The effect of corporate income tax rate on foreign direct investment in small island developing states

The effect of Corporate Income Tax rates on Foreign Direct Investment in Small Island Developing States (SIDS) Ciasmy Amaral Vera Cruz Mandinga Master Thesis in Finance and Taxation Supervisors: Professor Doutor Francisco Vitorino Martins Professor Doutor Elísio Brandão July 2015 THANKS “I have fought the good fight, I have finished my course, I have kept the faith. (2 Timothy 4:7) – but I was not alone. First and foremost, I thank God for giving me strength and health to keep going until the end. I would like to thank my teachers and advisors, Professor Francisco Vitorino Martins and Professor Elísio Brandão, who supported me throughout all of this project’s phases. My thanks go to the ANGLE Project through the ERASMUS MUNDUS as well, who believed in my potential and gave me this opportunity through a scholarship. I cannot forget Doctor Acácio Elba Bonfím, administrator of the International Bank of Sao Tome and Principe, who helped me set a theme for my thesis. Finally, I thank my wife and my son, who were so far from me during these two years, and my father, my brothers and my colleagues who have always encouraged me. ABSTRACT This study mainly examines the effect of the corporate income tax rate on foreign direct investment (FDI) for Small Island Developing States (SIDS). We aim to verify if the effective corporate tax rate on company profits, the Gross Domestic Product per capita (GDPpc), the market size and growth, the degree of openness, the availability of natural resources, the growth of the financial sector and the macroeconomic and political stability influence the behavior of FDI in 22 SIDS countries studied from 2004 to 2013. Empirical evidence based on data collected from World Bank, UNCTAD and Annual Reports of PWC is presented. The results of the partial adjustment model with panel data show that FDI is negatively related to both the corporate income tax rate, evidencing the initial role of fiscal policy in the attraction of FDI, and the growth of the financial sector, showing the inefficiency of the domestic finance sector in supplying capital needed by FDI. Furthermore, FDI is positively related to GDP per capita, market size and growth, degree of openness and macroeconomic stability. Key words: foreign direct investment, corporate income tax rate, degree of openness, market size, financial activity, SIDS - Small Island Developing States, panel data, partial adjustment econometric model. Acronyms AFDB African Developed Bank AGOA Africa Growth and Opportunities Act DB Doing Bussiness EBA Everything But Arms EU European Union FDI Foreign Direct Investment GDP Gross Domestic Product GDPpc Gross Domestic Product per capita IMF International Monetary Found MNE Multinational Enterprise or Corporation OECD Organization for Economic Co-operation and Development OLI Ownership, Location and Internalization PAD Public Aid for Development PWC PriceWaterCooper SIDS Small Island Developing States TIC Technology of Information and Communication UNCTAD United Nations Conference on Trade and Development USA United States of America USD United States Dollars WB World Bank INDEX Table Index Figure Index Chapter I - Introduction 1 Chapter II - Literature Review 4 Chapter III - Theoretical framework and research hypothesis 13 3.1 Foreign Direct Investment, characterization and advantages 13 3.2 Determinants of Foreign Direct Investment 16 3.3 Research Hypothesis 27 Chapter IVMethodology 29 4.1 Variables 29 4.2 Data and Sample 31 4.3 Explanatory Model of FDI with partial adjustment 34 Chapter VCharacterization of Small Island Developing 38 States (SIDS) Chapter VIResults and discussion 47 Chapter VII – Conclusion 55 Bibliographic References 58 Appendixes 63 Table Index Table 1. Summary of Literature Review, studies on Taxation and FDI 12 Table 2. Independent Variables (description and references) 30 Table 3. SIDS in study 33 Table 4. FDI flows by region, 2011-2013 (billions of dollars and per cent) 40 Table 5. SIDS: Announced Greenfield FDI projects by sector 43 in total and in top 10 destination countries, 2003-2013 (total capital expenditures in millions of dollars) Table 6. Descriptive statistics 48 Table 7. FDI adjustment partial model with panel data 52 Table 8.Validation of the research hypothesis 53 Table 9: Cross-section fixed effects by country 54 Table 10: Descriptive statistics of FDI net inflow in proportion to GDP 66 in SIDS-22 by year Table 11: Descriptive statistics of CTRProportion of corporate income 66 tax revenue in GDP by year Table 12: Descriptive statistics of GDP per capita (US dollars) in 67 SIDS-22 by year Table 13: Descriptive statistics of MSIZE: Gross Domestic Product 67 growth rate in SIDS-22 by year Table 14: Descriptive statistics of DO – Degree of Openness: import and 68 export of goods and services in proportion of GDP in SIDS-22 by year Table 15: Descriptive statistics of EXCRATEofficial effective exchange 68 rate in SIDS -22 by year Table 16: Descriptive statistics of FINANCEpercentage of credit contracted 69 to the private sector by domestic banking to GDP in SIDS-22 by year Table 17: Descriptive statistics of POLIT STABILpolitical stability and 69 absence of violence/terrorism in SIDS-22 by year Figure Index Figure 1. Importance of investment incentives in a country's 19 overall strategy to attract and benefit from FDI (per cent) Figure 2. FDI flows into SIDS by sub-region, 2001-2013 (millions of dollars) 42 Figure 3. Nominal tax rate on society’s income, SIDS-22, 2007-2012 45 Figure 4. Revenue from the tax on corporate income, SIDS-13, 2007-2012 46 Figure 5. Average Corporate Income Tax Rate in SIDS-22, 2007-2013 70 Figure 6-.FDI inflow for Small Island Developing States, 2004-2013 70 (billions of US dollars). Figure 7. Weight of FDI in SIDS and developed economies in the total FDI 71 inflow in world, 2004-2013. FEP – Master thesis in Finance and Taxation 1 CHAPTER I: INTRODUCTION The researchers’ concern about the effect that the tax rate has on Foreign Direct Investment is not recent. The problem in study has been investigated since the 1980s, when there was a boom of foreign direct investment (FDI) in the United States. One of the first authors that accurately initiated studies on tax rates and foreign direct investment was Hartman (1984), who concluded that the tax rates’ elasticity concerning the retained earnings is significant, while for the funds transferred it is meaningless. Hines (1993), through a panel data analysis, determined that high tax rates have a significantly negative effect on FDI in the USA; 1% increase on tax rate reduces FDI on average 79%. This study’s aim is to analyze the effect of corporate income taxes rate in attracting Foreign Direct Investment in Small Island Developing States (SIDS) and answer some questions: Will the tax on the income of companies be a relevant factor in attracting FDI in Small Island Developing States (SIDS)? Are there any other factors that determine the inflows of FDI in SIDS? The FDI provides for the host country numerous advantages; in particular, promoting innovation, new technologies, new management techniques, improving performance and competence, capital increases, creation of employment opportunities, the work conditions of employees and developing infrastructures in the host country (Wadhwa and Reddy S. 2011 and OECD 2007. 17). The nominal corporate income tax rate in Small Island Developing States (SIDS) fell on average approximately six percentage points over the last 10 years (2004-2013), from 28% to 22 %. The question is if this economic stimulus is enough to potentiate the growth of FDI or if other factors also contribute to the final result. The model of analysis to be FEP – Master thesis in Finance and Taxation 2 used must additionally take the countries’ specificities and yearly fluctuations into account. Foreign Direct Investment has assumed the role of the engine of economic growth in many economies, especially in developing economies. 1 Taxes are a crucial factor when deciding to invest. However, the inflow of FDI is attracted not only by tax factors but also by a number of other factors such as macroeconomic stability, legal and regulatory framework to support well-structured, skilled labor and a flexible labor market, the available natural resources, financing, degree of openness, the growth of the market size, purchase power of local markets; institutional factors, commerce and location. The inflow of Foreign Direct Investment brings to SIDS several benefits, in particular on the level of technological development, infrastructure, economic growth, human resources, and economic and social well-being 2 In 2013, FDI in SIDS was quite high (72%) when compared to world FDI (30%) – using FDI in proportion to the economy’s size. This is due to tax advantages and the attractiveness of natural resources existing in some of SIDS countries (UNCTAD 2014). 1 "Developing market economies maintain their lead in 2013. FDI flows to developed countries increased by 9 percent to $566 Billion, leaving them at 39 per cent of global flows, while those to developing market economies reached a new high of $778 Billion, or 54 per cent of the total. The balance of $108 Billion went to transition market economies. Developing and transition market economies now constitute half of the top 20 ranked by FDI inflows".(World Investment Report 2014). 2 "These constraints are reduced when low competitive pressure result in relatively high market shares for market-seeking FDI, mitigating the impact of the small size of the market and making add SIDS - in particular those with relatively high purchasing power - attractive niche destinations is specific services such the retailing, telecommunications, and energy. In the case of efficiency-seeking FDI, the development of information and communication technologies (ICT) has opened up opportunities in new areas that are not sensitive to transport costs, including call centers, data entry, and back offices (such the purchases, logistics, accounting, claims and payment processing), provided the skilled labor force and access to telecommunication and information networks are available" . (UNCTAD 2014) FEP – Master thesis in Finance and Taxation 9 reallocation of taxable income. High rates of indirect taxes reduce FDI only through the imposition of additional costs, but the magnitude of its impact is comparable to that of the income tax, which reflects, in part, the lack of credibility of indirect taxes’ payments, Desai, Foley and Hines (2004). Theoretical determinants of FDI and the external activity of multinational companies (MNEs). The argument about the way in which the Multinational Enterprises (MNEs) develop their activity, advantageous through the foreign direct investment, has been developed by John H. Dunnig at the beginning of the 1970s, Pinto et al. (2010 ) and OECD (2007 no. 17). Eclectic paradigm "OLI" encompasses the three specific criteria that the MNEs should have to invest in another country and obtain a competitive advantage over domestic firms located in this country, which are owned or held by ( 6 Ownership), Location and Internalization, Dunning (2000). The advantages of Ownership consist of the MNEs assets or resources (trademarks, patents, know-how, production processes and management capacity) which allow the corporations to have added value and gain advantages in terms of profitability in foreign markets: "Those relating to the possession of the bundle of scarce, unique and sustainable resources and capacities, which essentially reflect the higher technical efficiency of the particular firm relative to those of its competitors. These advantages are presumed to stem from, or create, add kind of barrier to entry to factor, or intermediary, product market by firm not possessing them. "Dunning (2000). The second advantage (Location) reflects the way in which the spatial dimension of FDI may affect the competitiveness of the entities investor. The hypothesis of this advantage is related to the specific variables of the country that may have an impact on MNEs Dunning (1999). Foreign direct investment must confer location advantages, referring to the location of the foreign countries where the MNEs will operate taking into consideration the factors specific to this location (low cost of transactions, energy and labor costs, low tax burden, market size, the industrial policies of the government, level of knowledge, accessibility, geographical distance) and the factors that are related to its 6 Ownership, Location and Internalization, Dunning (1999), Dunning (2000) FEP – Master thesis in Finance and Taxation 10 powers (capacity of the company to exploit its resources and assets) to get a comparative advantage, and make on-site production more profitable. According to the author of this paradigm, Dunning (1999, 2000), the MNEs should also pay attention to traditional factors of location (cost of transport, levels of demand, cost of installation, and other related factors) and also consider transaction costs related to the distance, the economies of agglomerations, the dynamic externality, the accumulation of knowledge and interactive learning, mergers and acquisitions, innovation and technological standards of border space that are related to the investment’s country of destination. The advantage of Internalization indicates options for MNEs to internalize or outsource their operations. The operations of FDI are more profitable to the extent that the MNEs derive income from owned properties and they begin to develop a business activity internally, instead of licensing the right to do it to a technical service or through the franchise of a foreign firm. The company will have a greater tendency to internalize their operations through the FDI; when exploiting the advantages of ownership this is an important factor in a given foreign country; Pinto et al. (2010), and it will invest in itself to foreign production, (Dunning 2000). When MNEs have these three advantages (Ownership, Location and Internalization) in common, it allows them to carry out foreign direct investment. Dunning wants to explain that this advantage jointly plays a role on four categories that FDI could be related to; market seeking, resource seeking, efficiency seeking and strategic asset seeking. Wadhwa & Reddy (2011) find that all of these categories of FDI attraction have a significant impact on FDI inflows. The advantages OLI reflect the characteristics and policies of a country or region’s economy and the companies that invest in them, as well as the characteristics of the country or region in which these companies are looking to invest in, the industry and the nature of the activity of the added value in which the company is involved, and the FEP – Master thesis in Finance and Taxation 11 individual characteristics of investing companies, including their goals and strategies to pursue them Dunning (2000). FEP – Master thesis in Finance and Taxation 12 Table 1. Summary of Literature Review, studies on Taxation and FDI Author Countries Studied and Time Period Empirical Evidence. James R. Hines (1993) United States 350 Observations(7 countries, 50 States),1987 Tax Rates has adverse and significant effects on FDI Desai, Foley and Hines (2004) United States 1982,1989,1994 Direct and Indirect Tax rates have adverse effects on FDI Mooij and Ederveen (2003) 25 Empirical studies, 1984-2001 Tax Rates have adverse and significant effects on FDI Djankov et al. (2010) 85 Countries, 2004 The evidence of relation between Statutory tax rate and FDI; large impact of that rate on investment Manuel Pereira, (2011) EU-15 (15 cross-sections), 1997-2007 Corporate income tax rate has adverse and significant effects on FDI, both short and long period Babatunde and Shakirat adepeju (2012) Nigeria, 1990 – 2010 Tax incentives positively affect FDI and have a significant effect. Statutory Corporate Tax Rate has a negative effect on FDI Haberty and Wójcik (2014) 38 Countries, 2004 No evidence of relation between tax rates and FDI Antonio Simoes at al (2014) 35 Empirical studies, 1997-2013 Most studies confirm that tax policies negatively affect the decision of the IDE Tidiane Kinda (2014) 30 Sub-Saharan African (SSA) Countries ,2000-2006 Taxation does not significantly affect foreign firms' locations (FDI). In the next step we will describe the main determinants of FDI and the research hypothesis proposed for this study. FEP – Master thesis in Finance and Taxation 13 CHAPTER III: THEORETICAL FRAMEWORK AND RESEARCH HYPOTHESIS In this chapter, we will discuss the characteristics and advantages of foreign direct investment in the host country: its main determinants that are the theoretical basis of this study and the hypothesis of research, always focusing on small island developing states. 3.1 Foreign Direct Investment, characterization and advantages Foreign direct investment has increasingly taken as the engine of economic growth in many economies, especially in the emerging and developing countries, and the guarantee of stability in developed countries. In terms of attracting foreign direct investment innovation benefits are enormous, as are new technologies, new management techniques, improving the performance and competence, increasing capital, creating employment opportunities, improving employees’ working conditions and developing infrastructures in the host country, increasing purchasing power, increasing tax revenue and reducing the deficit of the balance of payments, and improving economic and social well-being (Wadhwa and Reddy S., 2011 and OECD, 2007 n. 17). Summary of some advantages of FDI: ▪ Innovation - provides a number of benefits from gains from the more efficient use of the available resources, the effectiveness of the implementation of its tasks, improving the conditions of international competitiveness and internal improvements. ▪ New Technologies and new management techniques – allows the country to better use instruments of competitiveness by means of technical and human resources and to develop new techniques of information processing and management organization where decision-making is more efficient. FEP – Master thesis in Finance and Taxation 14 ▪ Capital Increase - involves entry of funds in the country welcoming foreign direct investment that will allow the increase of internal assets. ▪ Creation of employment opportunities - new investment projects tend to create more employment, which consequently will provide a set of improvements to conditions of the population, since the increase in purchasing power, higher level of satisfaction, the well-being of employees and for the state improvements at the level of tax revenues and the level of macroeconomic performance. Foreign direct investment has advantages over other types of capital flows, and it can be seen in three aspects (Albulescu et al., 2010): 1. Increases the general soundness of the financial system of the host country. 2. Reduces the sensitivity to host cycles of credit in the country. 7 3. Is a factor of stability during a period of crisis Foreign Direct Investment is defined as an action in which the foreign investor (individual or a business entity) applies all or part of their capital in an economy in which the resident company is different from that of the direct investor abroad, through a single transaction or several subsequent transactions between foreign subsidiaries, both embedded and nonembedded, in that this will exert a significant influence over the management of a long period in enterprise resident in another economy. According to UNCTAD (2007), foreign direct investment (FDI) is defined as an investment that involves a long-term relationship and that reflects a lasting interest and control by a resident entity in one economy (foreign investor direct or parent company) in an enterprise resident in an economy other than that of the foreign direct investor (FDI of the subsidiary company or of foreign subsidiary). 7 "The ability to manage credit risk, together with stronger capitalization, access to market or parent funding and diversification of the parent's risks, Trends to make foreign banks less sensitive to both home and host country business cycles" (Abulescu, Claudiu et Al. 2010). FEP – Master thesis in Finance and Taxation 15 The OECD definition of FDI is more careful, describing minimal participation levels of the foreign firm in the branch, this participation being 10% of the ordinary shares or voting power in the company. On the other hand, even such a participation is less than 10 %, as long as it has significant influence (active voice in management), able to influence the management of a company. 8 We can see that there are three components of classification by UNCTAD (2007), which are: the social capital, reinvested earnings and intra-company loans. ● The social capital 9 represents the capital that the foreign direct investor uses to purchase shares of a company in a country that is not their own. ● The reinvested profits are the parties’ remuneration of the invested capital (by percentage of participation) in the company that are not assigned to investors in forms of dividends by subsidiaries and that are reinvested in the company. ● Intra-Company loans or loan operations for intra-company, referring to loans of short and long term performed between parent Company (direct investor) and the subsidiary undertaking. 8 According the OECD, the direct investment enterprise is an incorporated or unincorporated enterprise in which a single foreign investor either owns 10 per cent or more of the ordinary shares or voting power of an enterprise (fairly slight it can be proven that the 10 per cent ownership does not allow the investor an effective voice in the management) or owns less than 10 per cent of the ordinary shares or voting power of an enterprise, yet still maintains an effective voice in management. An effective voice in management only implies that direct investors are able to influence the management of an enterprise and does not imply that they have absolute control. The most important characteristic of FDI, which distinguishes it from foreign portfolio investment, is that it is undertaken with the intention of exercising control over an enterprise. (Source UNCTAD 2007 pp. 245-250) 9 It is the part of the net worth of a company or entity from investment in the form of Shares (if corporation) or quotas (if it is a limited company) performed in the company by the owners or shareholders, which covers not only the parties invested by the shareholders, but also the profits obtained by the company and that, by decision of the shareholders or owners, are incorporated in the capital. FEP – Master thesis in Finance and Taxation 16 3.2 Determinants of Foreign Direct Investment in SIDS Foreign Direct Investment is not verified by using a single, independent factor, but by using multiple factors. The conclusions of recent researchers about the main determinants of foreign direct investment, Akimbobola & Saibu (2014) and UNCTAD (2014) reflected on a group of those determinants. Tax In countries where FDI represents a significant fraction of Gross Domestic Product and where the survival of the economy depends on this percentage, the growth in tax revenue by taxation of FDI represents a very significant fraction in total tax revenue, Anwar Shar & Joel B. Slemrod (1991). There is a considerable difference in tax rates between the Small Island States of Asia, Africa and the Caribbean. Borg (2006) concluded that these countries depend once more on revenue from taxes on international trade. FDI can increase the tax revenue of a country; however, the concern resides in tax policies in attracting foreign investors. The sensitivity of FDI to tax varies depending on the conditions of the country, the tax policies of the companies and the period of time in analysis. As Mooij & Ederveen (2003) state, it depends mainly on the conditions of the host country, the investment policies established there, types of industry, and commercial activity covered. One of the comments found in the study of the "Pwc, Paying Taxes 2014" 10 is that in recent times, while some countries drop their corporate income tax rate to improve its investment climate, others increase these rates to bring the deficits in public finances. This happens especially between large and small countries. Countries a large market tend to increase their tax rates while the small size of market is related to dropping tax rates to 10 "An interpretation of these trends is that the global financial downturn has had a significant impact on tax systems around the world. The policies, which governments are choosing to implement to address the issues, have become much more diverse. Add market economies are choosing to continue to reduce their rates to contribute to an economic environment which attracts investment and encourages growth, while others have started to reverse this to address the need for additional revenue streams to help fund public sector projects or to reduce public sector deficits" PWC Paying Taxes 2014. FEP – Master thesis in Finance and Taxation 17 attract more investment, validating the conclusion drawn by previous investigations, Hines (2005) and Andreas, Haufler (2006). A survey to taxpayers carried out a study on payment of tax: 82% of the taxpayers were of the opinion that one of the main goals of the current government’s policy is to increase the tax revenue, but 60% think that governments also have responsibility over the use of the tax system to encourage investment. 11 Therefore, for the member states to encourage foreign investors and successfully attract the FDI, it is necessary to adopt policies that neutralize the tax distortions. Some of these policies are replaced by tax Conventions to avoid International Double Taxation of profits of persons (individual or collective) that is accomplished through a constant exchange of information available in tax administrations of partner countries in bilateral tax treaties. In addition to eliminating the barriers to FDI, this facilitates international trade and investment, strengthens bilateral relations, provides security and protects the countries by preventing tax evasion. The tax credit scheme and the system of exemption are normally two mechanisms that countries choose to eliminate the double taxation of income earned abroad by domestic residents. The system of the tax credit depends on the tax rules of the country of origin. The income taxed in the country of origin is deferred in excess of tax paid in this country, i.e., the value to be deducted may not exceed the tax paid abroad (in a country where there is a convention to eliminate the double taxation). According to Slemrod (1990 pp. 79 - 122), to avoid double taxation, the countries allow their residents (individuals and legal entities) to credit paid taxes for foreigners against the tax due on income from abroad. The exemption system is based on withholding tax on income (interest, dividends, royalty); thus the income subject to withholding tax in the country of origin shall be exempted from taxation when they are transferred to parent company. Slemrod (1990) says that when the capital’s exporting country has a system of tax exemption, the 11 PAYING TAXES 2015 (PWC). FEP – Master thesis in Finance and Taxation 18 FDI’s level of taxation is equal to the tax rate charged by the host country of investment and when the capital’s exporting country has a tax credit scheme the purpose of taxation of profits is verified through the tax system of the country of origin. Pereira (2011) argues that the tax burden effectively supported by a multinational company is not supported only in the country of origin of taxable income, but also in the country where the parent company is located; and that the effect of tax rates on FDI should be examined in each pair of countries (effective bilateral tax rate). When the effect of the tax burden on investment is analyzed in a looming unilateral (in the country of destination of the investment), any increase in the tax rate in the country of destination will act as a discouragement to investment. But, if seen in a looming of effective bilateral tax rate, this increase may serve as an incentive to investment as it will create a negative impact on the competitiveness of domestic firms, in comparison to multinational enterprises (Pereira 2011). The most important role of any tax system is to increase the tax revenue and allocate it as most equitably as possible according to the needs of the state. The tax incentives are the most frequently used instruments by the majority of tax systems to attract more investment; thus allowing these investments to provide for the State. Reduction of “corporate tax rate” and the “tax exemption” are the main tax incentives completed in studies of the effects of tax incentives on FDI. As concluded on several studies in tax and FDI, Jankov et al. (2010), Dermirhan & Masca (2008), Pereira (2011) and Haberly & Wójcik (2014), corporate income tax rate has an adverse impact in FDI (this approach will be the base for the development of the hypothesis research (H1) in the methodology chapter, assuming that the tax rate has an adverse effect on FDI). The tax incentives are considered increments for incentives for FDI. But, according to UNCTAD (2000) investors select the country destination of FDI first by its fundamental determinants (market size, access to raw materials, skilled labor,…) and only then do they pay attention to tax incentives (reduction of the profit tax, tax exemptions, tax rules that allow the accelerated depreciation, transport losses, policies of reinvestment of profits) to the FDI. Investment expenditure reacts positively to tax incentives since it increases the FEP – Master thesis in Finance and Taxation 25 private sector by domestic banking to GDP as a measure of the size of the financial sector. They concluded that there is a significant and positive relation. But a recent study (Kinda, 2014) found adverse conclusions. According to this study, FDI reacts negatively to the growth of the financial sector. It argues that companies with high percentage of foreign capital (more than 50% of participation) are not pinning all their confidence in local financial systems for their financing needs as other companies do (national companies whose participation is less than 50% ). In terms of access to finance, they have better conditions in external financing, in most cases being financed by the parent companies. However, they are less attracted by the growth of the domestic financial sector because of access limitations to financing in the host country, when deciding where to locate their investments. Those who benefit the most from the growth of the internal financial sector are domestic and foreign that are associated with local partners and whose participation is less than 50% of capital. This argument is supported in the development of the hypothesis research (H6) in the methodology chapter. SIDS’s financial sector is considered to be small and limited due to lack of resources and financial infrastructures (payment systems, regulations and supervision). The access to credit is very weak in a group of countries where the level of the informal sector and the costs of information are high. 14 The lack of information about access to credit has been a hindrance in SIDS and is associated with high costs of processing such as the sharing of information between financial institutions about potential borrowers or even in case of failures. Creditors had the ability to recover assets that served as guarantees (UNCTAD 2009). 14 80% of economic activity is centered on the informal sector (UNCTAD 2009) FEP – Master thesis in Finance and Taxation 26 Macroeconomic and Political Stability Srinivasan (2002) says that foreign investors prefer locating their subsidiaries in a country where the uncertainties of the market are low. When macroeconomic policies are not sustainable – the variation of the exchange rate is high, the inflation varies and presents two digits or when the countries have high budget deficits – the investment climate becomes very unattractive (Moreira 2009), making these countries weaker in competitive terms when compared to those that are more stable. Stability creates favorable expectations for the investors regarding the business environment in a given market. However, there are uncontrollable factors in SIDS that destabilize their economy – vulnerability to external shocks, natural disasters, being price holders in international markets (an increase in the price of a given imported product does denigrate your local currency, the rate of exchange and therefore the balance of payments, having an impact on inflation). Babatunde and Shakirat Adepeju (2012) and Júlio et al. (2013) concluded that the macroeconomic stability has an effect in attracting FDI, but the definition of the variables that qualify macroeconomic stability is not the same for all authors. Djankov et al. (2010), Babatunde and Adepeju (2012) used the inflation and the exchange rates as a measure of macroeconomic stability and concluded that the first has a negative relation with the inflow of FDI. Regarding exchange rate, they did not find any significant relationship with FDI. Following Deborah L. Swenson (1993), the exchange rate influences the inflow of foreign direct investment. Studies on the effects of taxation in foreign direct investment in the US concluded that the depreciation of the domestic currency increases the incentive for foreign direct investment, because it makes the price of local assets and the cost of the currency lower. We support this argument in the development of the hypothesis research (H7) in the methodology chapter. Others emphasize the need for a good legal and bureaucratic environment (Júlio, et al., 2013). The corruption is taken as a negative aspect of business development and attraction of FDI (Julio et al., 2013). A high index of corruption tends move investors abroad (DB 2013), so there is a need for corruption’s control. FEP – Master thesis in Finance and Taxation 27 The control of corruption is taken as an indicator that measures the institutions’ quality and aims to eliminate all forms of activity that benefits themselves (WB world Governance Indicator). The state’s aim in this sense is to identify the elites of particular interest. The higher the level of corruption control in a country, the greater guarantees will foreign investors have regarding the fact that public power offers stability to invest in a particular site. The investors are attentive to all situations of political crisis in a given country (social conflicts, government corruption, wars, violence). When the country is politically stable it is more likely to attract foreign investors. We support this argument in the development of the hypothesis research (H8) in the methodology chapter. 3.3 Research Hypothesis The literature on taxation and FDI suggests that taxation is one of the main determinants of FDI for many countries (developed, developing and transition), but especially in the smaller sized countries, as demonstrated in studies of UNCTAD (2014). However, the tax rate’s effect on the FDI is not verified in an independent manner, but in conjunction with other risk factors. We have developed the following research hypothesis: ● H1:"In Small Island Developing States (SIDS), the corporate income tax rate has an inverse relationship in attracting FDI – Foreign Direct Investment". ● H2: "In Small Island Developing States (SIDS), the purchasing power has a direct relationship in attracting FDI – Foreign Direct Investment". ● H3: "In Small Island Developing States (SIDS), the market size has a direct relationship in attracting FDI – Foreign Direct Investment". FEP – Master thesis in Finance and Taxation 28 ● H4: “In Small Island Developing States (SIDS), the degree of market openness has a direct relationship in attracting FDI – Foreign Direct Investment". ● H5: "In Small Island Developing States (SIDS), the availability of natural resources has a direct relationship in attracting FDI – Foreign Direct Investment" ● H6: "In Small Island Developing States (SIDS), access to finance has an inverse relationship in attracting FDI – Foreign Direct Investment". ● H7: "In Small Island Developing States (SIDS), macroeconomic stability has a direct relationship in attracting FDI – Foreign Direct Investment". ● H8: "In Small Island Developing States (SIDS), political stability has a direct relationship in attracting FDI – Foreign Direct Investment". The formulation of these hypothesis are based on previous studies’ findings on the determinants of FDI and mainly on identifying the characteristics of countries that are part of the group of SIDS. After this brief contextualization of traditional determinants that affect foreign direct investment, we will, in the next chapter, describe the justification of the methodology chosen for this study. FEP – Master thesis in Finance and Taxation 29 CHAPTER IV: METHODOLOGY This study’s main goal is to contribute to the literature on taxation and the FDI using appropriate methodologies to capture the impact of corporate income tax rates on foreign direct investment in Small Island Developing States (SIDS). In this chapter, we will describe and develop the conceptual framework of our empirical analysis, as we are looking for evidence of distortions in taxation, which may impact on inflows of FDI in SIDS. According to Becker et al. (2006) the taxation may affect FDI in two ways – it can reduce the average income of an investment project, influencing the decisions of internationalization and localization of companies; and it can change the cost of the companies’ capital, influencing the investment decision. Our set of panel data does not capture the decision of internationalization and localization, but it does capture the inflows of FDI and its variation over time. 4.1. Variables Dependent Variable. The dependent variable in this research is the Foreign Direct Investment (FDI), which is defined in the majority of studies as the quotient between the aggregate inflows of Foreign Direct Investment made by all countries in Small Island Developing States (SIDS) and the Gross Domestic Product of each one of these countries (SIDS). Independent Variables. There are eight variables considered in this study as being influencers of the inflow of foreign direct investment in SIDS. In addition to the corporate income tax rate, we also have GDP per capita, GDP growth rate, degree of openness, FEP – Master thesis in Finance and Taxation 30 availability of natural resources, domestic credit provided by the financial sector (% of GDP), the exchange rate and political stability. The independent variables used to explain the inflows of Foreign Direct Investment (dependent variable) are presented below in Table 2. Table 2. Independent Variables (description and references) Name Measures Reference Corporate income tax rate (CTR) Revenue from the tax on corporate income (national currency) on the Gross Domestic Product (national currency ) Pereira (2011), Babatunde and Shakirat Adepeju (2012) Purchasing Power (GDPpc) Gross domestic product per capita in American dollars. Pereira (2011), Haberly & Wojcik (2014) Market Size (MSIZE) Gross Domestic Product (annual growth rate). Babatunde and Shakirat Adepeju (2012), Demirhan & Masca (2008), Haberly & Wojcik (2014) Natural Resources (NATRESH) Total revenue from natural resources as a percentage of the Gross Domestic Product Babatunde and Shakirat Adepeju (2012) Degree of Openness (DO) Quotient of the sum of imports and exports by Gross Domestic Product Pereira (2011), Babatunde and Shakirat Adepeju (2012) FEP – Master thesis in Finance and Taxation 31 Macroeconomic Stability (EXRATE) "The exchange rate is the price of one currency in terms of another. Official exchange rates and exchange rate arrangements are established by governments. Other exchange rates recognized by governments include market rates, which are determined largely by legal market forces, and for countries with multiple exchange arrangements, main rates, secondary rates, and tertiary rates.” (WB World Development Indicator) WB World Development Indicator Financial Sector Size (FINANCE) Domestic Credit provided by the financial sector as a proportion of GDP WB World Development Indicator Political Stability and Could Go Wrong of Violence/Terrorism: (POLIT. STABIL) Political Stability and Could Go Wrong of Violence/Terrorism captures the likelihood of the government being destabilized or overthrown by unconstitutional or violent means, including politically motivated violence and terrorism. Estimates give the country's score on the aggregate indicator, in units of the standard normal distribution, i.e. ranging from approximately 2.5 to 2.5" Worldwide Goverance Indicator” WB Worldwide Goverance Indicator 4.2 Data and Sample The literature review has allowed us to identify what are the main sources of data and the different methods for the analysis of the study related to the impact of the tax rate on foreign direct investment. The data were collected from the databases of the World Bank, "WORLDDATABANK", the Annual Reports of the "PriceWaterCooper” (PWC) about Paying Taxes (World Bank Group's Doing Business Projects) and UNCTAD from 2004-2013. From these databases we get information on the 22 countries that make up the group of Small Island Developing States (SIDS 22). FEP – Master thesis in Finance and Taxation 32 From “WB World Development Indicator” was extracted data of inflows of foreign direct investment as a share of GDP (FDI/GDP), data on the revenue from the company’s income tax and the gross domestic product (both in local currencies). Then the effective tax rate paid by the companies was calculated by dividing the tax revenue by the GDP (CTR/GDP) and by analyzing the Gross Domestic Product per capita at current prices in dollars (GDPpc), the growth rate of GDP, total revenues from natural resources as a proportion of GDP (Dnatres), domestic credit provided by the financial sector in proportion of GDP, estimated political stability and the effective exchange rate, whose depreciation or appreciation is in terms of USD. In Annual Reports of PWC we manually collected the data of corporate income tax’s nominal rate (Corporate Income Taxes Rate) from 2007 to 2014 due to non-availability of data for other years. UNCTADstat collected data on the imports of goods and services as a proportion of GDP, exports of goods and services as a proportion of GDP and the inflows of FDI in current prices expressed in dollars. The data on the degree of openness (DO) were calculated using the sum of the imports and exports of goods and services as a proportion of GDP. In this study we consider as a set of small island states only 22 out of the 29 States (5 in Africa, 14 in Asia and Oceania and 10 in the Caribbean), having for a reference UNCTAD’s last report (2014). In this study, the small island states that are associated with a large metropolis or island regions that enjoy a high degree of autonomy (table 3.) are excluded. This is because they have a greater opportunity to increase foreign preference, to share and outsource costs, to reduce the effects of natural disasters, to reduce economic vulnerability and to provide better conditions for comparative advantages in their businesses, thus leading to a greater flow of Foreign Direct Investment. 15 15 UNCTAD," FDI in Small Island Developing States: Its Limitation and Potential "Global Investment Trend Monitor Ed.n 17 September 2014 FEP – Master thesis in Finance and Taxation 33 Table 3. SIDS in Study Africa SIDS Cape Verde, São Tomé and Príncipe, Mauritius and Seychelles. Asia and Oceania SIDS Maldives, Timor-Leste, Fiji, Kiribati, Papua New Guinea, Tonga ,Samoa, Salomon Island. Sri. Lanka Caribbean SIDS Antigua and Barbuda, The Bahamas, Dominica, Grenada, Jamaica, Saint Kitts and Nevis, Saint Lucia, Saint Vicent and Grenadines, Trindade and Tobago Source: UNCTAD (2014) The sample consists of 22 SIDS countries in a period from 2004 to 2013 in a total of 220 observations. The choice of countries that are part of the group of Small Island Developing States (SIDS) is a result of the need to study a group of countries with characteristics as identical as possible, which allows us to obtain information from a more homogeneous sample. Panel data. We aim to describe arguments supporting the use of the model with panel data in estimating the equation and the used econometric model. The estimation of the equation explaining the FDI with panel data allows us to analyze the information through two dimensions, spatial and temporal. The spatial dimension component (cross-section) is composed of all the 22 countries of SIDS (Small Island Developing States), and the temporal dimension component (time series) is composed of observations over a period of 10 years from 2004 to 2013. As there are certain variables with missing observations, our panel is unbalanced; however, if there were no missing observations it would be a balanced one. This methodology assists in the identification and use of the econometric model and allows greater control over the effects that may arise in terms of heterogeneity. It also is highly capable in reducing possible multicollinearity effects between the explanatory variables, allowing the econometric estimators to be more effective. FEP – Master thesis in Finance and Taxation 34 One of the biggest advantages of this method is that we can get more understandable results and a more detailed analysis that what we perceive by looking only at a crosssection or time series individually. It also allows us to control the dynamic effects that are not visible in cross-sections (Greene 2012). 4.3 Explanatory Model of FDI with Partial Adjustment One of the ways to reduce both the number lagged terms in models with distributed lags and the problem of multicollinearity is by using a model with partial adjustment (Gujarati and Porter 2010). The temporal lags helps explain some bureaucratic issues for investors to achieve the business, as delays in moments of execution of the work, time for the project's approval, discrepancy in terms of supply of capital goods, time to transfer technologies and hire and train workers (Pereira 2011). One of the characteristics of the model with partial adjustment is that it replaces all lagged values of the explanatory variables for a single value of the lagged dependent variable. The model is called autoregressive because of the dependent variable’s presence among the explanatory variables (with lagged terms). The big advantage of using this model is that it will help us to assess the impact, both in the short and long term, of an explanatory variable on the dependent variable (FDI). More specifically, the model will capture the influence of all explanatory variables in foreign direct investment in the short as well as in the long term. For this reason, the partial adjustment model to estimate is composed by two equations. According to Gujarati and Porter (2010) and Pereira (2011), the first one is: 𝑭𝑫𝑰𝒊𝒕 ∗= 𝜷𝟎+ 𝜷𝟏𝑪𝑻𝑹𝒊𝒕 + 𝜷𝟐𝐥𝐧(𝑮𝑫𝑷𝒑𝒄𝒊𝒕)+ 𝜷𝟑𝑴𝑺𝑰𝒁𝑬𝒊𝒕 + 𝜷𝟒𝑫𝑶𝒊𝒕 + 𝜷𝟓𝑫𝑵𝑨𝑻𝑹𝑬𝑺𝒊𝒕 + 𝜷𝟔𝐥𝐧(𝑭𝑰𝑵𝑨𝑵𝑪𝑬𝒊𝒕)+ 𝜷𝟕𝐥𝐧(𝑬𝑿𝑪𝑹𝑨𝑻𝑬𝒊𝒕)+ 𝜷𝟖𝑷𝑶𝑳𝑰𝑻 𝑺𝑻𝑨𝑩𝑰𝑳𝒊𝒕 + 𝒖𝒊𝒕 𝑖 = (1,2,… 𝑛 ); 𝑡 = (1,2, … 10) (1) FEP – Master thesis in Finance and Taxation 41 trend was more pronounced: in Sub-Saharan Africa, where there was a drop of 41 per cent (499 million dollars), although it is the region where there is a lower number of SIDS. It shows that these countries have a higher rate of vulnerability in terms of fluctuations of FDI. The next sub-region that has experienced significant drops in flow of FDI is formed by the countries of Latin America, where the decline was 14 per cent (4.3 billion). In SIDS in Asia and Oceania the fall was of 3 per cent (853 million). The weaknesses of these countries are recognized by international communities and efforts have been made to correct them, by encouraging external funding through the Official Development Assistance (ODA) and the flows of private capital, as well as other consignments of capital (UNCTAD, 2014). 19 According to UNCTAD (2014), the global economic crisis slowed the growth of FDI to SIDS. It showed an average growth of 6.3 billion USD from 2005 to 2008, which was more than double compared to the period of 2001 to 2004. The growth of FDI came to grow 47% (4.6 billion) from 2009 to 2011, that growth being interrupted in 2013. Figure 2. FDI flows into SIDS by sub region, 2001-2013 (millions of dollars) Source: UNCTAD (2014) The sub-regions that attract FDI are Latin America and the Caribbean – 78% of the flows of FDI to SIDS are concentrated in this region during the period of 2001 to 2013. It is 19 The capital flows as the FDI, portfolios and flows of bank loans. FEP – Master thesis in Finance and Taxation 42 easy to understand that these countries are in a geostrategic position (close to large market of North America), which gives them a comparative advantage towards other sub-regions. SIDS of the sub-region of Africa registered a growth of flows of FDI in 20% (2005-2008) and 29% (2009-2013), the latter being the period of greatest growth in the last 10 years. In the sub-region of Asia and Oceania, Papua New Guinea and East-Timor are the countries that attract most of the FDI inflows, due to its potential in natural resources (extractive industry). The same happens with other countries: Mauritius has great potential for attracting FDI in the services sector (finance, hotels and restaurants, construction and navigation) and Jamaica is the country that most attracts investors in the primary sectors, industries and services (Table 5). According to the UNCTAD, from 2003 to 2013 foreign investors have announced through the ‘greenfield project ' an investment amount that is about 57% of the total FDI 20 made by these investors. Their main destinations were Papua New Guinea, Trinidad and Tobago, Timor and Fiji. Sao Tome and Principe belong to the Top 10 of SIDS that most attracted FDI over the past 11 years (2003-2013) in the Greenfield project, with a cumulative total of 512 million USD. There was predominance for the manufacturing and services sectors, in a country where the tourist potential is recognized. However, the weak infrastructures has attracted little foreign investors. Despite this, it is known that the recently discovered hydrocarbons (forecast to start operating in 2015) in this country can attract large MNEs and boost domestic development. We can conclude that although SIDS present some disadvantages (size, structure, vulnerabilities and poor infrastructures), they are also equipped with resources (natural and human capital) and a vast majority of them is located in a strategic position, good to access large markets, which is an investor’s requirement. 20 UNCTAD (2014), a project in which a foreign investor establishes a new subsidiary in a country through a greenfield investment, which will be through the establishment of a new production unit, acquisition of new fixed assets, goods and services, labor, in the host country. FEP – Master thesis in Finance and Taxation 43 Others have economies based on agriculture, fishing and services or are powerful in tourism, which is also interesting for foreign investment. If the tourist potential is well exploited, not causing environmental damage, it can boost the development of other sectors (agriculture, fisheries and services). Table 5. SIDS: Announced Greenfield FDI projects by sector in total and in top 10 destination countries, 2003-2013 (total capital expenditures in millions of dollars) Source: UNCTAD (2014) The majority of SIDS, like Sao Tome and Principe, remain vulnerable to external shocks with a growth rate of 4% per annum (2013). Efforts have been made by the authorities to ensure fiscal prudence. The economy of Sao Tome and Principe (STP) is dominated by the services sector (54% of GDP), agriculture (20% of GDP) and industry (13% of GDP). In terms of employment, the labor is intensive and almost 70% of the population depends on agriculture. The trade has a weight of 24% of the GDP but could be superior if the FEP – Master thesis in Finance and Taxation 44 government manages to control the high weight of informal trade. The high dependence on external financing for the State budgets (95% in the form of donations and external funding) makes the country more vulnerable. The trade balance is highly deficient (- 35.5% of GDP in 2013), the cocoa being the main export product with 1.6% of GDP. The foreign direct investment has been assumed to be the main factor in the development of STP and the biggest opportunities are in the sector of construction, transport and retail. Portugal and Angola have been the main sources of FDI in sectors of tourism and trade. The global financial crisis and the social unrest in North Africa boycotted several projects of planned investments, meaning that the weak infrastructures (ports, airports and roads) and the sectors of tourism, industry, services, education and health need special attention. Sao Tome and Principe has been promoting the development of a number of institutional and structural reforms to make the business environment more attractive and improve the quality of the institutions, namely from tax and customs reforms, such as changes in tax base and decentralization of tax services. The launch of the software SYDONIA (2013) in the customs department makes it possible to: (i) harmonize policies and procedures; (ii) reduce cost of transport on the import and export of goods; (iii) improve the coordination between ministries; and (iv) provide incentives for exports, IMF (2013). It will also improve the transparency and the modernization of the customs department. The money spent on the State budget will be managed and executed by managing public finances. SAFE was launched in 2013 and allows the creation of a single window that makes it possible for the creation of business to be done in less than 4 days. Anchoring the national currency (STD) to the Euro (from the fixed rate) in 2010 allowed for a greater control of the Central Bank of Sao Tomé and Principe (CBSTP) on the financial soundness of the banking sector. The launch in 2013 of the Central Credit Risk was important as it allows people to regulate and ensure financial stability. STP has access to large markets (EU and USA) – In the EU through the treaty of preferential “Everting BUT Arms (EBA)”; in the USA by the law of growth and opportunity for Africa -AGOA (Africa Growth and opportunities Act). FEP – Master thesis in Finance and Taxation 45 The majority of the countries from the group of SIDS has adopted policies to reduce its nominal corporate income tax rate, as we can see in figure 3. Figure 3. Nominal tax rate on societies’ income, SIDS-22, 2007-2012 Source: PRICEWATERCOOPER (PWC), Paying Taxes Report These policies do not necessarily mean measures to increase tax revenues, since as we can see in figure 4 the weight of tax revenue from the income’s tax in proportion of GDP fell. 0 10 20 30 40 50 60 Antigua and Barbuda Bahamas, The Cabo Verde Dominica Fiji Grenada Jamaica Kiribati Maldives Mauritius Samoa Sao Tome and Principe Seychelles Solomon Islands St. Kitts and Nevis St. Lucia St. Vincent and the… Tonga Trinidad and Tobago Timor-Leste Papua new guinea Sri.Lanka % Commercial Profit 2007 2012 FEP – Master thesis in Finance and Taxation 46 Figure 4. Revenue from the tax on corporate income, SIDS-13, 2007-2012 Source: World Development Indicators and own elaboration With the exception of Seychelles, Santa Lucia and St. Vincent and Grenadines, from 2007 to 2012 the corporate income tax revenue for these countries has decreased. In the next chapter we will discuss the results of the estimated model and see if it is according to our preceding hypothesis research. 0,0000 0,0500 0,1000 0,1500 0,2000 %GDP 2007 2012 FEP – Master thesis in Finance and Taxation 47 CHAPTER VI: RESULTS AND DISCUSSION This research’s results were obtained through the use of panel data, which includes annual time series from 2004 to 2013 and the set of 22 countries that are part of the SIDS group (Small Island Developing States). The procedure was based on a partial adjustment model (equation 4), performed by the Method of Generalized Last Squares. The errors autocorrelation between time periods and heteroscedasticity due to the different countries present in the sample were taken into consideration through the consistent estimation of White (for the variances and covariance of the coefficients’ estimators). Excluding the data with missing observations, the sample set was reduced to 110 observations, composed by 16 cross-sections (countries) with annual data, from 2005 to 2012. Eviews 8.0 software has been used for the model’s estimation (equation 4) and the main results are presented in Table 7. Descriptive statistics of the variables. We begin by analyzing some descriptive statistics, present in Table 6. On average, the proportion of FDI in GDP is 10.31 % for the set of all countries in the sample corresponding to all of the years (2004-2013) in analysis, with maximum values of (43.13 %) and minimum (0.16 %). There are certain differences in the countries under study. We can analyze these behaviors using the coefficient of variation, 0.7156. The average CTR is 5.7 %, i.e. the tax’s rate on the companies’ income is represented by the ratio of the revenue from the income of companies’ tax and the Gross Domestic Product. Its amplitude goes from a maximum of 21% to a minimum of 0,005 %, showing that tax policies adopted by countries (SIDS) are different from each other. FEP – Master thesis in Finance and Taxation 48 Table 6. Descriptive statistics Source: Eviews 21 The explanatory variable GDPpc is the Gross Domestic Product per capita and reflects the purchasing power. This variable has a mean of 7063,998 USD with an amplitude that varies from 21,395 USD maximum to 734.03 USD minimum. The coefficient of variation is (0.61) – table 6. The GDP growth rate (MSIZE) reflects the market size; this variable has a mean of 3.27% with an amplitude that varies from -12% minimum to 19.58% maximum. It is the variable with the third greatest variability in the sample, its coefficient of variation being (1.55). The average value of the Degree of Openness (DO) is 1.03, with a range that varies from 0.49 to 2.23. Its coefficient of variation is 0.3652. The income from natural resources (DNATRES) is a dummy variable that displays an average of 22 %, showing that there are only a few countries in the sample whose revenue from natural resources has some weight in the GDP. 21 Complete result of estimated model in annex FEP – Master thesis in Finance and Taxation 49 The average size of the financial sector (FINANCE) measured by Domestic credit provided by the financial sector (% of GDP) is 0.68 in SIDS, with maximum values of 1.27 and minimum of 0,043; its coefficient of variation being 0.43. Two other explanatory variables that demonstrate the macroeconomic (EXCRATE) and political (POLIT STABIL) stability have average values of 1100,680 and 0.47, respectively. EXCRATE shows maximum values of 19068.40 and minimum of 1.69. The POLIT STABIL presents amplitudes of 1.41 and -1.80; the best and worst levels of stability are between (2.5) to 2.5. Econometric model results. From the estimated econometric model (Table7.), we can clearly conclude that the variables Corporate Tax Rate (CTR), Market Size (MSIZE), Degree of Openness (DO) and Size of the Financial Sector (LogFINANCE) are statistically significant at a 5% level (P-Value), whereas Purchasing Power (LogGDPpc) and the indicator of Macroeconomic Stability (effective exchange rate, (EXRATE)) are statistically significant only at 10%. On the other hand, Political Stability (POLIT STABIL) and Availability of Natural Resources (DNATRES) are not statistically significant, not even at 10%. The explanatory variables used in the model, when considered together, are able to explain 92.44% of the total variation of the foreign direct investment (measured 𝑅`2), showing a good explanatory model of FDI, confirmed by the global significance test (pvalue of the F-statistic that is below the significance level of 0.01). Notes that Corporate Tax Rate (CTR) shows statistically significant effect and negative in Foreign Direct Investment and shows that it is the factor that determines the FDI with major relevance which is consistent with Pereira (2011) and Jdankov at al (2010) , Babatunde & Adepeju(2012) and Haberty & Wójcik(2014). An increase in the rate of corporate income tax by 10 percentage points drops the proportion of Foreign Direct Investment on GDP in 3.5 percentage points to the short FEP – Master thesis in Finance and Taxation 50 term, but in the long term, this effect is 4.7 percentage points. These results indicate that the decisions of tax policies of Small Island Developing States (SIDS) in terms of corporate income tax rate has an impact immediately on weight of direct foreign investment both in the short term and the long term in GDP and this effect grows throughout the year until it reaches the total impact of 4.7 by 10 percentage points of the increase in the tax rate. The purchasing power measure by log (GDPpc) is statistically significant and positive, with direct effect of 0,037. The increase of 1 per cent in per capita GDP increases the weight of FDI on GDP in 0,037 percentage point in short-term and being the effect of long-term of 0,049 . In SIDS where the per capita GDP has greater value and higher growth tends to attract larger inflows of FDI. The market size growth (MSIZE), when increases by 1 percentage point attracts the direct investment abroad and short-term investment that increase the weight on GDP in approximately 0,13 percentage points and in the long term this effect adds to 0,17 . The result is consistent with most studies and especially the recent Murthy & Brasin (2014) and Júlio et al. (2013). Showing that foreign investors are aware of the levels of economic growth of various economies, having this effect an important role when compared to other determinants. The short-term increase in the degree of openness (DO), with 1 percentage point of GDP, increases the proportion of FDI in GDP by 8 percentage points and in the long term this effect increases to 10,7 percentage points. We can consider that the internationalization of the economy has its immediate effect on GDP, and growing over the term and the need of SIDS to develop agreements and measures of expansion and greater openness to the outside world as has been referenced in the majority of studies on tax and FDI, Djankov et al (2010), Albulescu (2010), Murthy & Brasin (2014). The availability of natural resources (DNATRES) is not statistically significant, and neither is the political stability (POLIT STABIL) . The percentage of domestic credit provided by the financial sector’s coefficient’s result in proportion of GDP (FINANCE) is statistically significant and negative. This result FEP – Master thesis in Finance and Taxation 57 sample had to be reduced. 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The end phase of a period of explanatory variable is expressed in right-hand side of the equation and the respective coefficient(1 − 𝛿), which contains the complement to 1 of the adjustment coefficient(𝛿). Due to the existence of the explanatory variable offset in the model as a dependent variable, the model is called autoregressive. Equation (A3) is the same as equation (4) in its theoretical foundation. The short-term effects are directly given by the coefficient β in equation (4). Long-term effects depend on the coefficients β and δ, given by β / (1-δ) in equation (4), 𝜷𝟏 𝟏 − 𝜹 , 𝜷𝟐 𝟏 − 𝜹 ,𝜷𝟑 𝟏 − 𝜹 ,𝜷𝟒 𝟏 − 𝜹 ,𝜷𝟓 𝟏 − 𝜹 ,𝜷𝟔 𝟏 − 𝜹 ,𝜷𝟕 𝟏 − 𝜹 ,𝜷𝟖 𝟏 − 𝜹 FEP – Master thesis in Finance and Taxation 65 Appendix 2 –Regression results Result of the explanatory model of FDI, with panel data estimated by Eviews 8. FEP – Master thesis in Finance and Taxation 66 Appendix 3 – Descriptive statistics: tables and figures Table 10Descriptive statistics of FDI net inflow in proportion of GDP in SIDS-22 by year Table 11Descriptive statistics of CTRProportion of corporate income tax revenue in GDP by year