Taxes and the location of production: evidence from a panel of US multinationals

Abstract

This paper investigates a set of strategic decisions facing US firms. We develop a simple theoretical framework in which firms choose whether or not to serve a foreign market, and if so whether by exporting, or by becoming a multinational. The model is applied to a sample of US firms choosing whether and how to supply the European market. We take Europe to be a single market and allow the firms to choose to produce in one of the UK, France and Germany. In the empirical application we find that the average effective tax rate plays an important role in the choice of location. Our central estimate is that, conditional on the firm having decided to locate production in Europe, a one percentage point increase in the average effective tax rate in the UK would lead to a one percentage point reduction in the probability of locating in the UK. The equivalent figure for Germany is around three-quarters of a percentage point, and for France around one-third of a percentage point. This suggests that tax is a quantitatively significant factor in location decisions. However, in general, the evidence suggests that taxation is not a significant factor in the decision of whether to locate in Europe - either as opposed to exporting to Europe or not serving the European market at all. Other factors predicted by the theory also play a significant role. Most striking are the agglomeration benefits of being located close to other firms within the industry which undertake R&D. These agglomeration benefits affect both the decision as to whether to locate abroad and, conditional on that decision, where to locate. Also, firms with high plant level fixed costs are less likely to produce abroad.