Optimal Regulation of Multinationals under Collusion

• Published date: 01 August 2017
• Date: 01 August 2017
• DOI: http://doi.org/10.1111/twec.12410
• Author: Bilgehan Karabay

Optimal Regulation of Multinationals

under Collusion

Bilgehan Karabay

School of Economics, Finance and Marketing, RMIT University, Melbourne, Vic., Australia

1. INTRODUCTION

SINCE the second half of the twentieth century, globalisation has gained momentum. With-

out doubt, one of the leading indicators of this expanded economic activity has been the

steady rise in foreign direct investment (FDI) flows. While in 1970, world FDI inflows were only

$13.4 billion, they reached a record high value of $2 trillion in 20 07.

1

Lately, this upward trend

was interrupted with the advent of the 2008–09 global financial crisis.

2

Nevertheless, this inter-

ruption turns out to be short-lived (UNCTAD, 2013) and FDI flows still continue to play a key

role in facilitating international integration by making strong economic links between nations.

Despite the well-known benefits of FDI flows,

3

strict regulatory restrictions by host govern-

ments are fairly common. This is especially true for Asian countries such as Indonesia,

Thailand, China, Malaysia and the Philippines. These countries manage to attract large amounts

of FDI flows,

4

while following policy regimes that are not in the interest of multinationals. To

regulate multinationals, they make use of various restrictive measures including performance

requirements, sectoral prohibitions, screening and equity restrictions (Walter, 1999). Among

them, the most visible restriction is the foreign ownership restriction.

5

;

6

For example, according

to Productivity Commission Report of Australia (1996), ownership restrictions and joint venture

(JV) requirements are the primary hurdles in Asian countries faced by Australian firms.

A distinctive feature of FDI relative to other sorts of investments is the control over operations.

Ownership is the purchase of residual rights of control. As shown by Grossman and Hart (1986),

We would like to thank to Martin Byford, Maxim Engers, Bihong Huang, John McLaren, Benedikt

Rydzek and conference participants at 2014 Trade and Development Workshop in Deakin University,

2015 Australian Trade Workshop, 2015 Asia Pacific Trade Seminars and the theory group meeting in

RMIT University. All errors are our own.

1

These values are obtained from http://unctadstat.unctad.org/wds/.

2

According to UNCTAD (2012), FDI flows in 2011 were 23 per cent below their 2007 peak.

3

Some concerns are mentioned about the negative economic and political effects of FDI as well such

as balance of payment deficits, reduced domestic research and development, diminished competition,

crowding-out of domestic firms and lower employment. However, these claims are not well supported in

the data (see, for example, Graham and Krugman, 1995).

4

There has been considerable change in the distribution of investments across regions. While the share

of FDI flowing into Asia has surged, the Europe and North America experienced a decline in their share

(see Productivity Commission Report of Australia, 2010).

5

The limits on foreign equity are usually specified on an industry-by-industry basis and generally

concentrated in some sectors like transport, telecommunications, finance and electricity (see Golub, 2003).

6

In fact, over the years many countries (both developing and developed) have employed some kind of

indigenisation policy. Indigenisation is defined by Katrak (1983) as the requirement that the host country

imposes on an investor to share ownership of an affiliate with residents in the host country. Many coun-

tries have a policy that allows FDI only through ventures with local firms (Golub, 2003; OECD, 2007).

Imposing a joint venture is similar to ownership restrictions in that they require the MNF to offer a min-

imum profit share to the domestic partner.

©2016 John Wiley & Sons Ltd 1687

The World Economy (2017)

doi: 10.1111/twec.12410

The World Economy

Hart and Moore (1990) and Hart (1995), wrong allocation of residual rights can have harmful con-

sequences by distorting agents’ incentives in unintended ways. In other words, forcefully chang-

ing the ownership structure might create inefficiencies which can decrease the profitability of the

firm. In that case, it is puzzling to witness such a prevalent adoption of foreign equi ty restrictions

by host governments in lieu of alternative policy instruments. Karabay (2010) explores this issue

and concludes that under asymmetric information, utilising foreign ownership restrictions to force

a joint venture enhances the monitoring capacity of host governments. The idea is that multina-

tionals engage in many activities to obfuscate cash flows for tax evasion and JV partners can do a

better job in keeping track of cash flows than host governments due to their control rights.

In real life, firms often perform tax sheltering activities. For example, under US law, firms are

allowed to keep two sets of books –a bullish book income report released publicly to sharehold-

ers and a lowball tax income report provided to the IRS. In the late 1990s, the gap between book

and tax income was widening.

7

The income to shareholders went up rapidly. The taxable income

reported to the IRS stayed the same, and in some years, actually declined. Even though IRS grad-

ually discovers how these schemes work, corporations always come up with new schemes. They

use various financial mechanisms to create losses in their financial statements in order to avoid

taxation. The commonly cited one for multinationals is transfer pricing which is very well docu-

mented in the literature. However, it is not the only available tool. Firms also take advantage of

grey zones in reporting profits. For example, when a firm performs a renovation of an existing

asset, it can report it either as an expense or as a new asset. If reported as an expense, it can be

deducted from taxable income in the current period whereas if reported as a new asset then only

a small portion (depreciated part) can be deducted. Therefore, by reporting it as an expense, it is

possible that some part of the profit can be saved from taxation. It is hard for an outside authority

to assess whether it is really an expense or not. On the other hand, joint venture partners can do

better monitoring than outsiders due to ownership control rights. They are active monitors in

companies. Monitoring is enhanced due to the increased disclosure requirement among JV part-

ners. They have administrative controls such as appointing board of directors in proportion to

equity holdings. This provides a direct communication link with senior management of the

parent companies, facilitating superior monitoring of partner firms’ activities (Kogut, 1988).

To formalise this idea, a stylised model of FDI is developed in Karabay (2010). There is a host

market which can support a monopolist to take advantage of an investment opportunity.

Although either a multinational firm (MNF) or a local firm (LF) among a pool of competitive

local firms can undertake this opportunity, the MNF can generate a larger surplus due to its intan-

gible assets.

8

;

9

As a result, ceteris paribus, it is more efficient for the MNF to undertake this pro-

ject. The extra surplus is based on the MNF’s firm specific advantage, and to reap its benefits, the

MNF needs to incur costly unobservable effort. The host government’s welfare is made up of the

weighted average of its tax revenue and any local firm’s profit. The host government faces an

information disadvantage such that it cannot observe the extra surplus that the MNF can generate

7

See the documentary by Frontline at: http://www.pbs.org/wgbh/pages/frontline/shows/tax/.

8

These intangible assets are firm specific and include brand name, experience, scientific know-how,

patents, etc. Their dissipation risk is one reason why FDI is more like to occur compared to licensing

(Navaretti and Venables, 2004, p. 114).

9

This productivity difference of multinationals is also supported by other studies as well (see Haddad

and Harrison, 1993; Blomstr€

om and Wolff, 1994; Globerman et al., 1994; Doms and Jensen, 1998;

Sj€

oholm, 1999; Kokko et al., 2001; Helpman et al., 2004). Furthermore, in general the productivity is

increasingly firm specific (Cerny, 1995).

©2016 John Wiley & Sons Ltd

1688 B. KARABAY