Taxes and Agglomeration as Determinants of FDI in an Enlarged European Union

We empirically analyze the impact of corporate tax rates and agglomeration economies on FDI using panel data on bilateral FDI flows and stocks in the enlarged European Union. The novelty of the paper is that it explicitly deals with agglomeration forces and how these may explain differences in tax policies between new and old member countries. The empirical analysis closely follows the implicit underlying model where the foreign direct investment decision is seen a two-step procedure: first, whether to invest or not, and second, the amount of FDI to invest. The paper makes use of new data on effective marginal and average corporate tax rates for all 27 EU member countries and covers the period 1995-2007. We find that there are large differences in determinants of FDI going to EU15 and to the new member countries. First, tax differentials mainly seem to influence FDI flows to new members. Second, when it comes to agglomeration economies, these appear to play a somewhat more important role for the amount of investment made within the EU15. In addition, significant differences are found between the determinants of the extensive and intensive margins of the FDI decision.