Do tax sparing agreements contribute to the attraction of FDI in developing countries ?

This paper analyses the impact of tax sparing agreements on Japanese foreign direct investment (FDI) distribution in developing countries. These agreements are sometimes concluded between a developed country and a developing country which grants fiscal incentives to foreign investors. In that case, the former agrees not to tax its outward investors in order that the host country fiscal advantage is not compensated for by the increase in its own income taxes. Apart from the United States, the majority of developed countries have included these tax sparing provisions in their fiscal bilateral treaties with developing countries. Their impacts are observed on the distribution of Japanese FDI outflows and average size of capital transaction, on the Japanese firm sales and employment as well as on the difference between the Japanese and U.S. FDI shares, over the 1989-2000 period. The empirical results suggest that each additional year, subsequent to the signature of a tax sparing agreement, increases Japanese FDI activity by 1.7-11%. These findings are robust to the use of an instrumental variable specification and give empirical support to the debate on the exclusion or not of these provisions under the bilateral tax treaty. Thus, this study confirms that tax sparing agreements can be useful instruments to increase the attractiveness of a developing country.