ERASMUS UNIVERSITY ROTTERDAMERASMUS SCHOOL OF ECONOMICSMSc Economics & BusinessMaster Specialization International Economics

The Effect of EMU Membership on the Role of Corporate Tax Rate

Evidence from OECD countries during 1982-2011

Author: Edwin van BuurenStudent number: 311292ebThesis supervisor: Harro (G.H.) van Heuvelen MSc.Co-reader: Prof.Dr. Jean-Marie (J.M.A.G.) VianeFinish date: June 2014

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Copyright StatementThe author has copyright of this thesis, which represents part of the author’s study programme while at the Erasmus School of Economics (ESE). The views stated therein are those of the author and not necessarily those of the ESE.

Non-plagiarism StatementBy submitting this thesis the author declares to have written this thesis completely by himself/herself, and not to have used sources other than the ones mentioned. All sources used, quotes and citations that were literally taken from publications, or that were in close accordance with the meaning of those publications, are indicated as such.

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Acknowledgements

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Abstract

This thesis examines the role of EMU membership on the role of corporate tax rates, as a

determinant for FDI inflow. Also, the effect of EMU membership on the Laffer curve for

corporate tax is determined. Further, it studies whether during the financial crisis effects

change. Analyzing a dataset of 26 OECD countries between 1982 and 2011, four hypotheses

are tested. The results show that that there is a direct negative effect of EMU membership on

corporate tax rates. EMU membership and low corporate tax rates lead to higher FDI inflows.

No proof was found for the effect of economic integration the parabolic relation between tax

rates and tax revenues. The results show that during the financial crisis existing relations are

disturbed. This thesis concludes that EMU membership does directly and indirectly affect the

role of corporate tax rates.

Keywords: Corporate Tax Rates, EMU, OECD, Economic Integration, FDI

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Table of Contents

1. Introduction............................................................................................................................7

2. Literature Review.................................................................................................................10

2.1 Corporate Tax Rates.......................................................................................................10

2.1.1 Determinants for Corporate Tax Rates...................................................................10

2.1.2 FDI and Corporate Tax Rates.................................................................................12

2.1.3 Other influences of Corporate Tax Rates................................................................15

2.2 Laffer Curve...................................................................................................................16

2.2.1 Definition................................................................................................................16

2.2.2 Laffer Curve for Corporate Tax..............................................................................17

2.3 European Economic Integration.....................................................................................18

2.3.1 European Monetary Union......................................................................................18

2.4 Crisis and Corporate Tax Rates......................................................................................20

2.5 Research Question..........................................................................................................21

3. Data and Methodology.........................................................................................................24

3.1 Sample............................................................................................................................24

3.2 The determinants of Corporate Tax rates.......................................................................26

3.3 FDI inflow......................................................................................................................26

3.4 The Laffer Curve............................................................................................................27

3.5 Crisis vs. non-Crisis.......................................................................................................28

4. Results..................................................................................................................................29

4.1 Determinants of Corporate Tax Rates............................................................................29

4.2 FDI inflow......................................................................................................................32

4.3 Laffer Curve...................................................................................................................34

4.5 Robustness Checks.........................................................................................................38

4.5.1 Exclusion Netherlands and Ireland.........................................................................38

4.5.2 Introduction Country Dummies..............................................................................39

4.5.3 Introduction Year Dummies....................................................................................39

5. Conclusions..........................................................................................................................40

6. Limitations...........................................................................................................................42

Appendix I................................................................................................................................46

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Appendix II..............................................................................................................................47

Appendix III.............................................................................................................................48

Appendix IV.............................................................................................................................49

Appendix V..............................................................................................................................50

Appendix VI.............................................................................................................................52

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1. IntroductionThe financial crisis slows down the growth of the first world economies. There is a tendency

of losing trust. Consumers and companies have less confidence in the domestic economy and

banks are reluctant to lend out money. Governments reacted by adapting their corporate tax

policies to stimulate investments in their domestic economy. For instance, the Dutch

government gives companies the opportunity to stretch retroactively their losses/profits. This

allows companies to decrease their corporate tax payments and stimulates them to invest

more. The thought is that this type of government interventions needs to be immediate in

order to cope with the exceptionally large decrease in private demand and encourage

economic activity. However, there is uncertainty on the effect of certain tax policies

(Spillimbergo et al, 2009). Hemmelgarn and Nicodeme (2010) discuss the interaction

between financial crisis and tax policy. They state that countries have come short in changing

tax systems and fiscal policies should have a more preventive effect instead of a curing.

Previous research on the role of corporate tax rates shows that corporate tax rate is an

instrument to boost economic growth. Low corporate tax rates attract foreign direct

investments (FDI). DeMooij and Ederveen (2005), reviewing several studies, document a

significant negative relation between FDI inflow and corporate tax rates, indicating that low

corporate tax rates attract more FDI. The negative (semi-)elasticity in a globalizing

environment boosts a worldwide trend of decreasing corporate tax rates. Governments

anticipate on each other rates and ‘the race to the bottom’ is started (Swank and Steimo, 2002

& Overesch and Rincke, 2011). Further, corporate tax rates and revenue are linked with the

Laffer curve, explaining corporate tax revenues through corporate tax rates (Clausing, 2007

& Brill and Hassett, 2007). A parabolic relation was found, meaning that, theoretically, there

is a tax revenue-maximizing rate.

At the end of 2009 a new wave of economic downturn hit the Euro Zone, due to the

threat that Greece could not repay its debts. The Euro-crisis caused a lot of tension within the

European Monetary Union (EMU). More member states found themselves in difficult

budgetary problems. This questions whether ongoing economic integration between countries

could still be economically beneficial. More integration does lead to competition over

corporate tax rates between countries (Devereux, Lockwood and Redoano, 2008). This

stimulates the flow of capital between member states. It should help to optimize the

allocation of production resources and therefore increase the efficiency of production.

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However, financial and Euro crisis seem to distort these linkages. Therefore, it would be

interesting to better understand the role corporate tax rate within this ongoing “Euro

Integration”. This thesis tries to provide understanding of the effect economic integration on

the role of corporate tax rate. Further, it tries to investigate how the financial crisis affects this

role.

This thesis expands the current corporate tax literature in two ways. First, in this

thesis a distinction is made between countries that are part of the European Monetary Union

(EMU) and non-members. This could show the effect of further economic integration in

Europe on the role of corporate tax rates. Second, recent data allows for an analysis on the

role corporate tax rates during the financial crisis. This may give insight on the effect of

corporate tax policy during a financial crisis situation. It could provide implications for

governments whether and how EMU membership could affect the role of corporate tax rates.

In this thesis I focus on the effect of EMU-membership as an intense form of

economic integration. Economic integration has proven to be a determinant for the attraction

of FDI and determinant of corporate tax rates. It is verified that there is a parabolic relation

between tax rate and corporate tax revenues (Clausing, 2007 & Brill and Hassett, 2007).

Interesting would be to estimate the effect of EURO-integration concerning this relation.

Further, in this thesis the integration effect of the EMU-membership is questioned during the

financial crisis in OECD countries. The financial crisis directly hits the capital market and

consequentially the corporate activity. Being member of the EMU due to the strong economic

integration could lead to different influence of corporate tax rate. This thesis is centralized

around the question:

How does European monetary integration (EMU) impact the role of corporate tax rates?

Analyzing the effect of corporate tax rate, data on 26 OECD countries between 1982

and 2011 is used, mainly collected from OECD Stats. Ordinary least squares regressions

using STATA are performed used to define the effect of EMU membership. The results

indicate that becoming part of the EMU forces members to lower their corporate tax rates.

Besides, EMU membership leads to an increase of foreign direct investment that flows into

the country. The results do not show an effect of EMU-membership on the parabolic relation

between corporate tax rates and corporate tax revenues. The outcome shows that the crisis

disturbs the significant relations that were found for the period before the crisis.

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The sequence of this thesis will be as follows. Section 2 will review the literature.

Then, section 3 will discuss the data and methodology used in this thesis. Section 4 explains

the results. The thesis is concluded in chapter 5. Chapter 6 provides the main limitation to this

study and proposes thoughts for further research.

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2. Literature ReviewThis section reviews the corporate tax literature. It starts with discussing the determinants

corporate tax rates and the link with FDI. Then, the relation between corporate tax rate and

corporate tax revenue is reviewed. Next, an overview will be given on the economic

integration of the European Monetary Union. Afterwards, the effect of the crisis on the role

of corporate tax rates is examined. This section will be concluded with the formation of the

main research question and the three hypotheses this question is built on.

2.1 Corporate Tax Rates

2.1.1 Determinants for Corporate Tax RatesGovernments control their own corporate tax rates and generally impose these on the net

profits of corporations active in their country (Devereux, Lockwood, and Redoano, 2007).

Although they are free to set those rates, globalization forces them to adapt their corporate tax

rates (Overesch and Rincke, 2011). Previous literature focused on what factors determine the

corporate tax rates (Lee and McKenzie, 1989 & Swank and Steinmo, 2002 & ). Globally a

drop in the corporate tax rates is observed. Overall, globalization and the resulting tax

competition seem to boost a downward trend in corporate tax rates which is confirmed in and

the focus of the more recent literature (Mendoza and Tesar, 2005 & Devereux, Lockwood, &

Redoano, 2007 & Overesch and Rincke, 2011).

The increasing mobility of taxable assets and activities is a strong driver of tax

competition. The growing mobility of capital and corporations forces corporate tax policy

makers to consider the international climate and tax policies. Lee and McKenzie (1989) find

that trade openness and liberalization of the capital market are linked with a decline in tax

rates on capital. Swank and Steinmo (2002) address the question on how governments set

their tax rates in advanced capitalist democracies encountering the globalization. Analyzing

data from 14 developed countries between 1981 and 1995, they find that the increasing

mobility of capital and trade is associated with cuts in corporate tax rates. More specifically,

Mutti (2003) finds that small countries and countries with higher corporate taxes rates are

more likely to reduce their corporate tax rate.

These linkages, address the question whether international corporate tax rate

competition underlies the downward trend. Devereux, Lockwood and Redoano (2008) state

the question whether countries compete over corporate tax rates. Investigating data from 21

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countries between 1982 and 1999, they find evidence that there is such a competition

between open economies. Governments react to changes in other countries’ corporate tax

rates. In line with the decrease of the corporate tax rates, the Nash equilibrium implies that

the tax rates fall substantially over time. In the model of Devereux, Lockwood and Redoano

(2008), the reduction in corporate tax rate can almost entirely be explained by more intense

competition. The interaction between governments concerning corporate tax rates becomes a

prisoner’s dilemma and reducing tax burdens is the most optimal choice (Swank and

Steinmo, 2002). More specifically, the tax competition countries causes the downward trend

in corporate tax rates. Using data of 32 countries from 1983 to 2006, Overesch and Rincke

(2011) analyze the role of tax competition and find that countries fight over tax rates. Since

the mid-1980s, the tax rates on corporate income lowered for European countries. A

hypothetical scenario without tax competition in Europe from 1984 to 2006 reveals that the

mean tax rate in 2006 would be around 40 percent instead of the 27.5 percent it is now

(Overesch and Rincke, 2011).

Figure 1 Nash EquilibriumThis figure1 shows the prisoner dilemma concerning two countries (country 1 and country 2) with equal characteristics. The countries try to attract foreign direct investments and they have corporate tax rate as a tool. They can choose between a high and low rate. When both choose for the same rate this leads to an equal division of the investments. When country 1 chooses for a low rate and country 2 does not, the investment will flow to towards country 1 and vice versa.

1 Figure based on Swank and Steinmo (2002) and Devereux, Lockwood and Redoano (2008)

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Figure 1 shows the payoff matrix of setting corporate tax rates concerning the

attraction of investments. With consultation it would be optimal to both set equal high rates.

Then both countries attract a similar level of investments and receive relatively high amounts

of corporate tax revenues. However, if one country decides to choose to lower its tax rates the

most optimal decision for the other country is to lower their tax rates as well. The Nash

equilibrium as discussed by Swank and Steinmo (2002) is when both countries impose low

taxes on the profits of corporations.

Regarding the fact that the world is globalizing, this could trigger a race to the

bottom. However, analyzing the tax rates within the European Union, Mendoza and Tesar

(2005) find that the tax competition does not lead to a race to the bottom. The integration of

the financial markets in the early 1980s and thereby the increase of tax competition did not

cause a tax rate close to zero. Mendoza and Tesar (2005) modeled the EU countries to a one-

shot game. The outcome of the game shows that when countries compete over taxes, there is

no race to the bottom and the Nash equilibrium is close to the observed taxes.

Important to mention is that due to the possibility of addressing income to different

kind of taxes, the rate of other taxes could be a strong determinant for the corporate tax rates.

Slemrod (2004) links the role of individual income to corporate tax rates. Analyzing the

variation in corporate tax rates among 90 countries, he finds a strong significant relationship

between those two tax rates. An individual income tax without a corporate income tax could

be avoided through keeping the earnings within a corporation and remaining, and supplying it

through corporate-taxed profits to shareholders. Generally, the corporate tax may, in the

search of lower tax rates, be a ‘backstop’ for the individual income tax. It suggests that,

ceteris paribus, corporate tax rate will be higher in countries in which the top individual tax

rate is relatively high. Empirically, Slemrod (2004) finds that the drop in top individual rates

explains a decline in the average corporate tax rate between 1980 and 1995.

2.1.2 FDI and Corporate Tax RatesAs discussed in the previous subsection, countries are keen to encourage investments within

the country. Interesting are the investments that can be attracted from outside the country.

Receiving foreign direct investments (FDI) is a common source for economic progress.

Borensztein, De Gregorio and Lee (1999) report that FDI is an important channel through

which technology is transferred. FDI is, on average, even more valuable for economic growth

than domestic investment. This shows the important role corporate tax rate can play

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concercing economic growth. Part of the literature focuses on whether corporate tax rate is a

good indicator for inward FDI (de Mooij and Ederveen, 2005 & Jensen, 2006 & Bellak and

Leibrecht, 2009) The ‘OLI’ framework presented in Dunning (2000) gives an explanation for

why countries would succeed in attracting FDI. OLI is abbreviation for ownership, location

and internationalization advantages. These three conditions are necessary for the emergence

of the multinational firm. Ownership advantages refer to specific (competitive) advantages of

the firm (e.g. patents). Location advantages represent the benefits of alternative regions

outside the home country of the firm (e.g. low production cost). The existence of

internationalization advantages makes the exploitation most profitable when producing in an

affiliate firm. The investment could bring knowledge to the FDI-receiving country.

Commonly these are called knowledge spillovers. These spillover effects are positively

related to higher productivity, increasing workers skills and higher wages (De Mello, 1997 &

Ruane and Goerg, 1999 & Alfaro, Kalemli-Ozcan and Sayel, 2009 & Borensztein, De

Gregorio and Lee 1999).

Location factors from the OLI-framework are considered in this thesis. The variable

of interest in this thesis is corporate tax rate. Low corporate tax rates could be a location

factor that encourages foreign companies to invest. Bellak (2009) argues that the corporate

tax-rate is not a good indicator for attraction of FDI. However, the more varied mix of

location factors in the competing host countries, the smaller should be the influence of

taxation. De Mooij and Ederveen (2005) propose that the effect of corporate taxes is

challenged by economic geographic effects. The location decisions might not be crucial at all

when taking into account the increasing returns to scale and transport costs.

Figure 2 gives an overview of the relation between corporate tax rate (x-axes) and

inward FDI (y-axes). An increase in corporate tax rates discourages foreign companies to

become active in the country and vice versa. A downward slope is the result of this relation.

The optimal level of FDI inflows is reached when corporate tax rates decrease to zero. The

slope of the graph equals the following elasticity of corporate tax rates:

CorporateTaxElasticity= ∆ FDI∆ CorporateTaxRate (1)

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Figure 2This figure2 shows graphically the relation between corporate tax rate and inward FDI. The small triangle in the middle of the figure shows the elasticity between the corporate tax rates and FDI inflow.

Empirically, the literature shows significant evidence of this influence of corporate

tax rates (Bellak and Leibrecht, 2009 & OECD, 2008 & Jensen, 2006). The elasticity between

FDI and tax rates is estimated in several papers. Bellak and Leibrecht (2009) review eight

papers estimating the corporate tax-rates elasticities with respect to FDI inflow. They found a

median corporate tax-rate elasticity of around -1.45. This implies an inelastic response of FDI

with respect to the corporate tax rates. One percent point decrease in corporate tax rates is

translated in to an 1.45% increase of FDI inflows. Moreover, OECD (2008) claims a negative

elasticity 3.7% of corporate tax relative to FDI. Altogether, the research found a mean of -

3.72% with a standard deviation of 5.9%. This standard deviation suggests that it is possible

that low tax-rates can decrease the amount of inward FDI. Jensen (2006) even finds a weak

but positive relation between FDI and effective capital taxation. It does indicate that the

importance of corporate tax rates as a factor of FDI should not be overemphasized

The inflow of capital leads directly to more investments in the domestic economy,

creating more jobs and economic activity in the FDI-receiving country. Besides these direct

positive effects of FDI inflow, there are spillover effects that are beneficial for economic

growth. The spillover effects consist of more than these short-term effects. Attracting FDI 2 This figure is based on the elasticities found in the meta-analyses of De Mooij and Ederveen (2005)

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also leads to long-term knowledge spillovers (Alfaro, Kalemli-Ozcan and Sayel, 2009 & de

Mello, 1997). For instance, employee training resulting from alternative management

practices and organizational arrangement increase skill development. Therefore, the inward

FDI leads to an increase in the productivity of employees. Neoclassic theory predicts that

these more productive workers earn higher wages. Lipsey (2004) confirms this: he finds that

within the FDI host country the foreign-owned firm almost always pays higher wages than

domestic-owned firms. Hence, the incoming FDI not only boosts GDP by creating more

employment, but also increases the total income.

2.1.3 Other influences on Corporate Tax RatesBesides the attraction of FDI, there are more economic effects regarding corporate tax rates.

Two of these effects will be discussed. First, the phenomenon of transfer pricing is part of the

competition over corporate tax rates. Grubert and Mutti (1991) report that multinational

companies shift their profits from high corporate tax countries to countries with lower

corporate tax rates. This does not necessarily mean that companies invest more in low-

corporate-tax countries. They account more profitable activities in the low-tax countries. This

could lead to higher tax revenues for the low corporate tax countries.

Figure 3This figure3 shows alternative channels through which a decrease in corporate tax rates could affect GDP.

Alternative channels for

3 Source: https://www.gov.uk/government/

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Second, at macro level lowering corporate tax rates leads indirectly through different

channels to an increase of GDP. Figure 3 shows that through economic effects that a

reduction in corporate tax rates could lead to an increase in GDP. Post-tax earnings are higher

because of the lower corporate tax rates. This could be translated in higher wages for

employees or lower prices for customers. Both can lead to higher consumptions and therefore

an increase in GDP. Further, the rate of return will be higher for investors will motivate the

domestic investors to invest more in the domestic economy, which increases the GDP. The

higher wages and increase of investments lead both to higher productivities.

2.2 Laffer Curve

2.2.1 DefinitionSection 2.1 described a downward trend in corporate tax rates. Surprisingly, this trend is not

translated in a loss in corporate tax revenues (Devereux, 1965). Describing the developments

in corporate taxation in OECD countries over 40 years (1965-2004), Devereux (2007) finds

an inconsistency across countries between corporate tax rates and corporate tax revenues. The

average rate has fallen over time. The reverse has happened for the revenues. They on

average increased as a proportion of the GDP. This suggests a non-linear relation between

corporate tax rate and corporate tax revenues.

The Laffer curve shows the basic idea that fluctuations in tax rates have two effects

on tax revenues as introduced by Arthur Laffer (Laffer, 2004). First, an arithmetic effect is

basically that when tax rates increase the tax revenues will increase as well because the tax

revenues increase with the same relative amount as the tax rates. A higher corporate tax rate

with the same amount of corporate activity leads to higher corporate tax revenue (Laffer,

2004). The opposite is true for a decrease in tax rates. Second, an economic effect takes into

account the negative impact that increasing taxes had on the output of an economy. Higher

corporate tax rates discourage companies to generate more income (Laffer, 2004). The

reverse is true for a decrease in tax rates. The arithmetic effect works always in the opposite

direction from the economic effect. This means that the optimal tax revenue is not reached at

100 percent tax rate. When the arithmetic and economic effect are combined a parabolic

relation can be expected.

The Laffer curve for personal tax, the existence of the parabolic relation is statistically

proven for different kind of taxes (Hsing, 1996 & Matthews, 2003). The existence of a bell-

shaped Laffer curve is statistically proven by Hsing (1996). Running time series on U.S.

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based data during 1959-1991, he finds a bell-shaped Laffer curve with a tax revenue

maximizing tax rate between 32.67% and 35.21%. For value added tax (VAT) the existence

is proven by Matthews (2003). He finds for the EU between the 1970s and 1990s revenue

maximizing rate in the range 18.0-19.3%.

2.2.2 Laffer Curve for Corporate TaxInitially, the Laffer curve was modeled for personal income tax. Interesting question is

whether it exists for corporate tax. Yet, only two papers were found with a straightforward

relation of corporate tax rates and corporate tax revenues. Clausing (2007) and Brill and

Hassett (2007) draw the corporate tax Laffer curve for OECD countries. They find a concave

relation. Both get significant evidence for the existence of the Laffer curve for corporate tax.

Between 1979 and 2002 Clausing (2007) finds an optimal tax of 33% for OECD countries.

For the same group of countries Brill and Hassett (2007) report a 34% corporate tax rate in

the late 1980s, but found a steady decline to 26% for the period 2000-2005.

Figure 4This figure4 shows graphically the parabolic relation between corporate tax rate and corporate tax revenue. t ¿ represents the revenue optimizing corporate tax rate.

4 This figure is based on Laffer (2004) and Clausing (2007)

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Figure 4 gives an abstract example of the Laffer curve for corporate income tax. In point C,

in case of an increase in the corporate rates, the arithmetic effect outweighs the economic

effect. An increase till the optimal tax rate level (t ¿) leads to an increase in the corporate tax

revenue. When the corporate tax rate in a country equals point D, an increase in corporate tax

rate leads to a decrease in the tax revenue. Then, the economic effect outweighs the

arithmetic effect. Important to mention is that optimizing tax revenues does not necessarily

mean that the government’s budget is optimized (Laffer, 2004). The economic effects of a

decrease in corporate tax rates are more than the increase of corporate tax payers. For

instance, it also leads to an increase in employment. This means that the government has to

pay less unemployment benefits. Also, the increase in wages leads to an increase on personal

income tax revenue (Lispey, 2003). A lowered corporate tax rate could, through economic

effects, lead to a more optimized government’s budget.

2.3 European Economic Integration

2.3.1 European Monetary UnionAs discussed in 2.1.1 globalization drives tax competition. Economic integration goes parallel

with the globalization (Rodrik, 1997). Many economic treaties, regional and global were

signed in the 20th century. The level of integration can be judged along figure 5. As the figure

indicates a monetary union is an intense form of economic integration. Within the OECD, the

European Monetary Union (EMU) can be regarded as the economically most integrated union

of countries. Joining a monetary union has its benefits, but also comes with cost. On the one

hand being part of a monetary union cuts bureaucratic costs. It stabilizes prices for

consumers. It facilitates stability and growth and creates a stronger and more concrete symbol

of European identity (Alogoskoufis & Portes, 1991). On the other hand, because the Euro

zone has met some political instability, there is no full political and budget control on all

member states. This allows for an easier violation of Euro zone rules (Alogoskoufis and

Portes, 1991).

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Figure 5This figure5 represents a ladder of economic integration. Starting at the bottom with a independent economy as being the least international integrated system and the political union the highest level of cross-border integration.

The European Monetary Union currently consists of eighteen countries. These 18 counties

share a single currency, the Euro. The EMU is the outcome of the Maastricht Treaty of 1992

and the practical starting point was in 1999. The treaty was signed by twelve countries; ten of

those countries adapted their currency to the Euro. Before 2008 an extra 3 countries joined.

This was another step for the integration of (Western) Europe towards a political union. The

EMU does share their currency but not fiscal policy.

As Figure 5 demonstrates, a monetary union is not as integrated as a fiscal union. The

corporate tax rates are independently set by the different member states. This situation opens

room for competition at that level. Genschel, Kemmerling and Seils (2011) confirm this

competition. They report that the tax competition within the EU is stronger than the rest of

5 Source: http://www.economicsonline.co.uk

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the world. The integration effect of one market, one currency and a common law give a boost

to the corporate tax competition since the 1990s. The term integration effect is associated

with reduction on capital controls, exchange rate fluctuations that advances in the single

market programme. A stronger relation insinuates that that corporate tax rates is an important

factor within the EMU in fighting for foreign investments.

2.4 Crisis and Corporate Tax RatesThe current financial crisis puts a stop on economic activity in general. It slows down the

process of capital mobility. Given the size of the financial crisis, the stabilizing effect of

corporate tax could become obscured. The effect of the crisis exceeds the ordinary business

cycles. The question that rises is whether the effect of corporate tax rates on corporate tax

revenue diminishes in case of an extreme economic downturn. The role of corporate tax rates

as an instrument could become obscured. Not only is the scope of the crisis different from

other, the financial crisis seems to especially hit the banking sector and therefore capital

markets (Spilimbergo, Schindler and Symansky, 2009).

The current crisis has converted the interest in the extent to which the tax system acts

as an automatic stabilizer. Interesting is to observe what the effect of the credit crisis has on

the role of corporate tax rates. Usually, automatic stabilizers are defined as the elements of

fiscal policy that smoothen the output fluctuations. Buettner and Fuest (2010) state that

corporate tax rates works as an automatic stabilizer in two ways. First, it is directly imposed

on the profit of corporations. This implies that if the tax equals 20 per cent, it absorbs the 20

per cent of an initial shock in the gross profit of the firm. Second, the disposable profit is

decreased by the tax and therefore cannot be completely used for the demand of goods and

services.

Devereux and Fuest (2009) investigate to what extent corporate taxation can act as an

automatic stabilizer by smoothing the effects on investment of shocks to income. Examining

UK companies between 1980 and 2007, they found that corporate tax had no automatic

stabilizing impact. This is troubling, given the scale of the current financial crisis, because

this suggests that corporate tax rates cannot be used as an instrument that mitigates the

fluctuations of an economy. Buenttner and Fuest (2010) investigate a dataset of German

manufacturers. Controversially they find that corporate income tax amounts to about 8

percent of an initial shock to gross revenues. This effect seems to increase during a cyclical

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downturn. However the decreasing corporate tax rates leads to directly to a decreasing

stabilizing effect.

The elasticity between corporate tax rates on FDI inflow seems to reduce during a

crisis period (Ferreti and Tille, 2011). The current financial crisis led to a collapse in

international capital flows. Banks play a major role in this process, since they are reluctant to

lend money to corporations. This indicates that the link between low corporate tax rates and

an increase in the FDI inflow is distorted. Changes in corporate tax-rates might have less

influence on firms’ investment decisions. Tax burden may a less important locational factor

for firm’s investment decisions. Hemmelgarn and Nicodeme (2010) criticize the short term

tax policies changes of governments; they state that tax policies should have a more

preventing role instead of curing.

2.5 Research QuestionThis thesis attempts to provide a deeper perspective on the role corporate taxation on

government tax revenues and attraction of FDI in relation with economic integration,

centered around the following research question:

How does European monetary integration (EMU) impact the role of corporate tax rates?

Figure 6 gives an overview of how this problem is approached. Working with a sample of

euro and non-euro countries, allows for a comparison between a group of less economically

integrated countries and a group with more economic integration. By doing so, it could

become clear what the corporate taxation effects are of being part of a more integrated

economical union. Four effects will be estimated. First, the effect is of EMU-membership on

the height of corporate tax rates is estimated. Then, the effect of being part of the Euro zone

on the inflow FDI will be estimated. Further, the estimation of the parabolic relation (Laffer

curve) between corporate tax rates and corporate tax revenues will be performed. Finally, due

to the publish date, other researchers do not show the effect of the financial crisis on the role

of corporate taxation. By dividing the sample in to two periods; pre-financial crisis and

financial crisis, the effect of the financial crisis could become clear.

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OECD Countries (1982-2011)Economic Integration

EMU-membership

Stronger Negative

Elasticity FDI inflow and

Corporate Tax Rates?

Stronger integration

More Competition over Corporate Tax Rates

Different effect on Laffer Curve?

Different Effect during Crisis (2007-

2011)?

Figure 6 This figure is a graphical representation of the thought behind the research question of this thesis, based on the existing literature.

Answering the research question, the following four hypotheses are set:

H1: EMU membership increases competition over corporate tax rates and leads to lower

corporate tax rates.

Likewise, the second hypothesis adds the effect of EMU membership to the elasticity

between corporate tax rates and FDI. Due to stronger competition between countries the

following hypothesis is stated:

H2: The elasticity between inward FDI and corporate tax rates is stronger for countries

that are member of the EMU.

Consistent with the result of Clausing (2007) and Brill and Hassett (2007), it is expected to

find a concave relation between corporate tax revenue and corporate tax rates. In line with

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Brill and Hassett, the expectation is that the revenue-maximizing rate is influenced by

stronger forms of integration (EMU membership):

H3: The total tax revenue of a country is a concave function (Laffer curve) of its corporate

tax rate with an overtime decreasing stronger among EMU members.

The crisis years (2007-2011) could put a stop on the existing relation between corporate tax

rates and its determinants. Since the crisis directly harms the capital market, the role of

corporate tax rates as a location factor for foreign investors seems to diminish. The decision

to invest seems to depend less on the corporate tax rate. This leads to the following

hypothesis:

H4: The crisis influences the existing relation between EMU membership and corporate

tax rates differently compared to non-crisis years.

The next section will discuss the data used and how these hypotheses are tested.

23

3. Data and Methodology This section provides a description of the data and methodology used to examine the role of

corporate tax rates within the European OECD countries for the years 1981 to 2011. First, an

outline of the data will be given. Next, the method used to examine the elasticity for

hypothesis will be explained. Finally, the process to test the hypothesis regarding the Laffer

curve for corporate tax will be described.

3.1 SampleTable 1: Descriptive StatisticsThis table shows the summary statistics for the sample of 26 OECD countries. The table provides the number observations, mean, standard deviation, minimum and maximum of the variables used in this thesis. Source: OECD and Worldbank.

Variable Observation Mean Std. Dev.

CorporateTaxRate (%) 780 36.0 10.1

CorporateTaxRevenue/GDP (%) 753 35.4 7.85

GDP (in billion $) 818 943 1970

GDPperCapita (in $) 818 22,700 15,800

GDPgrowth (%) 788 2.149692 2.61

FDIInflow (in billion $) 769 18.4 40.7

FDIInflow/GDP 765 3.00 4.67

Population (in millions) 818 38.7 57.1

GovernmentExp/GDP (%) 808 19.4 4.21

EU Member 832 0.519 0.500

EU Applicant 832 0.0547 0.226

EU Complete 832 0.0216 0.147

EMU Member 832 0.188 0.391

EMU Applicant 832 0.111 0.314

The sample of OECD countries is mainly collected from the OECD’s library. The OECD

reports the yearly data of their member countries. The data reports of the statutory corporate

tax rates from 1982 onwards. So, the sample is restricted to years 1982-2011. The final

24

dataset includes 26 countries6. The inward FDI is retrieved from the database of the

Worldbank. The country characteristics are mainly taken from OECD’s library.

Table 1 gives an overview of the descriptive statistics. A variable of interest is

corporate tax rate, which is further explained in figure 7. In detail, Figure 7 shows the

average corporate tax rates of the sample between 1981 and 2012. The downward slope

confirms the international trend of lowering the corporate tax rates (Swank and Steimo, 2002

& Overesch and Rincke, 2011). The blue line represents the average rate of all the countries.

In 1981 the average tax rate was 47.7% and in 2011 this was decreased to 25.9 %. The red

and green line embodies the euro and non-euro countries. From 1981 till 2006 time the EMU

members show higher corporate tax rates. The year 2007 seems to be the turning point.

Afterwards, on average the euro countries have a lower corporate tax rate than non-Euro

members.

Figure 7: Descriptive Statistics Corporate Tax RatesThis figure gives an overview of the development of the average corporate tax rates concerning the 26-country sample between 1982 and 2011. This is represented in the blue line. The red and blue line represent the average corporate tax rates of the Euro countries and non-Euro countries.

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Average Corporate Tax Rates1982-2011

TotalEuronon-Euro

6 Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Japan, Mexico, The Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, United Kingdom and United States.

25

EU Member, EU Applicant, EU Complete, EMU Member and EMU Applicant are all

dummy variables. The value is 1 if true and 0 if not true. When EU member equals 1, country

is officially member of the European Union. If EU Applicant equals 1, the country applied

for EU membership. If EU Complete equals 1, the country completed the application process

of the EU, but is not an official member yet. The same applies for EMU Member and EMU

Applicant.

3.2 The determinants of Corporate Tax ratesTo test the first hypothesis, the corporate tax rates are regressed to the dummy variables of

memberships and several location factors. This is comparable to the initial regression o

Clausing (2008) using ordinary least squares (OLS) for panel data for country i at time t :

CorporateTaxRate¿=EMUmember¿+EUmember ¿+EUapplicant ¿+EUcomplete+¿¿controls+ε¿¿

The control variables include country characteristics; government expenditure, population,

GDP per capita and GDP growth. It is expected that all dummy variables are negatively

related to corporate tax rate. Further economic integration should lead to more tax

competition from outside, which will force the country to lower their tax rates. Besides

government consumption is expected to be positively related to corporate tax rates, since

governments that have higher expenses want to raise more income from tax by using higher

tax rates. Population is a proxy for country size and is expected to be positive, because

smaller countries are more likely to lower their corporate tax rates. They are more willing to

attract investments from abroad than bigger countries, because smaller countries are able to

larger amount of potential investments. The bigger countries have normally a larger amount

of capital that can be invested abroad. GDP per capita as proxy for productivity is likely to be

positive. Capital-intensive countries are more expected to choose for lower corporate tax

rates to attract more capital. GDP growth is a proxy for cyclical situation of the economy of a

country. The expectation is that GDP growth will be positive. A government could react in

case of low or negative growth by lowering the corporate tax rates to boost the economy and

vice versa.

3.3 FDI inflowTesting the second hypothesis the elasticity between FDI inflow and corporate tax rates will

be assessed. To estimate this elasticity a comparable regression is used as Billington (1999)

using OLS for panel data for country i at time t :

log(InwardFDI ¿¿¿)=(CorporateTaxRate¿)2+EMUmember¿+controls+ε¿¿

26

The log of FDI is the dependent variable and the main dependent variables are corporate tax

rate squared and the dummy variable EMU Member. Corporate tax rate squared is used

because it is expected to lead to a higher and more satisfactory level of R-squared (Billington,

1999). The sign is expected to be negative, because low corporate tax rates are related to high

rates of investments from abroad. EMU member is expected to be positive, because more

economic integration leads to an easier flow of capital between countries.

The control variables include country characteristics; Population, GDP per capita and

GDP growth. Population is proxy for country size and logically it is expected to have a

positive sign, because larger countries expect to receive a higher amount of investment from

abroad. GDP per capita is a proxy for richness and labor productivity. It is expected that GDP

per capita is positively related to inward FDI, as investors are more willing to invest in a

more advanced country with higher productivity.

3.4 The Laffer Curve To test hypothesis 3 the Laffer curve is modeled. The Parabolic relation of the Laffer curve

can be shown by putting corporate tax collections as a function of the corporate tax rate and

the square of corporate tax rate. The corporate tax revenue will be divided by GDP, so it is

controlled for the relative size of the country. This is similar to the initial regression of

Clausing (2007) using ordinaty least squares (OLS) for panel data for country i at time t :

CorporateTaxRevenue /GDP¿=TaxRate¿+(TaxRate¿)2+EMUmember∗TaxRate ¿+EMUmemb er∗(TaxRate¿ )2+controls+ε ¿

The control variables include country characteristics, Population GDP per capita and GDP

growth. To find a parabolic relation it is essential that Tax Rate has a positive sign and Tax

Rate squared shows a negative sign. To find a certain effect on the parabolic relation when

introducing the dummy variable EMU Member, EMU Member * Tax Rate needs to be

positive and EMU * Tax Rate squared needs to be negative to remain the parabolic relation

between corporate tax rates and corporate tax rates. The expectation is that they fulfill this

condition and the new parabolic relation has a revenue maximizing point with a lower

corporate tax than the parabolic relation when EMU Member equals zero.

GDP growth is a proxy for cyclical situation of the economy of a country. The expectation is

that is positively related to tax revenue, because when there is economic upturn companies

are expected to pay more taxes and vice versa. GDP per capita is expected to be positive.

GDP per capita is a proxy for productivity. When employees are more productive they

27

generate more revenue and profit for a company. This directly leads to higher corporate tax

revenues. The variable Population is a proxy for country size and is assumed to be negative

because larger countries are less competitive for the attraction of capital. Therefore larger

countries are less likely to have beneficial tax schemes for companies. This leads to less tax

revenues because the economic activity is relatively more concentrated in smaller countries.

3.5 Crisis vs. non-Crisis Further, to test the fourth hypothesis all three regressions will be redone for two separate

periods; non-crisis (1982-2006) and crisis (2007-2011). By doing so, it allows to estimate the

different effect during the different periods.

28

4. ResultsThis section reports the results found by performing the test as described in the previous

chapter. The results will be interpreted concerning the four hypotheses and eventually the

main research question of this thesis.

4.1 Determinants of Corporate Tax RatesTable 2 Determinants of Corporate Tax Rates 1982-2011This table reports the results of the OLS regression performed by STATA with Corporate tax rates as dependent variable. The columns differ in the use of country and year effects. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year.

(1) (2) (3)GovernmentExp(%GDP) 0.0109*** 0.0117*** 0.00978***

(0.00161) (0.00172) (0.00168)

Log(Population) 0.0162 -0.226*** -0.455***(0.0106) (0.0822) (0.0648)

GDPgrowth 0.00383*** 0.000363 0.00330***(0.00127) (0.00155) (0.00122)

Log(GDP p/c) -0.0524*** 0.0993*** -0.00719(0.00680) (0.0192) (0.00962)

EU-member -0.0746*** -0.124*** -0.125***(0.0146) (0.0169) (0.0165)

EU-applicant -0.0304* -0.0341** -0.0400**(0.0168) (0.0172) (0.0165)

EU-complete -0.0916*** -0.117*** -0.113***(0.0225) (0.0230) (0.0220)

EMU-member -0.0691*** -0.0610*** -0.0708***(0.0105) (0.0119) (0.0102)

Constant 0.420** 3.144** 7.933***(0.184) (1.419) (1.029)

Observations 782 782 782R-squared 0.311 0.402 0.357

Country fixed effects no no yesYear fixed effects no yes no

29

Table 2 reports the first results on determining corporate tax rates. Column (1)

presents the regression without fixed effects, column (2) uses country fixed effects and

column (3) uses fixed time effects. All three columns show similar results. As expected, all

three regressions do find significant effect of government consumption on corporate tax rate.

The variable population, proxy for country size, shows that there is a negative influence on

corporate tax rates in column (2) and (3). This is not in line with the expectations, since

smaller countries are more likely to set lower corporate tax rates.

The negative sign for year fixed effects (2) means that changes in population between

countries within years. The growth rate of population does differ between countries. It could

be positive since the crisis years are included. The adaptation of corporate tax rates could be

more intense within larger countries. The negative sign for fixed country effects (3) means

that changes in population growth within countries lead to lower corporate tax rates. This

means that it loses again it function for being a proxy for country size and therefore a

different size could be the outcome. The growth of GDP is as expected significantly and

positively related to corporate tax rates. When a country is in a situation of economic

downturn it will lower its corporate tax rate to boost the economy. GDP per capita has a

significant negative effect on corporate tax rates in without fixed effects (1). Capital-intensive

countries set corporate tax rates low to attract more capital. This effect however does not hold

for fixed effects (column 2 and 3). It could be that because the crisis years are included in the

sample, the outcome is distorted.

Interestingly, the process of becoming member of the EU member is highly

significant. The applying process, completing process and membership all have negative

influence on the corporate tax rate level. This confirms the view that economic integration

leads to a lower rate in corporate taxation. Becoming member of the EMU also leads to lower

corporate tax rates. This suggests that becoming part of the EMU means becoming more

economic integrated.7 This confirms the first hypothesis. However the effect is not as strong

as the effect of EU membership.

7 Also the dummy variable Emu Applicant was added, which equals one for the years the countries applied as a euro member, but the currency is not introduced yet. However, no significant results were found.

30

Table 3 Determinants of Corporate Tax Rates per PeriodThis table reports the results of the OLS regression performed by STATA with Corporate tax rates as dependent variable. The columns differ in the use of country and year effects. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year.

(1) (2) (3)1982-2011 1982-2006 2007-2011

GovernmentExp(%GDP) 0.0109*** 0.0127*** 0.000434(0.00161) (0.00190) (0.000951)

Log(Population) 0.0162 0.0201* 0.0288***(0.0106) (0.0121) (0.00630)

GDPgrowth 0.00383*** 0.00292* 0.000952**(0.00127) (0.00165) (0.000455)

Log(GDP p/c) -0.0524*** -0.0344*** 0.00813(0.00680) (0.00877) (0.0106)

EU-member -0.0746*** -0.102*** -0.0482**(0.0146) (0.0173) (0.0188)

EU-applicant -0.0304* -0.0360**(0.0168) (0.0180)

EU-complete -0.0916*** -0.107***(0.0225) (0.0239)

EMU-member -0.0691*** -0.0620*** 0.0163(0.0105) (0.0128) (0.0114)

Constant 0.420** 0.169 -0.282*(0.184) (0.215) (0.168)

Observations 782 628 154R-squared 0.3112 0.2437 0.0126

Table 3 compares the effect on corporate tax rates among the different periods.

Column (1) is presents the entire period (1982-2011), column (2) represents the period till

crisis years (1982-2006), column (3) reports the years of crisis (2007-2011). Column (2)

reports comparable results as over the entire concerning period (Column 1). Remarkably,

column (3) reports a non-significant relation between being EMU member and corporate tax

rates. The outcome shows that during the crisis years, being part of EMU does not directly

lead to setting lower corporate tax rates. An explanation could be that due to the intensity of

the crisis in the Euro zone, countries decide to not further decrease their corporate tax rates

31

because of the decreasing investments. It seems that the financial crisis distorts the existing

relation between EMU membership and corporate tax rates.

Further the control variables when significant show the expected sign. Only GDP per

capita does show a significant effect during the crisis period. It could be that during the crisis

period all government adapt their policies regarding corporate tax rates and therefore there is

no significant difference between countries with different GDP per capita.

4.2 FDI inflowTable 4 FDI Inflow per PeriodThis table reports the results of the OLS regression performed by STATA with FDI inflow relative to GDP as dependent variable. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year .

(1) (2) (3)1982-2011 1982-2006 2007-2011

CorporateTaxRate -3.499* -6.237*** 12.56(1.888) (1.383) (22.47)

Log(Population) -0.908** -0.661** -1.914(0.419) (0.285) (1.223)

Log(GDP p/c) 0.867*** 0.530** -0.759(0.334) (0.269) (2.205)

GDPgrowth 0.142*** 0.140*** 0.205(0.0551) (0.0499) (0.158)

EU-member 1.980*** 1.154** 2.740(0.672) (0.499) (3.329)

EU-applicant 0.650 0.460(0.797) (0.566)

EU-complete 0.430 -0.0449(1.026) (0.725)

EMU-member 0.962** 1.646*** -0.651(0.483) (0.390) (2.691)

Constant 9.796 10.03* 39.60(7.602) (5.399) (33.58)

Observations 737 586 151R-squared 0.1078 0.1925 0.1078

32

Table 4 shows the results that link the inflow of FDI to corporate tax rate, a set of country

characteristics and economic integration dummies. Column (1) represents the results covering

the entire period (1981-2011), column (2) the period before the crisis (1981-2006) and

column (3) presents the crisis years (2007-2011). Column (1) and column (2) show similar

results. As expected they demonstrate that lower corporate tax rate are related with higher

FDI inflow. Surprisingly, column (3) does not show this relation. This could be caused by the

fact that foreign investors are reluctant to invest money during a crisis and even they could be

withdrawing investments from countries that were normally attracted due to there corporate

tax rates. The elasticity can be calculated be using the following equation:

∂ log FDI∂TAX

=∂ log FDI∂TAX 2 ∙ ∂ TAX 2

∂TAX (2)

,where ∂ log FDI

∂ TAX2 equals –6.237 for the non-crisis period (column 2). This allows for a linear

representation of the relation between inward FDI and corporate tax rates, where ∂ log FDI

∂TAX

equals the slope of the line.

Since size of population is negatively related to inflow of FDI in column (1) and (2),

it suggests that smaller economies seems to be relatively more interesting for foreign

investors. This could be due the larger grow potential they have. GDP per capita is positively

related to FDI. This is as expected, since more wealthy countries are normally a more save

and stable environment for investments. They are also more capital-intensive and therefore

demand more capital. The significance of the variable GDP growth underlines the relation

between economic cycles and investments. Foreign investors are more willing to invest

during positive economic cycles and vice versa.

Further, column (1) and (2) show that EU membership leads to a higher inflow of

capital, which is in line with the thought of more economic integration that leads to more

flow of capital, confirming hypothesis two. However, this does not count for the application

process. No significant results were found regarding applying and completing membership of

the European union. EMU membership seems to be having the strongest effect during the

period before the crisis (Column 2).8 This confirms the thought that economic integration

leads to a higher rate of FDI inflow. The crisis period (2007-2011) does not show any

8 Again EMU Applicant is added as dummy variable and no significant results were obtained.

33

significant results. This proves the strong effect of the crisis on the investment climate. None

of the variables is able to declare the FDI inflow during the financial breakdown. Even, any

form of economic integration does not positively influence investments during this period.

4.3 Laffer CurveTable 5 Laffer Curve for Corporate taxThis table reports the results of the OLS regression performed by STATA with Corporate tax revenue relative to GDP as dependent variable. The columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year .

(1) (2) (3)VARIABLES 1982-2011 1982-2006 2007-2011

CorporateTaxRate 9.317** 0.915 91.48*(3.649) (3.946) (46.73)

CorporateTaxRate^2 -11.93** 0.0507 -120.7(5.269) (5.700) (77.70)

GDPgrowth 0.0454 -0.0320 0.0501(0.0328) (0.0412) (0.0325)

Log(GDP p/c) 1.232*** 2.128*** 1.647(0.217) (0.256) (1.177)

Log(Population) -1.096 -0.964 -3.255***(0.943) (0.989) (1.130)

Constant 39.78*** 30.68* 57.08**(15.20) (16.03) (23.60)

Observations 733 610 123R-squared 0.2706 0.3044 0.2745

Table 5 presents the parabolic relation between corporate tax and corporate tax revenue.

Column (1) represents the results covering the entire period (1982-2011), column (2) the

period before the crisis (1981-2006) and column (3) presents the crisis years (2007-2011).

Because corporate tax rate and corporate tax rate squared are significant in column (1), it

proves the existence of the Laffer curve. Besides, GDP per capita is, as expected positively

related to tax revenues. Higher GDP per capita corresponds with a larger corporate sector and

more corporate tax paying.

34

As mentioned, there is proof for a parabolic relation between 1982 and 2011.This is

significant at a 5 percent level and graphically the parabolic function is represented in figure

8. The revenue maximizing rate is 39% and corresponds to 1.8 % corporate tax revenue

relative to GDP. When distinguishing between the pre-crisis (Column 2) and crisis period

(Column 3) there is no significant proof in both periods for the existence of the Laffer curve

for corporate tax.

Figure 8: Laffer Curve for OECD countries between 1982-2011This figure gives an graphical representation of the Laffer Curve for Corporate tax rates concerning the 26-country sample between 1982 and 2011. This is represented in the blue line. The y-axis embodies the corporate tax revenue relative to GDP. Plotted along the x-axis is the corporate tax rate.

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Table 6 adds an interaction term the dummy variable EUmember times corporate tax

rates. Although the expectations are that due to the increasing economic integration the Laffer

curve would be steeper and have a lower revenue-maximizing rate, this is not translated in the

outcome. None of the different periods allow for a proper Laffer curve. This does not allow to

draw a Laffer Curve. Due to the insignificant results it cannot be tested whether economic

integration leads to lower revenue-maximizing corporate tax. Again, GDP per capita is

significant and positive. A larger corporate sector leads to higher tax revenues.

35

Table 6 Laffer Curve for Corporate tax: EU member dummyThis table reports the results of the OLS regression performed by STATA with Corporate tax revenue as dependent variable. The columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDP and GDPgrowth are lagged by one year.

(1) (2) (3)1982-2011 1982-2006 2007-2011

CorporateTaxRate 10.68*** 1.845 34.71(3.720) (4.002) (47.05)

CorporateTaxRate^2 -15.53*** -2.052 13.16(5.613) (6.032) (86.73)

EU* CorporateTaxRate -3.466 0.841 89.47***(2.854) (3.052) (22.20)

EU* CorporateTaxRate^2 10.39* 7.011 -192.0***(5.809) (6.223) (60.17)

GDPgrowth 0.0394 -0.0534 0.0418(0.0333) (0.0413) (0.0324)

Log(GDP p/c) 1.348*** 2.112*** 2.678**(0.231) (0.263) (1.083)

Log(Population) -1.512* -1.032 -2.554***(0.912) (0.969) (0.852)

Constant 45.55*** 31.35** 32.85*(14.61) (15.65) (19.32)

Observations 733 610 123R-squared 0.2827 0.3974 0.6349

Table 7 adds an interaction term the dummy variable EMUmember times corporate

tax rates. Although the expectations are that due to the increasing economic integration the

Laffer curve would be steeper and have a lower revenue-maximizing rate, this is not

translated in the outcome. This means it cannot confirm the fourth hypothesis stating that the

economic integration by becoming EMU member a country would have a steeper Laffer

curve and a lower revenue-maximizing rate.

36

Table 7 Laffer Curve for Corporate tax: EMU member dummyThis table reports the results of the OLS regression performed by STATA with Corporate tax rates as dependent variable. The columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDP and GDPgrowth are lagged by one year.

(1) (2) (3)1982-2011 1982-2006 2007-2011

CorporateTaxRate 7.826** 0.0800 89.84*(3.662) (3.937) (51.34)

CorporateTaxRate^2 -8.918* 1.997 -113.6(5.294) (5.702) (92.98)

EMU* CorporateTaxRate 0.680 3.336 3.507(4.072) (5.129) (10.95)

EMU* CorporateTaxRate^2 7.047 -1.725 -12.31(11.32) (13.91) (41.36)

GDPgrowth 0.0469 -0.0281 0.0512(0.0329) (0.0409) (0.0346)

Log(GDP p/c) 1.065*** 1.943*** 1.755(0.225) (0.263) (1.182)

Log(Population) -1.098 -0.911 -3.177***(0.926) (1.000) (1.047)

Constant 41.40*** 31.46* 54.53**(14.92) (16.22) (22.72)

Observations 733 610 123R-squared 0.2977 0.3178 0.2703

4.4 Crisis vs. non-Crisis Regarding the difference between crisis and non-crisis period the tables show some

interesting outcomes. Table 3 reports that the dummy variable EMU is significant for the

period 1982-2006 (column 2), but is not significant for the crisis period (column 3). This

could mean that the crisis within the Eurozone forces countries more to decrease their

corporate tax rate than the non-EMU members and crisis period. Because the crisis seemed to

37

hit the Eurozone harder than others, it could be that EMU do not try to compete over

corporate tax rate and try to solve their budgetary problems.

Table 4 shows that being member of the EMU leads to more inflow of FDI in between

1982 and 2006 (column 2). However, these significant results were not found for the period

after 2006 (column 3). The crisis put a stop on the existing relations between economic

integration and FDI inflow. Table 7 does not allow drawing conclusions on the effect of crisis

and the Laffer curve within the Eurozone. Summarizing, it could be stated that the crisis

indeed changes the existing role corporate tax rate play within the EMU.

4.5 Robustness ChecksAn ordinary question is whether the results found are robust. To check this robustness the

significant regression in this thesis are redone. Already it can be seen that the main variables

hold their sign and significance when introducing country and year fixed effects (table 2),

however this did not count for all control variables. This could indicate that there is some

outlying data in the sample. Three different adjustments are made to the regression to test for

robustness. First, two outlying countries are deleted from the sample. Second, country

dummy variables are introduced. Third, year dummy variables are introduced.

4.5.1 Exclusion Netherlands and IrelandTo test the robustness of the results the Netherlands and Ireland are deleted from the 26-

country sample. This is done because these two EMU-members use special tax policies to

attract investments besides relative low corporate interest rates and are even investigated by

the European Commission over multinational deals.

Appendix I and II show the results of regressing sample without Ireland and The Netherlands.

Only the regressions that showed significant effect of EMU-membership are redone.

Appendix I shows results of regressions similar to the regressions in table 3 are performed.

The exclusion of the tow countries has a no major effect for economic integration on

corporate tax rates. All the control variables show the expected significant signs. Even,

population is as expected positive for all periods. Indeed it can be said that two outliers. Thus,

the main outcome holds regarding this robustness test.

Appendix II is a review of the regression as performed in table 4. Again, only when country

obtained the member status it has significant effect on FDI inflow. Also, these are significant

during the non-crisis period and are not during the financial crisis. However, the control

variables do not hold their significance when The Netherlands and Ireland are excluded from

38

the sample. This indicates that the tax policy of the two countries play a crucial role

concerning the attraction of FDI. Still, the effect of economic integration is significant

regarding inward FDI.

4.5.2 Introduction Country Dummies Appendix III and IV present outcome similar to table 3 and 4, only 25 country dummies were

added. For presentation reasons, the dummy variables are not presented in the table. After the

introduction of country dummies the results still hold regarding the economic integration and

corporate tax rates (appendix III). The control variables show the expected sign, except for

population. The same problem seems to be appearing as in case of country fixed effects (table

2). By fixing country effects, the variable population becomes a variable for population

growth and the growth rate within in countries does not differ much. This could lead to

abnormal results. Appendix IV, with inward FDI as dependent variable shows results the

results as expected. Again, only the member status leads directly to more inward FDI. The

variable population appears to have the same issue as in appendix III.

4.5.3 Introduction Year Dummies Appendix V and VI represent outcome after the introduction of year dummy variables. The

same regression is performed as in table 3 and 4, only 29 year dummies were added. For

presentation reasons, the dummy variables are not presented in the table. Appendix V with

corporate tax rate as dependent variable shows the expected results regarding economic

integration, namely negative. The control variables are line with the expectations; only GDP

per capita is different.

Appendix VI regressing FDI inflow relative to GDP to the sample shows similar results as

table 4 regarding economic integration. Only in the non-crisis period the effects become clear

and are positive. The control variables lose significance but the signs are as expected.

39

5. ConclusionsThe corporate tax rates adopted an important role as for the attraction of FDI. It has proven its

role as a strong policy instrument. Interesting is the effect of economic integration on the role

corporate tax rate. Previous research did mainly focus on the effect of corporate tax rates in

general and focused on pre-crisis years. This left a gap for a more comprehensive

investigation on the role of EMU integration before and during the financial crisis.

This thesis tries to investigate the effect of EMU membership on the corporate tax

rates. By setting four hypotheses these issues are approached. First, it was tested whether this

form of economic integration leads to lower corporate tax rates. Second, it was checked

whether EMU membership leads to the attraction of FDI. Third, the influence on the Laffer

curve for corporate tax rates was tested. Fourth, the difference between two periods, crisis

and non-crisis, was checked.

Using a sample of 26 OECD countries, consisting of non-EMU and EMU countries

the four hypotheses were tested. Significant effects were found of EMU-membership

regarding corporate tax related issues. EMU-membership directly affects the height of

corporate tax rates, confirming the first hypothesis. The economic integration forces member

states to lower their corporate tax rates, because the lowering corporate tax optimizes the FDI

inflow. Besides, being involved in the EMU as a country leads to more FDI inflow in your

country. This strengthens the effect of low corporate tax rates. Finally, looking into the

difference between the pre-crisis and crisis period, it becomes clear that the financial crisis

distorts the existing relation between EMU-membership and corporate tax rates. The different

robustness tests did influence the outcome of the regressions. However, the effect of

economic integrations remained significant.

It can be concluded that the EMU membership has a significant effect on the role of

corporate tax rates. This seems to prove that the EMU is a higher level on the integration

ladder compared to the EU. It remains to be seen how the EMU countries will behave in the

future regarding corporate tax rates. Especially, when the European Union and EMU become

more fiscally integrated this relation could change. These results could influence policy

makers regarding the effect of corporate tax rates and EMU membership. EMU membership

can be seen as more economic integration, which leads to the attraction of more capital.

Besides, EMU membership seems to force countries to lower their corporate tax rates. Low

40

corporate tax rate itself also leads to higher amounts of capital inflow. The reallocation of

capital should, theoretically, lead to a more optimal division of production factors and

therefore lead to more wealth among member states. EMU membership seems to force

countries to choose for a more international economic optimized corporate tax rate, which

besides the reallocation of capital boosts economic activity in the domestic market. This

thesis urges future research to look deeper into the relationship between economic integration

and corporate tax rates and its effects.

41

6. Limitations

This thesis like every research has several limitations. The data on corporate tax rates is based

on a single number per country per year. However, concerning corporate taxation it is

common for country make arrangements with countries. Also, there could be an opportunity

for companies to avoid corporate taxation. Some activities could be differently taxed and

different per country. This is not represented in the variable of corporate tax rates.

Although the effect of economic integration seems to be robust, the entire model is

not. Not all control variables show the logic sign when checked for robustness. The model

covers country characteristics that have proven to influence corporate tax rates and FDI

inflow. The availability of more detailed data could cover the robustness problems.

The effect of crisis on the hard is point out. The models show that the effect of

economic integration is non-significant for the crisis period. It can be said that the crisis

disrupts the existing relations, however it is unclear what exactly causes this. Probably

variables like consumers confidence could give an indication what disrupt the model.

The effect of economic integration on the course of the Laffer curve for corporate was

not found to be significant, although the theory suggest it shoul. Other research with a

different data set found proof (Clausing, 2008). Working with a bigger or more detailed data

set could lead to finding a significant relation between the course of the Laffer curve and

EMU membership.

42

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45

Appendix IThis table reports the results of the OLS regression performed by STATA with Corporate Tax Rate as dependent variable. Ireland and Netherlands are left from the 26-country sample. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year.

(1) (2) (3)1982-2011 1982-2006 2007-2011

GovernmentExp(%GDP) 0.0105*** 0.0117*** 0.00150(0.00159) (0.00190) (0.00101)

Log(Population) 0.0226*** 0.0233** 0.0272***(0.00733) (0.00961) (0.00453)

GDPgrowth 0.00359*** 0.00261 0.00111**(0.00137) (0.00174) (0.000512)

Log(GDP p/c) -0.0441*** -0.0274*** 0.0217**(0.00671) (0.00882) (0.00911)

EU-member -0.0623*** -0.0848*** -0.0501***(0.0138) (0.0169) (0.0147)

EU-applicant -0.0300* -0.0332*(0.0174) (0.0185)

EU-complete -0.0899*** -0.104***(0.0236) (0.0248)

EMU-member -0.0668*** -0.0641*** 0.0285***(0.0115) (0.0142) (0.0104)

Constant 0.235* 0.0614 -0.417***(0.138) (0.180) (0.132)

Observations 738 596 142R-squared 0.2940 0.2263 0.0018

46

Appendix IIThis table reports the results of the OLS regression performed by STATA with FDI inflow relative to GDP as dependent variable. Ireland and Netherlands are left from the 26-country sample. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year .

(1) (2) (3)1982-2011 1982-2006 2007-2011

CorporateTaxRate -2.877 -5.660*** 36.89(1.844) (1.303) (24.79)

Log(Population) -0.657 -0.457 -2.157*(0.457) (0.297) (1.188)

Log(GDP p/c) 0.859*** 0.523** -1.902(0.330) (0.257) (2.221)

GDPgrowth 0.111** 0.0876* 0.197(0.0546) (0.0469) (0.162)

EU-member 2.264*** 1.463*** 3.829(0.674) (0.485) (3.237)

EU-applicant 0.739 0.559(0.772) (0.529)

EU-complete 0.524 0.0294(0.991) (0.675)

EMU-member 0.459 0.989** -2.234(0.489) (0.384) (2.729)

Constant 5.242 6.358 48.41(8.120) (5.507) (32.97)

Observations 693 554 139R-squared 0.1069 0.1848 0.0306

47

Appendix IIIThis table reports the results of the OLS regression performed by STATA with Corporate Tax Rates as dependent variable. Country dummies are introduced. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year .

(1) (2) (3)1982-2011 1982-2006 2007-2011

GovernmentExp(%GDP)

0.00978*** 0.0113*** -0.000216

(0.00168) (0.00200) (0.000989)

Log(Population) -0.455*** -0.526*** -0.252***(0.0648) (0.0850) (0.0969)

GDPgrowth 0.00330*** 0.00332** 0.000721(0.00122) (0.00158) (0.000443)

Log(GDP p/c) -0.00719 0.00880 -0.00446(0.00962) (0.0117) (0.0155)

EU-member -0.125*** -0.157*** -0.735***(0.0165) (0.0191) (0.195)

EU-applicant -0.0400** -0.0506***(0.0165) (0.0178)

EU-complete -0.113*** -0.130***(0.0220) (0.0234)

EMU-member -0.0708*** -0.0572*** 0.00659(0.0102) (0.0124) (0.0128)

Constant 9.168*** 10.34*** 5.361***(1.196) (1.581) (1.829)

Observations 782 628 154Number of id 26 26 26

48

Appendix IVThis table reports the results of the OLS regression performed by STATA with FDI inflow relative to GDP as dependent variable. Country dummies are introduced. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year.

(1) (2) (3)1982-2011 1982-2006 2007-2011

CorporateTaxRate -1.589 -4.210*** 19.15(2.042) (1.521) (37.63)

Log(Population) 0.542 5.309** -137.8***(3.112) (2.662) (41.23)

Log(GDP p/c) 0.957** 0.318 10.88(0.478) (0.376) (6.744)

GDPgrowth 0.143*** 0.132*** -0.0182(0.0551) (0.0497) (0.181)

EU-member 2.389*** 1.700*** -267.4***(0.840) (0.645) (85.93)

EU-applicant 0.796 0.516(0.853) (0.611)

EU-complete 0.729 0.217(1.079) (0.770)

EMU-member 0.815 1.393*** -1.941(0.496) (0.397) (5.301)

Constant -18.83 -103.6** 2,570***(57.43) (49.51) (791.1)

Observations 737 586 151Number of id 26 26 26

49

Appendix VThis table reports the results of the OLS regression performed by STATA with Corporate Tax Rates as dependent variable. Year dummies are introduced. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year.

(1) (2) (3)1982-2011 1982-2006 2007-2011

GovernmentExp(%GDP) 0.0102*** 0.0114*** 0.00104(0.00148) (0.00177) (0.000994)

Log(Population) 0.0293*** 0.0291*** 0.0317***(0.00715) (0.00898) (0.00612)

GDPgrowth 0.000465 -0.000137 0.000671(0.00157) (0.00183) (0.000702)

Log(GDP p/c) 0.0381*** 0.0614*** 0.0204*(0.0106) (0.0132) (0.0109)

EU-member -0.0539*** -0.0728*** -0.0471**(0.0131) (0.0159) (0.0184)

EU-applicant -0.00658 -0.00713(0.0169) (0.0181)

EU-complete -0.0620*** -0.0791***(0.0229) (0.0243)

EMU-member -0.0367*** -0.0300** 0.0173(0.0116) (0.0148) (0.0107)

GovernmentExp(%GDP) -0.740*** -0.932*** -0.479***(0.165) (0.203) (0.169)

Observations 782 628 154Number of id 26 26 26

50

51

Appendix VIThis table reports the results of the OLS regression performed by STATA with FDI inflow relative to GDP as dependent variable. Year dummies are introduced. The different columns present different periods. Standard errors are in parentheses. ***,**,* = 1%,5%,10% significance, GDPgrowth is lagged by one year

(1) (2) (3)1982-2011 1982-2006 2007-2011

CorporateTaxRate -7.137*** -5.439*** -17.99(1.791) (1.314) (22.69)

Log(Population) -0.713*** -0.671*** -0.799(0.137) (0.154) (1.217)

Log(GDP p/c) -0.559** -0.439 0.393(0.274) (0.277) (2.206)

GDPgrowth -0.0150 0.0749 -0.279(0.0754) (0.0550) (0.262)

EU-member 0.919** 0.880** 1.773(0.375) (0.360) (3.240)

EU-applicant -0.0315 0.0116(0.743) (0.525)

EU-complete 0.0798 0.0734(1.040) (0.694)

EMU-member 0.493 0.892** -0.103(0.495) (0.425) (2.615)

Constant 22.44*** 20.69*** 15.39(3.853) (3.905) (33.66)(3.853) (3.905) (33.66)

Observations 737 586 151Number of id 26 26 26

Standard errors in parentheses*** p<0.01, ** p<0.05, * p<0.1

52