Taxes Are The Price For Civilization Finance Essay - Free Essay Example

à ¢Ã¢â€š ¬Ã…“I like to pay taxesà ¢Ã¢â€š ¬?, said Oliver Wendell Holmes Jr, à ¢Ã¢â€š ¬Ã…“with them I buy civilisationà ¢Ã¢â€š ¬?. Taxes are the fuels that make civilization run. There is no civilization in the world history that did not have tax. The first civilization we know anything about 6000 years ago in Sumer, a fertile plain between the Tigris and Euphartes rivers in Iraq (Adams, 2001). The dawn of history and tax history is recorded on clay cones excavated at Lagsah, in Sumer. Taxation has powerful influence on several events of history that have marched across the worlds stage and the collection of tax is the factor for many sweeping changes of civilisations in the world. Taxation played a fundamental role in ancient international politics. The struggle over the extraction of taxes between the rulers and the ruled has been one of the longest and most keenly fought contests in the world history. Monarchies were overthrown by revolution and governments were brought to a violent end on tax recovery issues. Empires battled for the right to tax the loser. The rebellion in America that became the Revolutionary War is often dated to the Boston Tea Party, which was motivated by the conviction that unjust taxes were being levied on the colonies. The slogan à ¢Ã¢â€š ¬Ã…“Taxation without representation is tyrannyà ¢Ã¢â€š ¬? provided one of the central motifs of the revolution. 1.2 Tax is an enforced contribution Unlike most transfers of money from one individual to another, which are entered into voluntarily, tax is an enforced contribution, extracted pursuant to sovereign authority of the state. The variety of taxes, that the governments have levied, is huge. There were taxes on earnings, properties, business transactions, gifts, sale of securities, dividends and even on death etc. Taxes can be broadly classified into two broad categories i.e. direct taxes on individuals corporations and indirect taxes on goods and services. Earlier the tax policy in any country was conceived in a clearly separated national market as there were having restricted cross border transactions. Accordingly, taxation systems are introduced and developed primarily to address domestic economic and social concerns. The forms and levels of taxation were established on the basis of the desired level of publicly provided goods and transfers, with regard also taken to the allocative, stabilising and redistributive aims which are considered to be appropriate for a country. At that time the international dimension of tax structure of a country was limited to the amount of tax imposed on foreign source income (income generated outside) of residents of the country and the domestic income of non-residents. 1.3 It takes more brains and effort to evade taxes than it does to make the income. The efforts of the subordinate population to escape taxation imposed by the state have been a consistent feature of human society since first known system of taxation was introduced in ancient Egypt. Tax evasion practices usually involve an individual or a corporation who misrepresent their income to the State by dishonest means, including declaring less income, profits or gains than they actually earned or by exaggerating deductions, or hiding money. Over a period of time the society has witnessed abuse of intellectual ingenuity and sophisticated financial wizardry in evading taxes. With globalisation o f economy and financial integration, the state has witnessed several tax evasion schemes involving tax heavens. A tax haven is a low-tax country or territory where individuals or corporations shift their income to avoid the taxes of their home location. By channeling investments or passive income (e.g. interest) through foreign entities, some individuals evade taxes illegally by not reporting these assets or income on their tax returns. 1.4 Globalisation and the Battle for World Economy. The process of globalization of economy led to greater economic integration across the national borders and generated opportunities for economic growth, technology transfers, flow of capital and free trade (Bhagwati, 2004). Globalization is primarily a monetary phenomenon in which expanding liquidity induces investors to take more à ¢Ã¢â€š ¬Ã…“risksà ¢Ã¢â€š ¬? in investing in underdeveloped markets with anticipation of higher investment return. Under this argument, globalization is cons trued as being initiated not by political or social motives, but by investors economic incentives. Thus one of the conspicuous consequences of globalization as well as deregulation and liberalization is the mobility of capital (Daniel Yergin, 1998). Over the last two decade, this changing global economic and political environment has led to spectacular growth in global Foreign Direct Investment (FDI in short) flows since 1990s. During eighties the majority of the developing economies were undergoing severe financial constraints following the borrowing binge and the breaking down of normal financial relations. This has translated into a sharp decline in investment and growth rates in these economies. This resulted in the growing importance of FDI as a relatively reliable source of capital flows for the developing countries. The other major channel of attracting capital is allowing investments in capital market through Foreign Portfolio Investments (FPI in short). The foreign po rtfolio investment is the flow of capital a country where non-residents invest in the countryà ¢Ã¢â€š ¬Ã¢â€ž ¢s stock and bond markets, usually for speculation. It is a short term investment, as opposed to Foreign Direct Investment which is a longer term partnership, usually involving participation in the management through joint-venture, transfer of technology and know-how. Concurrently, the à ¢Ã¢â€š ¬Ã‹Å"mobility of capitalà ¢Ã¢â€š ¬Ã¢â€ž ¢ and advent of foreign capital has changed the basic relationship amongst domestic tax structure. 1.5 Harmful Tax Competition an Emerging Global Issue Decisions to undertake FDI, by multinationals are usually complex since they involve strategic decisions. For a multinational that seeks to maximize the value of the firm, FDI is attractive if the so-called OLI conditions are met, referring to Ownership, Location and Internalisation. It is à ¢Ã¢â€š ¬Ã‹Å"taxesà ¢Ã¢â€š ¬Ã¢â€ž ¢ that can affect all three OLI conditions. For instance, i t can affect the tax treatment of a foreign firm, relative to domestically owned firms. The tax rate can also be a factor that determines the attractiveness of a location for undertaking investments. Because governments are competing with another for scarce capital, they are compelled to adopt market friendly or even investor friendly policies for fear of seeing capital locate in or relocate to other jurisdictions. As there is increased competition among business houses in the global market place to corner higher market share and more profit they look for new ways by which they can minimise and avoid taxes. This has led to negative effects of opening up new ways which countries exploit these new opportunities by developing tax policies aimed primarily at attracting financial and other geographically mobile activities. These create harmful tax competitions between States, carrying risks of distorting trade and investment and lead to the erosion of national tax bases (OECD, 1998). Most studies of harmful tax practices and race to the bottom, focus on potential host countries competing for mobile capital, neglecting the role MNEs, of the corporate tax planning and of home governments facilitating this planning. 1.6 Cross Border Transactions State Control The cross border financial flows have outpaced states capacities to control it. Consequently the State has less control over the economic outcome (Jeffery, 1997). The ability of Multi National Enterprises (MNEs in short) to adjust their scale of operation, character and location of their worldwide operations, had opened up new avenues by which companies can evade or avoid taxes. The recent studies indicate that taxes exert a strong influence on location decision of MNEs (Rosanne Altshuler, 2001). Some countries exploit these new opportunities by developing policies and acted as conduit of capital diversion (ViherkenttÃÆ' ¤, 1991). These unhealthy competitions induce potential distortions in the pa tterns of investments and erode national tax bases of other countries (OECD, 1998). We have noticed proliferations of tax havens, indulgence of multi nationals in transfer mispricing, cases of capital flight, mispriced financial transfers, round tripping and massive tax frauds. 1.7 Capital Inflows into India: With the process of globalization and under the liberalized foreign exchange transactions regime the composition of capital inflows to India has changed significantly over the years. Dependence on aid has vanished and foreign direct investment (FDI), foreign portfolio investment (FPI), external commercial borrowings (ECB) and nonresident Indians (NRI) deposits dominate the capital flows. Among these again, there has been a gradual shift away from debt components to equity flows (the proportion of non debt has gone up from about 2% in the second half of the 1980s to over 60% during the 2007-08). [Fig 1: COMPOSITION OF CAPITAL FLOWS in 1990-91 and 2007-08] The pattern of Foreign Direct Investments (FDI) in India subsequent to the adaptation of policy of economic liberalization revealed the investment practices of Multi National Corporations. In early nineties Foreign Direct Investments (FDI) are allowed in various sectors and also Overseas Corporate Bodies (OCBs) and Foreign Institutional Investors (FIIs) were allowed to participate in the capital market.  TABLE1: COMPOSITION OF CAPITAL FLOWS (NET)  Item 1990-91 1995-96 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08PR 2008-09P  1 2 3 4 5 6 7 8 9 10 11  Total Capital Flows ( Net) (US $ mn) 7,056 4,089 8,551 10,840 16,736 28,022 25,470 45,203 107,993 9,146  Percentage share in total net flows  1 Non- Debt Creating Inflows 1.5 117.5 95.2 55.5 93.7 54.6 84.0 65.8 58.9 231.0   a) Foreign Direct Investment 1.4 52.4 71.6 46.5 25.8 21.4 34.9 50.3 31.7 382.5   b) Portfolio Investment 0.1 65.1 23.6 9.0 67.9 33.2 49.1 15.5 27.2 -151.5  2 Debt Creating Inflows 83.3 57.7 12.4 -12.3 -6.0 35.2 41.0 64.2 38.9 87.2   a) External Assistance 31.3 21.6 14.1 -28.6 -16.5 7.2 6.9 4.0 1.9 28.9   b) External Commercial Borrowings 31.9 31.2 -18.6 -15.7 -17.5 19.4 10.8 36.4 21.0 75.9   c) Short term Credits 15.2 1.2 -9.3 8.9 8.5 13.5 14.5 14.6 15.9 -63.4   d) NRI Deposits 21.8 27.0 32.2 27.5 21.8 -3.4 11.0 9.6 0.2 46.9   e) Rupee Debt Service -16.9 -23.3 -6.1 -4.4 -2.2 -1.5 -2.2 -0.4 -0.1 -1.1  3 Other Capital 15.2 -75.2 -7.6 56.8 12.3 10.2 -25.0 -30.0 2.2 -218.2  4 Total (1 To3) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0  Source: RBI report on Currency and Finance 27/08/09 1.8 Development of Mauritius Route According to figures available with the Department of Industrial Policy and Promotion, of the total $98 billion foreign direct investment (FDI) that has come into India since April 2000 (till August 2009), $43.14 billion was routed through the Mauritius  [2]  . Though India has a Double Taxation Avoidance Agreement with several developed and rich countries, it is Mauritius which is the most preferred route for FDI inflows. A closer scrutiny will reveal that tax exemptions have been a major factor for companies routing their investments into India through Mauritius. By routing the investments through Mauritius the effective tax rate comes to around 3% only against expected rate of 33%. Further, it was also revealed that Mauritius-based foreign institutional investors (FII) are also major players in the Indian capital markets  [3]  . In spite of earning substantially in share transactions these FIIs neither have paid any taxes in India (due to India Mauritius tax conventio n) nor at Mauritius (no capital gains tax as per their domestic law). There are several such instances where it is found that the residents of the third states attempted to avail benefits of the bilateral tax treaty between India and Mauritius. There are also instances of misuse of other tax treaties in varying measures as well. As discussed earlier these schemes are designed to evade taxes which will ultimately result in erosion of tax base. This will also seriously affect the tax structure as there will be tendency to shift the tax burden from mobile to relatively immobile factors. Thus it is the time to take effective policy measures to counter such moves, as many more arrangements and agreements would be subject to atrocious misuse. This dissertation attempts to address the problem faced by India in the form of treaty shopping from the policy formulation perspectives. 1.9 OBJECTIVES OF THE RESEARCH: What drives FDI to a country and how important is the tax factor in this decision? On the backdrop of above facts and studies, the trends of foreign direct investment (FDI) flows since 1991-92 are examined to explore the reasons behind these trends and the role of multinationals and their investment activities are ascertained. One main objective is to provide a review of empirical studies of the effects of taxation on FDI flows, with the aim of better understanding what factors explain variations in estimates of the sensitivity of FDI to taxation. The second main objective is to evaluate economic policy considerations guiding the treatment of cross-border investments (inbound and outbound FDI). The third objective is to develop an approach for incorporating commonly employed cross-border tax-planning strategies in standard tax rate models used to identify tax distortions to investment. Do Double Taxation Avoidance Agreements attract more FDI to India? Blonigen and Davies (2004) in an analysis of bilateral FDI outflows and outbound stocks from OECD countries to other countries during the period 1982à ¢Ã¢â€š ¬Ã¢â‚¬Å"92 noticed that there is no statistically significant effect that bilateral tax treaties affect FDI activity, despite statements by the OECD and other sources that such agreements are meant to increase efficiency of world capital flows. Instead, their results suggest either that the provisions of a treaty have no effect or that the positive and negative aspects of treaty formation largely cancel one another (BLONIGEN DAVIES, 2004). Developing countries like India signed double taxation avoidance agreements (DTAAs) in order to attract more foreign direct investment (FDI). They succumb to restrictions on their ability to tax corporate income from foreign investors, which can only pay off if more FDI is the reward. But do DTAAs attract more FDI to India? As mentioned in preceding paragraphs majority of FDIs are ro uted through Mauritius, a quasi tax haven. The beneficial provisions of the DTAA with Mauritius are being exploited to take unfair advantages. Hence a study of à ¢Ã¢â€š ¬Ã‹Å"double taxation conventions and the use of conduit companiesà ¢Ã¢â€š ¬Ã¢â€ž ¢, on FDIs coming to India is being made. The study will test a hypothesis that tax incentives (especially in promoting EOUs and SEZs) play a significant role in determining the inflow of FDI to host countries. The study will also touched upon the investment behaviour of firmà ¢Ã¢â€š ¬Ã¢â€ž ¢s towards tax policies and other determinants of FDI. Analysis of trends in cross border mergers acquisitions and business re-organization from tax avoidance point of view. In the era of globalisation one of the modus of FDI is through mergers and acquisitions (MA). The boom in cross-border MA has given new urgency to understand the complex consequences such as the merger activity has been a major cause of rising concentration, mergers have been major instruments of growth by firms and often involve large scale financial outlays and economic theories relating to profit maximization consequent to M A etc. There are numerous studies on this count. However the MA strategy can also be utilized as an instrument of tax evasion and there are no studies in this regard  [4]  . Thus the trends in cross border mergers acquisitions and business re-organization from tax avoidance point of view are analysed. 2.0 RESEARCH QUESTIONS/HYPOTHESIS What is the qualitative response of FDI in response to a change in tax policy? The relative role of taxes in determining the level of FDIs inflows to India in comparison to other factors of FDI. How does the foreign investorà ¢Ã¢â€š ¬Ã¢â€ž ¢s countryà ¢Ã¢â€š ¬Ã¢â€ž ¢s double taxation relief system affect the response of FDI in India to effective tax rate? What is the response of establishment type FDI to average effective tax rate? Whether the international transfer pricing (ITP) is used by multinational enterprises (MNEs) to minimize incidence of tax liability in India? CHAPTER II REVIEW OF THE LITERATURE The changing global economic and political environment has led to rapid and steady growth in global FDI flows. A wide range of variables have been studied and observed to be significantly correlated with FDI in different directions in different studies. A vast empirical literature has developed around the issue of determining the forces attracting FDI. These studies have used cross-country regressions to search for empirical linkages between FDI and a variety of economic variables. 2.1 Taxes exert a strong influence on inflow of Foreign Direct Investments: Most of the literature on the issue of tax sensitivity of FDI comes to a general conclusion that taxes have statistically significant effect on inflow of foreign direct investments. But most of these researches have focussed on investment to and from the United States. Hartman (Hartman, 1985) made the first contribution and found that taxes, through their effects on after tax rates of return, could significantly affect the level of FDI in the United States. Subsequently, Grubert and Mutti (Grubert H. J., 1991) had performed empirical analysis to determine i. the ability of MNCs to shift profits from high-tax countries to low-tax countries, ii. the effect of host country taxes and tariffs on the distribution of real capital, and iii. the influence of these policies on the international trade patterns of the United States and host nations. Their results indicate that taxes and tariffs have a strong effect on MNC operations. The observed pattern of reported profits in high- and low-tax countries is found to be consistent with income-shifting behavior. It appears that U.S. imports and exports are greater to and from low-tax countries where MNC investment is greater. Altshuler and others (Altshuler, 2001) pointed out that American multinationals are more sensitive to taxes on FDI and quantified that countries with an increase of 10 percent in their tax rates received 30 percent less American direct i nvestment. Similarly, Gropp and Kostial (Gropp, 2000) found strong evidence that FDI is affected by tax factors. It was found that, of the countries examined, those with lower taxes had larger inflows of FDI than those with higher taxes. They also note the trend that the competitive market for FDI causes countries to systematically lower their corporate tax rates and thus erode the tax base Jackson, S. and S. Markowski (Jackson, 1995) empirically examined how taxes shape foreign direct investment, and found that increased taxes spur inward foreign investment. This finding conforms to theories that recognize that foreign investor response is critically shaped by the tax provisions faced by the foreign investor in his home country, and by the effects of tax reform on pre-tax asset returns. The effects of policy and non-policy variables on the location of U.S. direct investments abroad were comprehensively examined by Loree (Loree, 1995). His results indicate that the location is affected by investment incentives (positive), performance requirements (negative), and host country effective tax rates (negative). A study was conducted by Billington (Billington, 1999) to examine the factors that determine the choice of location for foreign direct investment. Data were drawn by him from two models: a multi-country model comprised of seven industrialized countries and a multi-region model consisting of the 11 regions of the U.K. Both models seek to incorporate all those location factors that previous work has shown to be potentially significant. He concluded that corporate tax and interest rate are substantial determinants of location of foreign direct investment. According to Gordon and Hines (Gordon, 2002), à ¢Ã¢â€š ¬Ã…“Tax policies are obviously capable of affecting the volume and location of FDI, since, all other considerations equal, and in the absence of countervailing effects, higher tax rates reduce after-tax returns, thereby reducing incentives t o commit investment funds.à ¢Ã¢â€š ¬? Harry Grubert and John Mutti (2000) used data from tax returns of more than 500 U.S. multinational corporations to identify the role of host country tax rates in determining the amount of capital invested in 60 potential locations. The empirical results show that average effective tax rates have a significant effect on the choice of location and the amount of capital invested there. A lower tax rate that increases the after-tax return to capital by one percent is associated with about 3 percent more real capital invested if the country has an open trade regime. The attractive power of low tax rates is weakened if the country has a more restrictive trade regime. It claimed that approximately 19 percent of U.S. capital abroad would be in a different location in the absence of any effect of taxes. Bellak et. al (Bellak, 2007) also agree that changes in the corporate tax rate are negatively correlated with FDI inflows. They also say that chan ges in the tax rate become less effective at attracting FDI as a nationà ¢Ã¢â€š ¬Ã¢â€ž ¢s infrastructure becomes more developed. Desai and Hines Jr. (Desai, 2001) studied the effect of taxes other than the corporate income tax. They inferred that taxes other than income taxes significantly affect the pattern of income production by multinational firms by altering their investment and transfer-pricing incentives. They also said that governments are likely competing actively for FDI using their other tax rates as differentiation. Mooij and Ederveen (Mooij, 2001) took the analysis a step further and calculated that a 1% chance in corporate income tax rate corresponds to 3.3% decrease in FDI inflows. They also argue that marginal or average tax rates have more of an impact on investment decisions than the statutory base rate does. Cummins and Hubbard (Cummins, 1994) argued that tax parameters influence foreign direct investment in precisely the ways indicated by neoclassical models. Hines Jr. (Hines Jr, 1993) was unique in that it looked at investment decisions for individual U.S. states. It found that the same patterns found in country-level data held true for states, pointing out that high corporate income tax rates had a negative effect on a stateà ¢Ã¢â€š ¬Ã¢â€ž ¢s investment flows from other states. Eggerat (Egger P. e., 2007) had findings consistent with most empirical studies. They observed that unilateral tax rates significantly affect the production and location decisions of multinational firms. However, their paper goes on further to explain that bilateral tax rates (the tax rate of the host country in relation to the investing country) are also very significant for investment decisions. Overall, the general consensus is that corporate income tax rates do in fact have a statistically significant effect on foreign investment decisions. The observed effects of tax on FDI as observed by various authors are given in the following table. OBSERVED EFFECT OF TAX ON FDI IN DIFFERENT STUDIES Negative Positive Insignificant Hartman (1984) Grubert and Mutti (1991) Hines Rice (1994) Loree Guisinger (1995) Guisinger (1995) Cassou (1997) Kemsley (1998) Barrel and Pain (1998) Billington (1999) Swenson (1994) Wheeler Mody (1992) Jackson Markowski (1995) Yulin Reed (1995) Porcano Price (1996) 2.2 Different types of Foreign Direct Investments respond differently to taxes FDI comprises several types of capital such as i. real investment in plant and machinery (PM), either in the form of new plant and equipment or plant expansions, ii. financial flows associated with mergers and acquisitions. This involves a change in ownership without any real investment taking place  [5]  and iii. joint ventures and equity increases etc. The latter component typically comprises investment in financial capital. The distinction between the different types of FDI is important be cause the different components may respond differently to taxes. (Auerbach and Hassett, 1993). 2.3 The Effects of Bilateral Tax Treaties on FDI Flows: The return to foreign direct investment may be subject to international double taxation. In particular, a foreign subsidiary is always subject to corporate income tax in the host country. These profits of the subsidiary can be taxed again under the corporate income tax in the home country of the parent. As this international double taxation would strongly discourage international business activity, most countries avoid it by means of bilateral tax treaties based either on the OECD or UN Model Tax Convention. Bruce A. Blonigen and Ronald B. Davies (2000) estimated the impact of bilateral tax treaties using both U.S. inbound and outbound FDI over the period 1966-1992 and their estimates suggest a statistically significant average annual increase of FDI activity for each additional year of a treaty which ranges from 2% to 8%. Ex amination for nonlinear effects of treaty age on FDI activity suggests that while treaties have an immediate impact on FDI flows, there is a substantial lag before treaty adoption positively affects FDI stocks and affiliate sales. Finally, they conclude that bilateral tax treaties have an effect on investment outside of the withholding tax rates they alter, which may include the commitment and risk reduction effects of these treaties. In their subsequent paper (Bruce A. Blonigen, 2002), they explore the impact of bilateral tax treaties on foreign direct investment using data from OECD countries over the period 1982-1992 and suggest that recent treaty formation does not promote new investment. However they had indicated that treaty formation may actually reduce investment as treaties are intended to reduce tax evasion rather than promote foreign investment. Millimet and Kumas (Kumas, 2007) provide a theoretical framework illustrating why the impact of tax treaties may be heterogen eous across the distribution of FDI, and thus why focusing on the average effect of tax treaties may be misleading. They had indicated that there are positive effects of tax treaties at lower quantiles of the distribution of FDI, but negative effects in the upper quantiles. Moreover, while the negative effects are substantially larger in absolute terms relative to the positive effects. Davies (Davies, 2009) reported that, tax treaties appear to have little impact on the level of FDI activity. However, his findings reveal that tax treaties increase the probability of a Swedish multinational having an affiliate in a given country. Findings suggest that the impact of treaties might be greatest due to their effect on issues of uncertainty rather than by adjusting the effective tax rates that companies face. Peter Egger (2006) (Egger P. , 2006)investigated the effect of tax treaties on bilateral stocks of outward FDI. For this purpose he employed a numerically solvable general equi librium model of trade and multinational firms to study the impact of tax treaties on both welfare and outward FDI. The model indicates under which factor endowment configurations countries gain in welfare when implementing a tax treaty. This motivates an empirical specification of the endogenous selection into implementing new tax treaties. Using data of bilateral OECD outward FDI between 1985 and 2000, he found a significant negative impact of newly implemented tax treaties on outward FDI stocks. 2.4 There is a perception that FDIs is taking advantage of tax havens and thereby paying less taxes in host countries: Some of the studies conducted at United States revealed that American firms locate a significant part of their foreign operations in à ¢Ã¢â€š ¬Ã‹Å"tax havensà ¢Ã¢â€š ¬Ã¢â€ž ¢ (a group of countries with unusually low tax rates) that has been extremely successful at attracting US business. It was observed by James Hines and Rice that the tax haven affiliates of Amer ican corporations account for more than 20 percent of U. S. foreign direct investment, and nearly a third of the foreign profits of U. S. firms. American companies report extraordinarily high profit rates on their tax haven investments. This behavior implies that the revenue-maximizing tax rate for a typical haven is around 5-8 percent. (JAMES R. HINES, 1994). Sometimes the response of FDI to corporate profit taxation is unnoticeable due to the use of transfer pricing and intra-firm debt contracting allows firms to shift profits where taxation is the lowest, therefore disconnecting the location of profit and production. Secondly, location decisions depend on the combination of taxation and public goods provision available in host countries (Tiebout, 1956), which can soften the link between the tax level and the amount of FDI located in a country. Randall Morck and others (Randall Morck, 2008) indicated that Chinas outward foreign direct investment is biased towards tax havens and Southeast Asian countries. The top destinations are Hong Kong and Caribbean tax havens, which account for about 80% of the flow. FDI into these locations by Chinese firms might also be designed to hide wealth from tax authorities, other authorities, or even public shareholders. The tax havens provide confidentiality to foreign investors and so are commonly used by multinational firms to store wealth beyond the purview of tax authorities (Harris, 1993). Rosanne Altshuler and Harry Grubert (Grubert R. A., 2005) studied the evolution of tax burdens on US companies abroad. They had used various types of U.S. data, including firm level tax files, to identify the role of three stake holders such as host governments, home governments and multinational companies. The evidence indicates in the early part of the period, from 1992 to 1998, the decline in tax burdens seemed primarily driven by the host countries desire to compete and defend their market share. From 1998 onwards the ta x planning by the companies seems much more significant, facilitated by more permissive U.S. rules introduced in 1997. Effective tax rates on U.S. companies had a much weaker link with local statutory tax rates. Furthermore, the disparity in the reported profitability of subsidiaries in high-tax and low-tax jurisdictions grew substantially. After 1997, there was a very large growth in intercompany payments and a parallel growth of holding company income. They had made an estimate how much of these payments were deductible in the host country and conclude that by 2002 the companies were saving about $7.0 billion per year by using the more aggressive planning strategies. This amounts to about 4% of foreign direct investment income and about 15% of their foreign tax burden. The changes in tax rates during the 1984-90 period led to global income shifting by U.S. multinational firms (KLASSEN, LANG, WOLFSON, KLASSEN, K.; M. LANG; AND M. WOLFSON. Geographic Income Shifting by Multinati onal Corporations in Response to Tax Rate Changes, 1993). Regression results indicated that income was shifted to the U.S. from Canada and from the U.S. to Europe in 1985-86, due to higher Canadian rates and lower rates in Europe. In 1987, with rates lower in the U.S. and relatively constant elsewhere, income moved to the U.S. Results generally showed shifting from U.S. to non-U.S. units other than Europe and Canada in 1988, perhaps due to tax cuts in countries such as Australia and Japan. For 1989, results show shifts to Canada from other non-U.S. units after large cuts in Canadian tax rates Most of these studies relating to effects of taxation on both inward and outward foreign direct investment have focused exclusively on FDI in the United States. There are not enough studies to comprehend impact of taxation on Foreign Direct Investments in India or any other developing countries. CHAPTER 3 THEORETICAL FRAMEWORK At the centre of policy debate over the appropriate corporate tax rate on business profit in the host country, is the difficult question of the sensitivity of FDI to corporate taxation. Addressing this question is critical to an assessment of how best to address competitiveness pressures and avoid capital relocation, while also central to cost/benefit assessment of tax relief and to estimates of the revenue response to a corporate tax policy reform. 3.1 MACROECONOMIC STUDIES Most of the empirical literature on the effects of taxation on both inward and outward foreign direct investments has focused exclusively on FDI in the United States. Interest in this topic has been stimulated by the unexpected increase in the late 1980s of FDI into the US. This is one of the factors led to promulgation of Tax Reforms Act 1986 in US. Empirical study of the effect of taxation on the time series of FDI in the U.S. was initiated by Hartman (Hartman, 1985). Hartman estimate the following equation for FDI (denoted as I*) ln(I*)= a + a1ln[r(1-t)]+a2ln[r0(1-t)]+a3ln[(1-t0)/(1-t)] where [r(1-t)] is the measure of return on inbound FDI after corporate tax rate  [6]  . According to Hartman, this reflects the impact on new investment; [ro(1à ¢Ã¢â€š ¬Ã¢â‚¬Å"t)] measures is the gross rate of return on investment in the US, reduced by the US tax on FDI. This variable is said to reflect the effect of acquiring existing capital on which no extraordinary return is earned. The third term on the right hand side of the equation ln[(1-t0)/(1-t)] is a relative tax term, capturing a valuation effect and t denotes the average US corporate tax rate (assumed to be equal for foreign and domestic firms), and to denotes the average US corporate and personal tax rate on income from capital. Variables enter the equation in natural logarithms (ln) to facilitate elasticity computations. Using annual data from 1965 to 1979, Hartman estimated the response of FDI, separately for investment financed by retained earnings and transfers from abroad, to three variables: the after-ta x rate of return realized by foreign investors in the U.S., the overall after-tax rate of return on capital in the U.S., and the tax rate on U.S. capital owned by foreigners relative to the tax rate on U.S. capital owned by U.S. investors. The first two terms are meant to proxy for the prospective return to new FDI, the first term being more appropriate for firms considering expansion of current operations and the second more applicable to the acquisition of existing assets which are not expected to earn extraordinary returns based on production of differentiated products or possession of superior technology. The relative tax term is designed to capture the possibility that tax changes which apply only to U.S. investors will, by affecting the valuation of assets, alter the foreign investors cost and therefore the return to acquiring the asset 3.2 A number of subsequent papers have extended or modified Hartmanà ¢Ã¢â€š ¬Ã¢â€ž ¢s paper. Boskin and Gale (Boskin, 1987) extend the Har tman analysis by using a longer time series from 1956 -1984 using revised average tax rate. They also experiment with a linear instead of a log specification. The results of Boskin and Gale more or less confirm the main findings of Hartman, i.e. the impact of US taxes on retained earnings is more robust than the impact on transfer of funds. Young (Young, 1988) also extends the Hartman analysis by means of a somewhat longer sample period from 1953 1984, a slightly different specification. He used revised data on investment, GNP and rates of return earned by foreigners to estimate similar equations. These changes increase the estimated elasticities with respect to the rate of return realized by foreigners and the respective rate of return. He used the following model: ln(I*) = a0 + a1ln[r(1-t)] + a2ln[r0(1-t)] + a3ln[(1-t0)/(1-t)]+ a4lnGNP+a5ln FDI Using a corrected after-tax rate of return series, Newlon finds that the estimated coefficients are unstable and sensitive to the time period considered. When considering years 1965-73, he finds that the investment equation explaining transfers of funds fits better than the one explaining retained earnings, reversing the earlier findings. When the interval is changed 1956-1984, the equation explaining transfers of funds performs poorly, and no estimated coefficient is found to be significant. It is notable that none of these studies has deviated very far from the approach taken in Hartmans 1984 paper. Thus the Hartman model will be adopted for study of impact with some modifications. 3.3 In one of the comprehensive studies of the tax rate sensitivity of total foreign earnings, Grubert and Mutti [1991] (Grubert H. J., 1991) examine aggregate data on U. S. manufacturing affiliates in 33 foreign countries. They regresse two profit rate measuresà ¢Ã¢â€š ¬Ã¢â‚¬ the ratio of profits to local sales, and the ratio of profits to local equityà ¢Ã¢â€š ¬Ã¢â‚¬ on local tax rates. The results suggest that reported profits are sensitive to tax rate differences. 3.4 MICROECONOMIC STUDIES Unlike most other studies that concentrate on the macro level study of the sensitivity of FDI in host countries, a micro level approach by looking into several particular industries may also be tried. In most multinational firms, there is a significant amount of intra firm trade. When a multinational parent provides a service or sells a non-marketed good to a foreign subsidiary, a transfer price has to be charged. If market prices are not available, multinational firms may distort the transfer price from the price that would be charged by two independent businesses in order to shift taxable income to the jurisdiction where taxes are lower. Another method commonly used by multinationals that allows profits to be shifted is to move debt to the high-tax jurisdiction. There are several models to study the income shifting behavior of firms through transfer pricing such as models proposed by Horst (Horst, 1971), Copithorne (Copithorne, 1971) and Eden (Eden, 1978) etc. CHAPTER 4