Foreign direct investment flows to the US have seen a sharp decline in the past two years, despite a cut in the corporate tax rate from 35% to 21% in 2017. Previous research suggests that such a tax cut should have resulted in increased investor appetite. This column argues that countervailing forces, in particular the shift in investment sentiment driven by the corrosion of US openness to trade and global cooperation, have played the dominant role in reducing flows.
In 2019, net foreign direct investment (FDI) flows into the US were 10% lower than during the two previous years, despite the corporate tax cut adopted by the US administration in 2017, which should have increased the appetite of foreign investors (e.g. Hymer 1960, Alfaro 2015). Actual greenfield foreign investment in the US shrank by 19% in 2018 and a further 56% in 2019.
Yet empirical studies show a negative correlation between a host country’s corporate tax rate and inbound FDI flows. Using data from 84 countries, Djankov et al. (2010) show, for example, that inward FDI as a share of GDP is expected to increase by 2 percentage points if the corporate tax rate drops by 10 percentage points. In 2017, the US corporate tax rate was cut from 35% to 21%, which therefore should correspond to a 2.8 percentage points increase in inward FDI as a share of GDP. Using data on German greenfield investments, Hebous et al. (2011) find that after controlling for firm- and country-specific characteristics, a reduction in the statutory corporate income tax rate of 10% increases the probability of choosing a country to host a greenfield investment by about 6.4% – a large effect. Greenfield investment tends to react stronger to tax rate changes than other forms of FDI (Mooij et al. 2008).
It is likely that the positive effect of the corporate tax cut in attracting FDI to the US was outweighed by trade disputes and threats of withdrawal, as well as actual withdrawals, from international treaties and organisations, which may have scared investors away. This fear may explain the puzzle of falling FDI in the wake of the corporate tax rate cut. More research is needed to establish the precise relation between FDI and its determinants in the US.
Declining M&A and greenfield investment in the US
Net inward investment to the US dropped 23% from $315 billion in 2017 to $243 billion in 2018, with a rebound to $282 billion in 2019. The decline in FDI was driven by a contraction in equity capital (excluding reinvestment earnings) and debt instruments. Debt instruments are transactions between the parent firm and foreign affiliates, driven by companies’ short-term financing needs. Equity capital consists of greenfield investments and mergers and acquisitions.
Figure 1 FDI into the US, 2012-2020
Source: BEA. International Transactions, International Services, and International Investment Position (IIP) Tables. Assessed on 10 November 2020.
In 2018, mergers and acquisitions (M&A) and greenfield investment (both announced and occurred) into the US declined, while those into most other major FDI destinations increased (Figure 2). Yet, the US was the only major economy to implement a significant corporate tax rate cut (Djankov 2017). The fact that M&A and greenfield investment was moving around the US to other developed economies in 2018 despite the tax rate cut indicates that US attractiveness to foreign investors was waning for other reasons.
Mergers and acquisitions in the US continued to decline in 2019. Actual greenfield investment – foreign investors’ expenditures on either establishing a new US business or expanding an existing foreign-owned US business – shrank at an annual rate of 19% in 2018 and 56% in 2019 (Figure 2). Relatedly, first-year employment in new FDI projects declined from an average of 505,000 between 2015-2017 to 426,000 in 2018 and 211,000 in 2019.
Figure 2 Net M&A and greenfield investment into the US and other major economies, 2016-2019
Source: Data on net M&A value and announced greenfield projects from the UNCTAD World Investment Report 2020; realised greenfield investment expenditures for the United States were retrieved from BEA on 10 November 2020.
Reasons for the decline in FDI
There may be reasons behind the decline in FDI that have not been previously thought of as informing FDI decisions. For example, the years since 2016 have witnessed declining trade openness, as well as lower migration flows into the US. The US exit from the World Health Organization and the Paris Agreement on climate change have signalled a less-cooperative attitude towards major global partners. These developments may be treated as correlates of an overall corrosion in the openness of the US economy. Foreign investors may have taken note and acted accordingly. Future research might consider proxies for such sentiment shifts and incorporate them in the analysis of FDI determinants.
Alfaro, L (2015), “Foreign Direct Investment: Effects, Complementarities, and Promotion”, in O Manzano, S Auguste, and M Cuevas (eds), Partners or Creditors? Attracting Foreign Investment and Productive Development to Central America and Dominican Republic, Inter-American Development Bank, pp. 21–76.
de Mooij, R and S Ederveen (2008), “Corporate tax elasticities: a reader’s guide to empirical findings”, Oxford Review of Economic Policy 24(4): 680-697.
Djankov, S (2017), “United States Is Outlier in Tax Trends in Advanced and Large Emerging Economies”, PIIE Policy Brief 17-29.
Djankov, S, T Ganser, C McLiesh, R Ramalho, and A Shleifer (2010), “The effect of corporate taxes on investment and entrepreneurship”, American Economic Journal: Macroeconomics 2(3): 31-64.
Hebous, S. M Ruf, and A Weichenrieder (2011), “The effects of taxation on the location decision of multinational firms: M&A vs. greenfield investments”, National Tax Journal 64(3): 817–838.
Hymer, S (1960), The International Operations of National Firms: A Study of Direct Foreign Investment, MIT Press.