Multinational Investment in Developing Countries

A Study of Taxation and Nationalization

Thomas Andersson

• Publisher: Routledge
• Year: 2002
• Print ISBN:
  9780415062190
• eBook ISBN:
  9781134925360
• Topic: Business
• Subtopic: Business General
• Index: Business

This book explores the struggle for gains from direct investment between multinationals and developing countries. It discusses which policies work best in influencing the behaviour of MNEs and how developing countries compete with one another for multinational investment. It argues that the tax regimes of different countries rarly deter investors but that nationalisation acts as a powerful disincentive. It also concludes that governments should not be expected to sacrifice the environment to attract multinationals.

Part I
Introduction

1 Statement of the issues

INTRODUCTION

A considerable proportion of the flows of goods and factors between countries takes place within multinational enterprises (MNEs).¹ As an operative definition we associate this with firms which own and control income generating assets in more than one country (cf. Buckley and Casson 1985). A subsidiary owned and controlled abroad is established through direct investment. According to conventional theory, discussed in Chapter 2, direct investment is motivated by specific advantages associated with ownership, combined with advantages in internalization and inter-country differences in factor costs and technology (Dunning 1977).

A more profound understanding of MNEs is certainly needed, but can in any case explain only half the impact of (foreign) direct investment on resource allocation and social welfare. This depends on the behaviour of firms, as well as that of countries. Although political motives certainly matter for countries’ behaviour, there is considerable evidence that economic factors are of great importance. With sovereign nation states, there are no universal or reliable rules for the division of profits across national boundaries.

Beginning in the 1970s, there has been a general change of course in economics. It has become clear that, in an imperfectly competitive world, the actions of one agent affect others, and that this interaction is taken into account by everybody when acting. Traditional ‘structural’ approaches have now become supplemented by ‘strategic’ ones, which allow agents to adapt to changes in each others’ behaviour. The analytical tools have gradually been refined. New insights into the role of expectations, the nature of equilibria, sequential bargaining and time consistency have revised our view of, for example, monetary and fiscal policy, public finance and inter-country policy co-ordination (see, for example, Selten 1975; Lucas 1976; Kydland and Prescott 1977; Rubinstein 1982; Binmore and Herrero 1984; Shaked and Sutton 1984; Barro and Gordon 1986).

There has been a similar revision of the view of international capital flows. Following Eaton and Gersovitz (1981), imperfections in the standard model of international borrowing have been examined in a number of studies (Sachs and Cohen 1982; McFadden et al. 1985; Hajivassiliou 1987; Bulow and Rogoff 1989a). Much of this literature is concerned with interaction between sovereign debtor nations and perfectly competitive creditors. Concerning direct investment, Hartman (1985) and Newlon (1987), among others, have investigated home country behaviour in the form of tax treatment of foreign source income. Hines (1987) has taken into consideration the response of host country governments to US tax increases. Most opportunities for strategic behaviour prevail in the interaction between countries and large firms, however, especially as improved information and administrative capacity enhance the ability of governments to discriminate policies between firms. The most palpable influence is likely to be exerted by host countries whose gains to some extent directly offset the profits of MNEs.

Clarifying the consequences of strategic interaction between MNEs and host countries should be an important research agenda for the ‘new course’ in economics. This is particularly important for the developing countries, which are host to some 25 per cent of the world’s direct investment but home to only about 3 per cent. Owing to this asymmetry, they benefit primarily as hosts, and must be expected to do the best they can in this capacity. These countries also have a particularly great need of the capital, technology and human skills that direct investment can provide.

For a long time, MNEs were believed to require protection from their home governments in order to prevent host countries from expropriating gains earned under their jurisdiction. Much of the world’s history in the last two centuries has, in fact, been shaped by the desire of the leading industrialized countries to safeguard the undertaking of profitable business operations abroad. This has led to many clashes with less developed capital-importing countries. The attitudes towards foreign firms became hostile, particularly in the 1960s, and Gilpin (1975) predicted difficult times for investors with declining US hegemony in the world economy. Today, however, this hostility seems to have mostly disappeared, and the general atmosphere in developing countries leans more towards harmony and co-operation.

The MNE—host country relationship was from the beginning viewed as a bilateral monopoly, with the two sides struggling over the structuring of projects and the division of gains. Penrose (1959) argued that a foreign firm should receive as much profit as induces it to invest. Kindleberger (1965) considered that this was only a lower limit, and added an upper limit set by the scarcity value to the host country of the services provided by an investment project. Most subsequent work in the field builds on the studies by Vernon (1971) and Moran (1974) who added the time dimension and the role of risk. Their findings are referred to as the theory of ‘obsolescing bargain’ or the ‘changing balance of power’. The idea is that, over time, there is a shift in the bargaining position to the advantage of poor countries as they attain a higher level of development and investment projects become sunk.

Among the empirical studies of host country behaviour vis-à-vis direct investment, those preceding 1980 mostly lacked comprehensive data. In the last decade, nationalization has been studied by, for example, Jodice (1980), Kobrin (1980, 1984) and Minor (1987, 1988). Other policies have been examined by, for example, the Harvard Multinational Enterprise Project, directed by Vernon,² and Guisinger (1985). Most of this work has provided useful information on cross-country variation in policies at a certain time, but developments over time have not been satisfactorily examined. Among the formal models allowing for strategic interaction, Eaton and Gersovitz (1983, 1984) determined time-consistent equilibria with regard to taxation and nationalization respectively. Shenfeld (1984) investigated host country policies pursued by an individual country, and Doyle and van Wijnbergen (1984) analysed taxation when there is competition between host countries. However, these studies have not resolved some of the pertinent issues left unanswered by the empirical studies. The theoretical work on nationalization has generally not explained its occurrence, and studies of taxation have tended to assume perfect competition and zero profits, thereby neglecting the distribution of gains from direct investment.

To gain as much as possible from direct investment, host countries may use a variety of policies, ranging from those that aim at a general and sweeping transformation of the domestic economy, to measures that target MNEs directly. There is no general formula to establish which are the most effective. For the transfer of technology to developing host countries, Blomström and Wang (1989) indicate that support of domestic firms may be preferable to imposition of performance requirements on the behaviour of MNEs. However, throughout the developing world, there has for decades been an abundance of policies which interfere with MNEs directly. This study is concerned with such policies.

Although there are many diverse host country policies vis-à-vis MNEs, we can think in terms of two broad categories. On the one hand, there are policies which stimulate certain kinds of behaviour on the part of MNEs. Among them are, for example, regulations, tax incentives and subsidies. On the other hand, there are policies which interfere with the ownership and control of MNEs, such as joint ventures, licensing agreements and, in the extreme, complete takeover by the host country. The former are referred to here as taxation, the latter as nationalization.

Currently, there is general uncertainty regarding the extent to which the nature of MNE-host country conflict impedes or distorts the potential welfare effects of direct investment. The threat of adverse host country behaviour for example, has been put forward as a partial cause of the decline in direct investment that has occurred in developing countries in the 1980s. Liberalization of the foreign investment regime, with a reduction of burdens and restrictions, is a standard part of the policy package advised by the International Monetary Fund to countries afflicted by balance of payment difficulties. Moreover, a multilateral insurance agency was instituted in association with the World Bank in the mid-1980s to encourage equity investment by alleviating investors’ concerns about non-commercial risks. At first, it caused controversy, and had to await ratification from the required number of countries. The host country attitudes have gradually become more favourable, however, and the Multilateral Investment Guarantee Agency (MIGA) was established in April 1988.³

In this book we investigate the impact of host country behaviour on the undertaking of direct investment and the distribution of gains. Most of the questions addressed have already been dealt with in a voluminous literature. However, we add to most previous work by considering that direct investment is traded in a market where it is supplied by firms and demanded by countries. In this market, we consider competition between host countries, real profits and alternative host country policies. On the basis of theoretical models which allow for strategic interaction and pay attention to co-ordination problems, we come up with new explanations of host country policies and results which partly contradict mainstream views. Some hypotheses are formulated and tested against empirical data.

In this chapter we introduce the issues to be studied. The first section reviews the history of direct investment and ‘foreign property rights’ is surveyed in the next section. Particular attention is paid to the extension of these rights to developing countries and their subsequent gradual breakdown. In the following section, we are concerned with host country policies from the late 1960s, and point out the importance of economic motives for nationalization and taxation of MNE affiliates in this period. Next we survey the flow of direct investment in the last decades, comparing the trend with those of direct investment in other parts of the world, as well as other capital flows to developing countries. Finally, we summarize the chapter and present an outline of the book as a whole. Owing to the extent of the ground covered, the presentation is sweeping and only major circumstances and events are discussed.

THE HISTORY OF FOREIGN PROPERTY RIGHTS

Property rights should be expected to be crucial for the undertaking of direct investment, the purpose of which is control through ownership in another country. The meaning of property cannot be taken for granted, however, but is rooted in the social and institutional heritage of a society, which is subject to continuous change. It is even more difficult to justify any a priori or moral vision of property across the boundary of jurisdictions. Nevertheless, or perhaps because of this state of facts, there have been repeated violations of ‘foreign property rights’ for more than a hundred years.

Itinerant merchants in the Middle Ages were protected only by local municipal laws. Foreign property rights evolved as orderly national economies developed in Europe, and commercial treaties were set up between them bilaterally. By the mid-nineteenth century, foreign property rights had been well defined in Europe and gradually became codified as international law. According to the basic principles, foreigners were subject to local law. Additional minimum standards deemed interference with foreign property permissible only in exceptional cases, then requiring ‘prompt, adequate and effective’ compensation.

Foreign property rights emerged initially as a result of reciprocal interests. They facilitated capital flows and international economic specialization between nations. Within Europe, they were supported less by the threat of coercion than by the withdrawal of normal reciprocities. The extension of rules beyond Europe was different, as can be exemplified by the 1838 Anglo-Turkish Convention. Essentially, this meant that a 300-year-old tradition of mutual commercial privileges was replaced by a treaty which forced the Ottoman Empire to open its markets for European goods. The same course was followed in the Anglo-Chinese wars of 1839–42 and 1856–60, the Anglo-Japanese treaties of 1854 and 1858, consular arrangements in Africa and similar arrangements by the other major European powers with countries outside Europe. Throughout, this resulted in both a modern structure of property rights and commercial penetration.

Outside Europe, foreign property rights served to establish and maintain order in a system of diverse and unequal countries. Their extension reflected the increasing military strength of the capital exporting countries: ‘…international property rights were effectively guaranteed by the extraterritorial application of European and American laws’, (Lipson 1985:14). Concerning the policies of Great Britain, Platt (1968:353) states that the call was not for special privilege, but ‘equal favour and open competition for British finance and trade overseas’. This is shown by the reliance on most-favoured-nation treaties. In Africa and Asia, however, outright colonialism was accompanied by an overrepresentation of direct investment from the colonial powers, especially the smaller ones (Svedberg 1981).⁴ In Latin America, Great Britain rejected territorial ambitions after the defeats in the Rio de la Plata region in 1806–7.

Until the 1890s, bonds were the major kind of investment in Latin America, with Great Britain owning three-quarters of the region’s foreign debt. Latin America welcomed foreign investment, but disputed the rights of investors to call on outside powers for assistance at times of dispute. There were, indeed, many defaults as well as disputes. The British government was unwilling to defend individual subjects, but determined to steer off general assaults on property rights. Generally it did not have to, because British denial of further credit was a powerful tool, particularly after the Franco-Prussian War crippled its major competitors and London attained a near credit monopoly. This ensured the settlement of most defaults.

The British stock of direct investment grew rapidly from the early 1860s and surpassed the outstanding value of bonds by the 1890s. This was not surprising since the rate of return was considerably higher. Most of this investment was concentrated in railways and public utilities. Britain turned out to be more ready to intervene by force to defend direct investment than in the case of default. On the whole, there were at least forty examples of British military intervention in Latin America between 1820 and 1914, and a great many were primarily concerned with the protection of direct investment.

Soon after its independence, the United States emerged as a champion of property rights. This ambition became more predominant as the country’s economic and political expansion began in the late nineteenth century. At the time of the First World War, the United States became the greatest investor in Latin America, mainly through direct investment in agriculture, mining and oil. Like Britain, the United States firstly signalled an unwillingness to intervene in private activities. However, the Roosevelt Corollary of 1903 declared a duty and responsibility to intervene in the American continents on behalf of all foreign investors. European entanglement was prevented, but the United States became compelled to retaliate wherever foreign property rights were threatened. The result was a stream of coastal landings, armed interventions, involvement in civil wars etc.

Despite growing military intervention in the early twentieth century, there were as yet no real disputes over the nature of foreign property rights. Expropriation for example, was universally viewed as robbery, and conflicts tended to concern countries’ right to enforce rules bilaterally. The Hague Conferences at the turn of the century produced fragile compromises on this issue. Thus, the nature of foreign property rights remained intact until the Soviet nationalizations in 1918, which represented the first real challenge. The United States failed to raise support for military retaliation or to organize a unified set of economic sanctions. The Soviet Union exploited the individual interests of the Western powers and concluded agreements bilaterally, step by step reopening its market for foreign investment. Unofficially, however, and contrary to the British strategy, the United States blocked settlements that would have acknowledged the right to nationalize.

The Soviet nationalizations demonstrated the weakness of international law. In the following decades, the poorer countries became more active in the League of Nations, where all countries had the same voting power, and the poor soon outnumbered the industrialized countries. The diplomatic process began to dilute the traditional norms. Sovereignty was increasingly stressed, and partial rather than full compensation from nationalization advocated. However, the United States and some other capital exporters continued to defend traditional property rights with great determination. Unlike the Soviet Union, poor countries had little opportunity to resist either military or economic retaliation. Turkey, Mexico and Bolivia nevertheless undertook nationalizations that departed from traditional rules, and got away with them. With a world war on the horizon, the United States had to make choices between the protection of investment and the need for stable allies. Military intervention could result in chaos, causing higher costs than revenues, which meant that the very weakness of expropriating countries could be to their advantage.

After the Second World War, the United States sought to reconstruct an open world economy. One step was a charter for world trade, along with which the United States brought up investment security, arguing for the traditional principles of prompt, adequate and effective compensation. As discussed by Lipson (1985), this measure was self-defeating. In 1952, a resolution by the General Assembly of the United Nations endorsed nationalization of natural resources. In 1962, compensation standards were diluted as ‘appropriate’ compensation was called for in Resolution 1803 on Permanent Sovereignty over Natural Resources. In 1972, the conditions justifying nationalization were stated to be irrelevant. Finally, in 1974, the Charter of Economic Rights and Duties of States placed the rights with host countries, and the duties with firms and capitalexporting countries.⁵

Despite the disputes, most direct investment remained secure until the late 1960s. Passing resolutions is not the same as passing international law, and the defence of traditional rights continued. One aspect of the US resistance to relinquishing its investment protection was the country’s long-lasting refusal to sign the UN Convention on the Recognition and Enforcement of Foreign Arbitral Awards, which was signed by twentyfive countries and came into force in June 1959. Among other things, the Convention precluded the courts of the states that signed from interfering in conflicts covered by an arbitration clause. The benefits of predictable and uniform arbitration rules were downplayed relative to the desire to make extraterritorial applications of the US securities laws. Even after pressure from private organizations finally made the Senate consent to accession to the UN Convention in 1970, US cou...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Acknowledgements
• Part I: Introduction
• Part II: Taxation of multinational enterprise affiliates
• Part III: Nationalization of multinational enterprise affiliates
• Part IV: Conclusion and policy implications
• Notes
• References