuanced than we think.

“The previous research on this strategic issue is a bit contradictory. It requires a more objective assessment to understand the effects of this strategy on the productivity of the host countries,” explains Soni Jha, one of the study’s authors and a doctoral candidate from the department of strategic management at Temple University.

“We reasoned that these effects may depend on the position of the multinational company’s home country in the global foreign direct investment network. At the same time, countries that are connected to more tax havens in the network may benefit from more inflowing foreign direct investment.”

Jha, along with corresponding author Snehal Awate of the Indian Institute of Technology Bombay, evaluated these ideas by analyzing data from 212 countries for the years between 2002 and 2012. Then they constructed a global foreign direct investment network and evaluated the economic productivity of both home and host countries using a concept called “total factor productivity” (essentially, how much output can be produced from a fixed amount of input).

At the primary level, the analysis revealed that routing foreign direct investments through multiple tax havens has different effects on the productivity of the home and host country. Dispersing foreign direct investments across a wider number of tax havens reduced the productivity of the home country. But at the same time, host countries benefitted from a greater number of foreign direct investments coming through the global network and had increased productivity.

“Visualizing the global foreign direct investment as a network allowed us to understand how it affects different countries and stakeholders,” explains Awate. “For example, the analyses also revealed that investments flowing to and from prominent and central tax havens are beneficial for the productivity of both, the host and home countries.”

To gain further insights, the authors classified these results based on the income level and developmental status of the countries in the network. They found that the benefits of incoming foreign direct investments from prominent, well-connected tax havens were mainly felt by less developed and low-income countries.

These findings fill in critical gaps in the understanding of tax havens and foreign direct investment. They highlight that being connected to a global tax haven network has benefits for less developed countries, and that the use of tax havens by multinational companies is not necessarily negative. These are particularly important to policymakers and researchers who are having conversations about a global tax framework.