Does resource dependence cushion the impact of thin capitalization rules on foreign investment inflows? Evidence from Africa
Introduction
Tax evasion and capital flight have caused Africa to lose USD 1.8 trillion since 1970 (Ndikumana, 2017) and continue to capture more than 2% of Africa GDP each year (Cobham and Janský, 2018). Multinational companies (MNCs) are responsible for 65% of this financial haemorrhage through trade misinvoicing and corruption (Baker et al., 2014). MNCs have indeed drained their profits towards jurisdictions offering significant tax reductions by exploiting the loopholes created in the host countries' tax shields by incentivizing policies to attract more foreign investment (UNDP, 2017). Unfortunately, even the expected outcome of these incentive tax policies has not been achieved. Since 1970, Africa has remained the least attractive region in the developing world in terms of foreign direct investment (FDI). In 2018, Africa attracted three and 11 times less FDI than America and Asia's developing economies, respectively (UNCTAD, 2020). Recent studies have argued that Africa reduced attractiveness due to institutions' weakness, which, moreover, justifies that the region has attracted more FDI in the extractive sectors (Feulefack and Ngassam, 2020; Jumanne and Keong, 2018; Sen and Sinha, 2017).
Since national tax provisions deduct interest to determine the taxable profit base, one of the many tricks is for MNCs to restrict equity to a minimum and finance much more by borrowing from subsidiaries or other related parties located in tax havens (Shay, 2017). To neutralize this trick, Ghana adopted in 2000 the thin capitalization rules (TCRs), limiting the deductibility of interest on the global debt or that of the related parties to a specific equity ratio. In 2006, Kenya then Mozambique and Rwanda in 2008 followed Ghana by introducing TCRs while mineral prices rose sharply. Several other mineral exporting countries, including the Democratic Republic of Congo (DRC), Namibia, Uganda, Zambia, and Zimbabwe, have also adopted TCRs after the fall of the world prices minerals from 2011 (Deloitte, 2019).
The results of the few studies identified suggest that introducing TCRs could effectively restrict the tax planning of multinationals. Indeed, the introduction or strengthening of TCRs has neutralized German's propensity (Buettner et al., 2012) and US multinationals (Blouin et al., 2014) to react to tax incentives. Also, the TCRs' enforcement led to an adjustment of the MNCs' capital structure and modification of their market value (Weichenrieder and Windischbauer, 2008; Overesch and Wamser, 2010; Wamser, 2014; Blouin et al., 2014). Logic, therefore, suggests that implementing TCRs should impact the investment of MNCs. Unfortunately, this concern has received very little interest. To the best of my knowledge, only two studies have examined this relationship. As a result, the TCRs hurt German multinationals' investments (Merlo et al., 2020), especially in OECD countries (Buettner et al., 2014).
Therefore, TCRs' effect on FDI inflows in Africa remains poorly understood, and this study seeks to fill this gap. In Africa, resource-rich countries are preferred destinations for FDI (Poelhekke and Van der Ploeg, 2013) and the primary capital flight sources (Ndikumana and Sarr, 2019). Given the positive correlation between FDI and capital flight in Africa (Ndikumana and Sarr, 2019), introducing TCRs should also significantly impact FDI inflows. However, the sensitivity of countries that have implemented TCRs to resource trends could mitigate the expected effects.
The sharp fall in mineral prices between 2011 and 2015 led to the collapse of African growth and the rise in budgetary pressures, exceeding USD 11 billion in some countries (King and Wood, 2016). As a result, Ghana, Zambia and Mozambique, for example, have requested support from the International Monetary Fund to fill the void created by the drastic drop in revenues (Pilling, 2016). Furthermore, to increase tax revenue, resource-rich countries have embarked on a race to the bottom, consisting of revising mining codes and contracts with extractive companies by granting more tax incentives (Third World Network Africa, 2016). In the past eight years, Zambia has changed its mining regime six times, modifying corporate tax and royalty rates. Ghana has also granted similar tax breaks to mining companies such as Goldfields. Besides, the DRC waited 13 years after adopting the transfer pricing provisions to apply them (ECA, 2017).
It should be highlighted that the increase in mineral prices between 2001 and 2011 led to a decrease in the share of government hold in several resource-rich countries. However, the profits of extractive firms increased disproportionately (Sachs et al., 2013). In 2011, the top 40 mining companies' earnings increased by 156% (PWC, 2011). Between 2002 and 2010, overall revenues from the African mining sector raised by a coefficient of 4.6, while the tax resources collected only increased by a factor of 1.15 (Laporte et al., 2015). Empirical evidence shows that a doubling of the oil price causes a 22% increase in haven deposits owned by petroleum-rich autocracies, meaning that around 15% of the windfall gains increased to petroleum-producing countries with autocratic rulers is diverted to offshore accounts (Andersen et al., 2017). More generally, potential exogenous shocks to revenues from natural resources under government control, including oil and mining revenues, are associated with significant increases in hidden wealth, especially when institutional checks and balances are weak (Andersen et al., 2017). Consequently, between 2002 and 2012, 22 African countries revised their tax systems to capture a more significant rent share (Sachs et al., 2013). Thus, African tax systems seem sensitive to trends in resources.
This study seeks to analyze how trends in mineral prices and rent affect TCRs' impact on FDI inflows into Africa.
This paper is organized into five sections. The second section presents some empirical studies, the third the methodological framework, while the fourth shows the results, and the last concludes.
Section snippets
A brief literature reviews
In the European Union, several studies show that the location of MNCs is negatively impacted by tax harmonization (Smith, 1999), tax competition (Mitchell, 2002), and the harvest rate (Hines, 1999; Gropp and Kostial, 2000; Desai and Hines, 2001). However, some studies argue that there is no effect (Cassou, 1997; Jun, 1994; Devereux and Freeman, 1995; Pain and Young, 1996; Bénassy-Quéré et al., 2005). Besides, Hassett and Hubbard (1997), Edmiston et al. (2003), Muller and Voget (2012), and
Model specification and data sources
The model developed by Feulefack and Ngassam (2020) to analyze the cross effect of natural resources and the quality of institutions on FDI inflows in African oil-exporting countries serves as the basis for the estimates in this study. The final expression of the model to be estimated is:where μi represents the fixed effects and εit is the error term. FDI inflows in logarithmic
How do fluctuations in mineral prices modulate the impact of TCRs on FDI inflows?
The results reported in Table 3 show that the thin capitalization rules (TCRs) harm foreign direct investment (FDI) inflows into Africa. The coefficients resulting from the estimates by the OLS and the fixed-effects are not significant. These two estimates are plausibly not very robust. Indeed, the impact of TCRs on FDI inflows becomes significant at the 5% level when simultaneity and endogeneity biases are controlled and corrected through the system-GMM estimator. Thus, everything else being
Conclusion
The need for resources to finance development has led African countries to grant substantial tax breaks to MNCs. This policy's unexpected downside is the capital flight, which tears more capital from Africa than the total funds from abroad. The introduction of TCRs by a dozen African countries suggests that their relatively insignificant attractiveness will be definitively compromised. But then, noting their dependence on mineral resources, it appeared the hypothesis that the impact of TCRs in
Authorship statement
I, FEULEFACK KEMMANANG Ludovic, certify that I have carried out: the Conceptualization, conception and design of the study, Funding acquisition, acquisition of data, Formal analysis, analysis and interpretation of data, drafting the manuscript, revising the manuscript critically for important intellectual content.
Acknowledgements
I am indebted to the anonymous referees who reviewed the paper and provided comments and suggestions that helped in shaping and improving the overall quality of the article. The findings made and opinions expressed in this paper are exclusively those of the author and cannot in any way be attributed to UNECA. The author is also solely responsible for the content and any errors.
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