Does resource dependence cushion the impact of thin capitalization rules on foreign investment inflows? Evidence from Africa

Highlights

• Foreign direct investment (FDI) inflows to Africa increases substantially with the rise in prices and rents of minerals.

• Thin capitalization rules (TCRs) negatively impact foreign direct investment inflows into Africa.

• There is a breaking point at which any increase in the price or rent of minerals absorbs the negative impact of TCRs on FDI.

• When the mineral price moves below 103.54 and mineral rent is less than 28.32% of GDP, TCRs undermine African attractiveness.

Abstract

Due both to the prevarication of political elites and to tax evasion and capital flight by multinationals, Africa's development has not benefited as much from the continent's mineral resources as it should have. The thin capitalization rules (TCRs) implemented by several mineral resources rich-countries to alleviate this concern seem contradictory to the attractiveness policies in force, which results in multiple tax cuts, especially when the shocks observed on mineral prices lead to budgetary pressures. This study investigates how changes in mineral prices and rents affect the impact of TCRs on foreign direct investment (FDI) inflows into Africa. The analyzes are carried out through the two-step systems GMM, using data from 33 cross-countries between 2005 and 2018. Consistently with the assembled literature, the study finds that TCRs harm FDI inflows. This study provides an additional contribution by showing a breaking point from which the rise in the price and the rent of minerals becomes a shield that fully absorbs the negative impact of the TCRs on multinationals' decision to settle. The price and the resulting breaking income are such that the negative impact of the TCRs on FDI inflows is overcompensated when, on average for the sample, the mineral price index goes beyond 103.54 or whenever the mineral rent exceeds 28.32% of the host country's GDP. These results are robust when controlling for the efficiency of government in revenue mobilization. The study shows that resource-rich countries in Africa should consider promoting the non-extractive sector's attractiveness in anticipation of the depletion of mineral reserves.

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.