THE EFFECT OF TAX AND INVESTMENT TREATIES ON BILATERAL FDI FLOWS

TO TRANSITION COUNTRIES

By Tom Coupé, Irina Orlova and Alexandre Skiba

Tom Coupé, Kyiv School of Economics and Kyiv Economics Institute

Irina Orlova, Center for Social and Economic Research, CASE Ukraine

Alexandre Skiba, The University of Kansas

Abstract: This paper estimates the effect of double taxation treaties and bilateral investment

treaties on FDI flows into transition countries. Using various approaches, including IV, we find

evidence for the FDI promoting effects of bilateral investment treaties but find no convincing

evidence for the effect of double taxation treaties.

1
 INTRODUCTION

According to the Monterrey Consensus on development financing (2002) rich countries are
committed to undertake measures to increase foreign direct investment and other private flows to
low-income and transition economies. The idea behind this political commitment is that all sorts
of resources must be mobilised for development. Specifically, the Consensus states that a central
challenge is to create the necessary domestic and international conditions to facilitate direct
investment flows. The question then is how FDI flows can be promoted by rich countries: what
policies or measures can enhance FDI out-flows to a given poor country? Among the priority
areas the Monterrey Consensus mentions are the development of a regulatory framework for
promoting and protecting investments, including the areas of human resource development, the
avoidance of double taxation and the signing of investment agreements. Also the World
Investment Report, UNCTAD (2003) focuses on policies that can help to stimulate FDI, focusing
on such instruments as the adoption of bilateral investment treaties (BITs) and bilateral treaties
for the avoidance of double taxation (DTTs).

The Monterrey Consensus was adopted in 2002, when there was a continuing downturn in global
investment. Already in 2004 the rise in flows to developing countries, South-East Europe (SEE)
and CIS not only put an end to the downturn that had begun in 2001, but it also represented the
highest ever level of investment flows to these countries. The question is whether this rise was
due to the increasing efforts of the international community to enable more foreign investment.
Even though this particular historical episode escapes our empirical analysis, with this research
we try to shed light on the relation between specific policies and FDI.

To contribute to the ongoing debate we focus our study on the effect of international treaties,
more specifically, bilateral investment treaties and bilateral tax treaties, on FDI. Bilateral
investment treaties are agreements between two countries for the reciprocal encouragement,
promotion and protection of investments in each other's territories by companies based in either
country. The general purpose of double taxation treaties is to provide a favorable investment
regime by exclusion of double taxation of an investor. According to UNCTAD (2000), double
taxation can be defined as the levy of taxes on income/capital in the hands of the same tax payer
in more than one country in respect to the same income or capital for the same period. DTTs
arise to avoid such a hardship.

2
The existing studies analyzing the effect of treaties on FDI focus either on bilateral investment
treaties or bilateral tax treaties, but not on both types of treaties simultaneously. 1 The studies on
the effect of BITs provide mixed results. Using a dyadic approach, Hallward-Driemeier (2003)
finds little evidence for the effect of BITs. Using the same approach, Salacuse and Sullivan
(2005), however, find a positive effect for BITs signed by the United States, but no effect for
BITs signed by other OECD countries. Neumayer and Spess (2005) use a non-dyadic approach
and provide evidence that a greater number of BITs signed by a host country increases the FDI a
developing country receives. Tobin & Rose-Ackerman (2005) find a positive effect when using a
non-dyadic approach, but no effect when using a dyadic approach.

Studies that analyze the effect of tax treaties on FDI are not numerous either. The fundamental
work on the issue belongs to Blonigen and Davies (2000, 2002, 2004). The basic point of their
studies is that there is no empirical evidence of the standard view that treaties increase foreign
direct investment.

In this study, we empirically examine the effect of both treaties BITs and DTTs on foreign direct
investment simultaneously. Since previous studies consider either bilateral investment treaties or
tax treaties, but do not include both in one regression, their results suffer from omitted variable
bias. This omitted variable bias can be substantial since the correlation between the two treaties
is quite high: in our sample it is 0.272.

We further separate tax treaties into three categories: income and capital tax treaties (ICT),
income tax treaties (IT), and social security treaties (SS). This division is based on the
categorization by the International Bureau of Fiscal Documentation. Using several dummies,
rather than one catch-all dummy as is done in previous studies, is important since we thus use
more information – the extent to which a specific treaty influences FDI might depend on its
specific category - and can get more precise estimates. Some studies also distinguish between
tax treaties, but based on a time criterion, as Blonigen and Davies (2004) include two treaty
dummies: one for new treaty and the other for old treaty, differentiating them by the date of
signature.

1
An exception is the unpublished MA thesis of Goryunov (2004). His results are problematic however because he does not
include year dummies in his regressions, thus his results confound year effects and treaty effects.
2
This correlation is computed between a BIT dummy and a tax treaty dummy which is one if there is any tax treaty and zero
otherwise (see more about this below).

3
Finally, not all studies consider the potential endogeneity issue – FDI might cause treaties to be
signed or not signed rather than vice versa. We provide an extensive treatment of this issue by
experimenting with several possible instrumental variables.

Our study provides strong evidence for a positive BITs effect: throughout numerous
specifications, we get a positive significant estimate of BITs. However, our tax treaty dummies
do not show such consistency: different specifications give different results. In our preferred
specifications most tax treaty effects are insignificant.

This paper is structured as follows: the section describes bilateral investment and tax treaties
reviews existing empirical studies on both BITs and DTTs. Next we describe the methodology
and data, followed by estimation technique and results. The final section concludes.

BITs and DTTs

Bilateral Investment Treaties (BITs)

The general purpose of bilateral investment treaties is the promotion and protection of
investments from one country to another country. While all BITs are very similar in their major
provisions, some variations exist. These variations are between the two basic models of BITs
that have emerged so far. First the “European model” appeared. It was endorsed by the OECD
Ministers in 1962. Then in the early 1980s the “North American model” was developed. Both
models cover the following areas: admission and treatment, transfers, key personnel,
expropriation and dispute settlement. The two models differ in several aspects. In the
“European model” treatment provisions apply only to an investment after establishment, while in
the “North American model” treatment provisions concern also the investment at the pre-
establishment phase (this refers to the entry of investments and investors of a contracting party
into the territory of another contracting party). Also, the US model has more elaborate
provisions on some matters (e.g. right of entry) than the European BITs. As to protection of
established investments, both models contain more or less the same concepts. These include
national treatment (terms no less favourable than those that apply to domestic investors) and
most-favoured-nation treatment (terms no less favourable than those that apply to investors from
third countries), free transfers of funds, adequate and effective compensation in the case of
expropriation, full protection and security of investments and dispute settlement mechanisms.

Most BITs have been signed between developed capital exporting countries and developing
capital importing countries. The majority of BITs were signed during the last two decades.

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UNCTAD has been actively monitoring and analysing the increase in the number of BITs. The
total number of treaties quintupled, rising from 385 at the end of the 1980s to 1,857 at the end of
the 1990s. During the same period the number of treaties concluded by developing countries and
by CEE countries has increased from 63 to 833. According to UNCTAD statistics the total
number of BITs reached 2,265 in 2003 (see Appendix A). They now involve 177 economies.
The recent proliferation of bilateral investment treaties suggests that they are playing an
increasingly important role in international investment relations.

Double Taxation Treaties (DTTs)

Tax treaties exist between countries on a bilateral basis to prevent double taxation (taxes levied
twice on the same income, profit, capital gain, inheritance or other item). There are a number of
model tax treaties published by various national and international bodies, such as the United
Nations and the OECD. The OECD Model Convention on Income and on Capital serves as a
model used by countries when negotiating bilateral tax agreements. The Convention is dynamic
in that it is constantly monitored and updated as economies evolve and new tax questions arise.
In recent years, for example, special reports had to be made on tax treatment of software and
treaty characterization issues arising from e-commerce.

According to the International Bureau of Fiscal Documentation 2,390 double taxation treaties
have been signed by the end of 2005. These treaties include income treaties, income and capital
treaties and social security treaties. Over two thirds of DTT’s (1,632 treaties) have been signed
since 1980 with a notable surge in the activity in the 90’s when 731 treaties were signed. A
sizeable portion of all treaties is signed by Central and Eastern European countries. CEE’s
participate in 41% of all signed treaties. Most of them, about 70%, were signed since 1985.

As outlined by Blonigen and Davies (2004), tax treaties perform four primary functions. The
first is to standardize tax definitions of treaty partners. Differing tax definitions can lead to
double taxation and inefficient capital flows. The second is to reduce transfer pricing and other
forms of tax avoidance. The third goal of tax treaties is to prevent treaty shopping. Treaty
shopping is described as the routing of income through particular states in order to take
advantage of treaty benefits that were designed to be given only to residents of the contracting
states. The most common rules regarding treaty shopping restrict treaty benefits if more than
50% of a corporation’s stock is held by a third, non-treaty country’s residents (Doernberg, 1997).
Finally, tax treaties affect the actual taxation of multinational corporations. They do so through
the provisions for double taxation relief and the rules that reduce maximum allowable

5
withholding taxes on three types of remitted income: dividend payments, interest payments, and
royalty payments.

From the above discussion, we can see that theoretically tax treaties can both promote or reduce
investment. On the one hand, tax treaties can promote investment by reducing uncertainty about
the tax environment abroad; on the other hand, a tax treaty which reduces the ability to transfer
price or somehow prevents other types of tax evasion also reduces the incentive to invest (if
investment activity is purely for tax minimization reasons). Empirically the question about what
dominates remains open.

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 LITERATURE REVIEW

A dramatic increase of foreign direct investment during the 1990s led to a boom in economic
research studying the forces affecting FDI. A part of this literature looks at the relation of
government policies and FDI. In this section we review the literature that deals with
international treaties and their effect on FDI.

While most economic texts use the assumption that treaties encourage FDI, one can find little
evidence in support of this statement in empirical literature.

We start with the review of studies that deal with the impact of tax treaties on FDI. These are
not very numerous. Blonigen and Davies (2000) were the first to directly explore the effects of
tax treaties on foreign direct investment. They use data over the period 1966-1992 on US
inbound and outbound FDI. Several approaches are introduced to capture the effect of treaties.
A first approach uses a simple dummy variable which indicates whether there is a treaty or not
for a specific country pair. In the second approach the authors use a treaty age variable equal to
the number of years that a treaty had been in effect. In both cases authors find positive and
significant effects and conclude that tax treaties have a strong, positive impact on FDI.

One problem with this approach is that it combines the effects of older treaties in place long
before their sample period began with more recent ones. Since the old treaty partners of US
(Europe, Japan, Canada, Australia, New Zealand) are also the largest hosts and homes for US
FDI; this means that treaty variables may have been capturing some unobserved differences
between these countries and other nations. Therefore, in the more recent version (Blonigen and
Davies, 2004) they separate the treaty dummy and include two dummy variables: one for old
treaties, the other for new treaties. With two dummies they find that the old treaty dummy has a
positive and significant effect while the new treaty dummy has a negative and significant effect.

The same approach is used by Blonigen and Davies (2002) in their paper where they use
inbound and outbound FDI stock and flow data for OECD countries from 1982 to 1992. Their
findings are similar to those in the previous work: when old and new treaties are not separated,
the data indicates a positive and significant effect; after separating treaties the old treaty estimate
is positive and significant whereas the new treaty estimate is negative and significant.

Louie and Rousslang (2002) use a different approach but also do not find strong support for the
FDI encouragement story. They use 1990s income tax return data for US MNEs (Multinational
Enterprises) to calculate the rate of return for foreign subsidiaries. They test whether this rate of

7
return changes after a treaty is ratified. They do not separate the effects of old and new treaties,
but only count those treaties that had been in force prior to 1987. The coefficient on their treaty
dummy is significant and negative. However, when authors include in the regressions proxies
for corruption and political instability, the significance of the treaty dummy fades entirely. Thus,
they attribute their initial result to the omitted variable bias and conclude that good governance
attracts both FDI and tax treaties but that treaties have no effect on FDI.

All studies considered above do not account for treaties signed throughout the 1990s, while most
transition countries emerged during that period. Moreover, CEE countries concluded the
majority of tax treaties during the 1990s.

On the contrary, studies that investigate the influence of BITs on FDI flows do cover the 1990s.
UNCTAD (1998) used a dataset for 133 countries and 200 BITs to show that there is a rather
weak correlation between the existence of a treaty and an increase in FDI. In this research only
cross-sectional data was used (year 1995). Hallward-Driemeier (2003) used data on FDI flows
from 20 OECD countries to 31 developing countries over the period of 1980-2000. She also
finds little evidence of a strong positive correlation between bilateral investment treaties and
increase in FDI flows.

Salacuse and Sullivan (2005) provide three cross-sectional analyses of FDI inflow to 99
developing countries in the years 1998, 1999, and 2000, as well as a fixed-effects estimation of
the bilateral flow of FDI from the United States to 31 developing countries over the period of
1991-2000. They find that signing a BIT with the United States is associated with higher FDI
inflows, whereas the number of BITs signed with other OECD countries is statistically
insignificant. But since this analysis is cross-sectional, it cannot detect how a higher number of
BITs raises the flow of FDI to developing countries over time. In addition, in their fixed-effects
regression the authors do not include year dummies, which could mean that the treaty dummies
reflect year effects.

Neumayer and Spess (2005) use a larger and more representative sample compared to previous
work. It covers the period from 1970 to 2001 and includes 119 developing countries. Their
main explanatory variable is the cumulative number of BITs a developing country has signed
with OECD countries. They find a strong positive effect of BITs on FDI inflows. They use a
non-dyadic research design, which means that the authors analyze total OECD FDI flows into a
developing country, instead of looking at country-to-country flows. They criticize Hallward-
Driemeier (2003) and Salacuse and Sullivan (2005) on the grounds of using a dyadic modeling,

8
which cannot capture the potential of BITs to attract more FDI from other developed
nonsignatory countries as well, and therefore may underestimate the effect of BITs.

Tobin and Rose-Ackerman (2005) analyze the impact of BITs using non-dyadic FDI inflows, in
a panel from 1980 to 2000. Their general conclusion is that a higher number of BITs lowers the
FDI a country receives at high levels of political risk and raises the FDI only at low levels of
risk. In an additional dyadic analysis of 54 countries, they fail to find any statistically significant
effect of BITs on FDI flows from the Unites States to developing countries.

Summarizing the above studies on BITs, different approaches tend to lead to different
conclusions – authors that use a dyadic approach find no effect, while authors that use a non-
dyadic approach do find an effect.

In our research we adhere to the dyadic design, since it controls for country pair specific effects,
and hence allows us to control better for omitted variables. In contrast to previous studies that
use a dyadic design and despite the fact that we work with a smaller sample, include both BIT
and DTTs and tackle the endogeneity issue, we do find robust empirical evidence of a positive
effect of BITs on FDI.

9
 METHODOLOGY AND DATA

Methodology

The empirical specification is based on the so-called gravity model. The gravity model was
developed by Tinbergen (1962) and Poyhonen (1963). Originally, it was used to analyze only
trade flows between countries. Theoretical work on the gravity model for FDI however is scant.
One prominent study is Bergstrand and Egger (2005). The general idea is the following: the
amounts of bilateral resource flows will positively depend on size of source/destination countries
(usually represented by GDP, sometimes by population size or land area, or even all mentioned
factors simultaneously), which just reflects potential supply/demand, and negatively by
transportation costs (that is inversely proportional to physical distance between countries).
Usually, the gravity equation takes a log-linear form:

ln( FDI ij ) = α + β1 ln( GDPi ) + β 2 ln( GDP j ) + β3 ln( DIST ij ) + ∑γ k Dkij + ε ij

k

where FDIij – FDI inflows from country i to country j

GDPi- GDP of country i
GDPj- GDP of country j
DISTij- distance between the capitals of countries i and j
Dij- dummy variables (treaty dummy, common border, common language dummy)
k – indicates the number of dummy variables included in the regression

In this study, we will focus on transition countries. The reasons for this focus are multiple.
First, a lot of newly concluded treaties involved transition countries – hence, a sample of
transition countries is onee where there is a lot of variation in the ‘treatment’ variable over time.
Such variability is important to get precise (more efficient) estimates. Second, by focusing on
transition countries we get a relatively homogenous sample – while we sacrifice degrees of
freedom by restricting our sample, we decrease the extent of omitted variables. Third, for the
transition countries, the EBRD reform ratings are available which provide us with a good proxy
for a wide range of home policies3.

Previous studies either include a BIT dummy or a tax treaty dummy as an explanatory variable.
In this study, we include both dummies simultaneously to avoid omitted variable bias. In
3
The only other study that focuses on transition countries is the above mentioned unpublished MA thesis of Goryunov (2004).

10
addition, instead of including just one tax treaty dummy variable as is usually done, we classify
tax treaties on the basis of their content and include three dummies. The International Bureau of
Fiscal Documentation categorizes tax treaties in the following manner: income/capital tax
treaties, social security treaties, administrative assistance, inheritance/gift, and transport tax
treaties. We pick up three major categories out of this classification, which constitute the vast
majority of treaties. These are: 1) income and capital tax treaty; 2) income tax treaty; 3) social
security treaty. Income and income and capital tax treaties can be differentiated on the bases of
taxes covered. Thus, income and capital tax treaties cover taxes on both income and capital,
while income tax treaties cover taxes on income only. For instance, Ukraine has an agreement
with the Federal Republic of Germany for the avoidance of double taxation with respect to taxes
on income and capital (income and capital tax treaty); this treaty covers the following taxes in
Germany: income tax, corporation tax, capital tax, and trade tax, and in Ukraine: tax on profit
of enterprises, income tax on citizens, tax on property of enterprises, and tax on immovable
property of citizens. Whereas with Sweden Ukraine has concluded only an income tax treaty,
which covers tax on profit of enterprises and income tax on citizens in Ukraine; and State
income tax, special income tax for non-residents, special income tax for non-resident artistes, the
communal income tax – in Sweden.

As to social security agreements, they are often signed with tax treaty partners. For example,
United States has social security agreements with many of its tax treaty partners. Under these
agreements, many people who work or have worked for both countries can receive credit for
work performed in both countries under the social security system of one country.

We allow for more differentiation between tax treaties because it does matter what treaty or
treaties among the three mentioned above has/have been signed. Different treaties imply
different degrees of integration between the countries. For instance, the existence of an income
tax treaty between two countries implies a lower degree of integration as opposed to the case
where an income and capital tax treaty is in place. Moreover, a country with an income and
capital tax treaty might be more attractive than a country with just an income tax treaty. In our
sample there can be at most two tax treaties in place between any two countries, since income
tax treaties and income and capital tax treaties are mutually exclusive. We incorporate this
information in our research design in the following way. We include three dummies: income
and capital tax treaty dummy, income tax treaty dummy, and social security treaty dummy.

The signs and magnitudes of correlations between these tax treaty dummies vary substantially.
The ICT dummy and IT dummy are negatively correlated (-0.68) which makes sense since these

11
treaties are mutually exclusive; IT and SS treaties are negatively correlated (-0.17) while there is
a positive correlation between ICT and SS treaties (0.19).

Variables

Our dependent variable is the annual bilateral flow of FDI, converted to constant US$ of 2000
with the help of the US Implicit Price Deflator. Since we take the natural log of the dependent
variable, we lose all zero FDI flows. In our analysis we disregard zero flows (259 out of 1,224
observations). But if instead we set all zero FDI flows to positive FDI flows of US$1, as do
Neumayer and Spess (2005), our results are hardly affected. We only include flows from OECD
countries to transition countries since we are interested in how FDI streams to developing
countries can be stimulated (the list of countries can be found in appendix C).

Our main explanatory variables are four bilateral treaty dummies: (1) BIT dummy capturing the
effect of bilateral investment treaties; (2) ICT dummy capturing the effect of income and capital
tax treaties; (3) IT dummy capturing the effect of income tax treaties; (4) SS dummy capturing
the effect of social security treaties. All four variables are constructed as zero/one dummies.
Thus, we have one bilateral investment treaty dummy and three bilateral tax treaty dummies.
Since income tax treaty (IT) and income and capital tax treaty (ICT) are mutually exclusive, the
maximum number of tax treaties per country pair is two. The possible combinations are: (1)
social security treaty and income tax treaty and (2) social security treaty and income and capital
tax treaty. Each dummy takes on the value of one for every year starting from the ratification
year. To have an effect on FDI attraction, a treaty needs to be ratified. However, there can be
initial mover advantages and investors might start investing long before the actual date of
ratification. Therefore, as a robustness check we also run a specification with a dummy based on
the date of signature.

Our control variables are those conventionally considered as the determinants of FDI in a gravity
model. We include the natural logs of host and source GDPs; host GDP (GDPj) is used as an
indicator of market size, while source GDP (GDPi) is proportional to the pool of potential
investors from source country. Natural log of host’s GDP per capita (GDPCAPj) proxying for
production costs is also included. However, as discussed by Globerman and Shapiro (2002), the
sign of the impact of GDP per capita is ambiguous, since this variable both reflects the level of
development (encouraging FDI) and the level of wages which can discourage inward FDI if not
compensated by productivity.

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The distance variable (DISTij) is calculated as a mean distance between the main towns of each
country. These basic variables are complemented with a dummy for contiguity (CONTij) or
common border and another one for common language (COMLGij). Like distance, these two
variables account for various transaction costs incurred when investing abroad. Common border
and common language data are taken from CIA World Fact book.

Since transition countries that are members of the World Trade Organization (WTO) might
receive more FDI as it is easier to export goods back to the home country, we account for this
with a dummy variable (WTOj) indicating whether a host country is a member of the WTO or
not.

To control for host country policies and quality of institution, we include a composite transition
index (INDEXj) compiled from the EBRD Transition Indicators. These are nine qualitative
country-by-country indicators with the scale from 1 (little/no progress) to 4.33 (standards of
advanced market economy) covering first phase reforms (small scale privatization, price and
trade liberalization) and second phase reforms concerning institutional development (large scale
privatization, governance, competition, infrastructure, and financial institutions). The transition
index is constructed as the first principal component of the EBRD Transition Indicators for the
host countries over the whole sample period. The first component accounts for 80.55% of the
variance in the nine EBRD Transition Indicators.

Thus, our baseline equation is the following:

ln( FDI ij ) =α1 +α2ln( GDP i ) +α3ln( GDP j ) +α4ln( GDPCAP j ) +α5ln( DIST ij ) +α6BIT ij

+α7ICT ij+α8IT ij +α9SS ij +α10 CONT ij +α11COMLG ij +α12WTO j +α13 INDEX +εij
j

Data Description

We have created a database of tax treaties involving transition countries. The data includes the
dates of signature, ratification, and termination. We find a few cases4 when a treaty was
terminated, but in the same year a new treaty was ratified. In these cases since the treaties were
re-signed within a year of termination the dummies do not have an interruption.

We have also considered the difference between the old/inherited and new treaties. Inherited
treaties are ones which were in place before our sample began.5 Inherited treaties may
4
Renewed tax treaty dummies constitute less than 3% of observations.
5
These are SS, ICT, and IT, which were mostly signed during the 1960s and 1970s, as well COMECON or CMEA tax treaties.
The Council for Mutual Economic Assistance (CMEA) was dissolved in 1990. However, the tax authorities of the signatories to
the multilateral CMEA treaties have agreed to observe the provisions of the treaties amongst themselves until new bilateral
treaties are in place. This agreement took place before the dissolution of the USSR. Original parties to this treaty were: Bulgaria,

13
complicate identification of the treaty effect. If we get a positive correlation between the tax
treaty variable and FDI, it will not be clear whether other unobservable characteristics may be
leading to increased FDI activity. This occurs because the tax treaty variable will pick up any
residual effects on FDI which are not measured by other regressors. However, the majority of
treaties in our sample were signed after our sample data began. We will call them new treaties.
Inherited treaties comprise only about 6% of our data. Thus, in this respect our treaties can be
divided into two categories: inherited have only cross-country variation and no time-series
variation, however, cross-country variation is sufficient; and new treaties have both cross-
country and time-series variation. These new treaties have a better opportunity to measure the
impact of a tax treaty, as we have data on FDI activity before and after the treaty.

The data on tax treaties is taken from International Bureau of Fiscal Documentation tax treaties
database.As to bilateral investment treaties, this data is drawn from UNCTAD database on
Bilateral Investment Treaties.

FDI data is drawn from OECD Direct Investment Database. The source of OECD data are
Central Banks and Statistical Offices of the FDI home countries, which follow the
recommendations of the IMF Balance of Payments Manual and the OECD Benchmark
Definition of Foreign Direct Investment. OECD data is considered more reliable compared to
other databases compiled on the basis of host country statistics, since it is based on IMF
methodological guidelines and therefore tends to be more uniform. Host country source of data
in case of FDI is less reliable because of large discrepancies. Even though new EU member
states and the candidate countries now follow the IMF definition of foreign direct investment,
deviations were frequent in the past. For instance, most Western Balkan countries still fail to
report all the forms of FDI (equity investment, reinvested profits, other investment). There are
discrepancies due to the very definition of FDI as well. According to IMF Balance of Payments
Manual, Revison 5, capital investment abroad is regarded as foreign direct investment if the
purpose is to establish and maintain permanent equity relations with a foreign company and at
the same time to exercise a noticeable influence on the management of that company; the share
of the foreign investor must make up at least 10 per cent of the target firm’s equity capital.
However, not all the countries apply the 10% equity threshold.

Czechoslovakia, Hungary, German Democratic Republic, Mongolia, Poland, Romania and the USSR. Following the dissolution
of the USSR, the Members of the Commonwealth of Independent States (CIS) have, in principle, agreed to honour the
international treaties, including income tax treaties, concluded by the USSR until new treaties have been negotiated in their own
name. However, some exceptions took place. For example, Estonia, Latvia, and Lithuania have announced their general
disapproval of USSR treaties.

14
Thus, as mentioned above we consider OECD data to be more reliable. Also, it is observed that
most of the outward FDI emerges from developed countries and about 87 per cent of this comes
from the OECD countries, where the top three positions are taken by United States, United
Kingdom and France (see Appendix B). Our dataset covers 17 OECD (home) countries and 9
transition (host) countries over the period of 1990-2001. We should mention here as well that
OECD data does not contain negative values of FDI (disinvestment).

The OECD database contains FDI data in nominal terms; in local currencies. With the help of
annual average exchange rates and Implicit Price Deflator (IPD) we convert flow data to US
dollars 2000.

Data on GDP is borrowed from the World Development Indicators (WDI) database. Information
about common borders and common language is available in the CIA World Fact book.
Common border may affect the amounts of capital flows. Distances between countries’ capitals
are calculated using online source http://www.indo.com/cgi-bin/dist/.

Data on WTO dates of membership is taken from the World Trade Organization official website
http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm.

The composite transition index is compiled on the basis of EBRD Transition Indicators borrowed
from EBRD website.

Information on treaties is summarized in figures 1 through 3. Figure 1 with the cumulative

number of bilateral investments treaties by FDI host country demonstrates the differences in the
treaty signing patterns among transitioning countries. We will exploit these differences to
identify the effect of treaties on FDI. Hungary, Poland, Czech Republic come into our data
having investment treaties with most source countries while during the same period there are
some country pairs that do not sign a treaty. Bulgaria, Romania, Slovenia, and Ukraine show the
most activity and sign most of the treaties between 1990 and 2002. Even among the most
dynamic countries there is some variation in the timing of activity. Romania and Ukraine sign
most of the treaties in the first half of the 90’s while Slovenia and Bulgaria are still signing
treaties towards the end of the decade. Figure 2 shows the cumulative number of investment
treaties and cumulative number of the double taxation treaties (IT and ICT). The figure suggests
that the periods of signing of both types of treaties often coincide and both exhibit a fair amount
of variation over time. Figure 3 describes components of the total number of BIT’s by groupings
of the host countries. Countries experience growth from different sources. Slovenia starts
signing treaties with the non-G7 European countries without a common border and does not sign

15
any treaties outside Europe. Romania signs treaties with G7 European countries before
expanding to other countries in Europe. Ukraine starts with G7 Europeans, continues to other
European countries before signing outside the continent.

16
 EMPIRICAL ESTIMATION AND RESULTS

Estimation procedures

Our sample can be grouped in two different ways: by country pairs (153 groups) and by host
countries (9 groups). We do the estimation for both groupings. When we do the host country
grouping we keep host characteristics constant and look across source countries. When we do
country pair grouping we take a pair and look within the pair trying to identify whether the
timing of the effect played a role.

Our estimation starts with several tests, which allow us todecide whether fixed effects, random
effects, or simple OLS on pooled data should be preferred. First, we look at panel versus simple
OLS on pooled data estimation. Since we suspect country-specific effects in the data, we
perform fixed-effects, and the F-test applied after carrying out the fixed-effects estimation
answers the question of fixed-effects vs. pooled OLS. Second, if F-test suggests that panel
estimation should be preferred, the Hausman specification test is applied to discriminate between
fixed and random effects estimation of the panel data. The tests mentioned above suggest fixed
effects specification for host country grouping and random effects specification for country pair
grouping.

There is potentially a problem of endogeneity: countries with larger bilateral FDI flows are also
more likely to enter into an agreement. One way to tackle endogeneity is to use instrumental
variables estimation. Successful implementation of this approach hinges on availability of valid
instruments. What we need are variables that affect the probability that two countries conclude a
treaty but are not directly related to the volumes of FDI between these two countries. We will
refer to these factors as country’s propensity to conclude treaties.

One possibility is to use the number of other tax/investment treaties a host has entered into with
countries other than the source country being considered. We will further refer to these treaties
as outside treaties. This is exactly what Hallward-Driemeier (2003) does. She writes: “The
willingness of a host to ratify a BIT, as measured by the number of outside BITs, should be
correlated with the probability it signs with this particular host country, but shouldn’t affect the
amount of FDI that particular source country would send. Thus, when US investors are
considering investing in India, their decision would not be affected by whether India has ratified
treaties with the UK or France. However, that India has entered other treaties would be expected
to influence their willingness to enter such a treaty with the US”. Note that those who claim the

17
non-dyadic approach is better, like Neumayer and Spess (2005) believe that BITs do have
positive spillover effects because of what they call the signaling effect. The signing of BITs
(especially with major capital exporting countries) sends out a signal to potential investors that
the developing country is generally serious about the protection of foreign investment. The
authors assume that it is difficult to say how important the signaling effect is (which benefits
investors from all countries), compared to the commitment effect (which only relates to investors
from BIT partner countries). Still, if the signaling effect is important, how can one explain, for
example, Ukraine signing 66 tax treaties and 58 BITs with other countries. Indeed if spillovers
were important we would observe that countries would sign only treaties with the most important
capital exporting nations. Therefore, in our opinion, the dyadic approach is better because it
allows us to control for omitted variables (unlike the non-dyadic approach) and the propensity of
signing treaties can be used as a valid instrument.

Instead of using just the number of outside treaties a host country has, we construct another
instrument – the sum of outside treaties a host and a home country have. A pair of countries is
more likely to conclude an agreement, when both countries, not just the host country, have the
habit of signing such agreements. Our instruments are intended to reflect the overall propensity
of countries to sign such types of treaties. The coefficients of correlation between treaty
dummies and suggested instruments range from 42% (SS) to 64% (ICT). We have tried other
possible options for instruments. Among them the conventionally used number of outside
treaties a host country has, as well as the number of outside treaties a home country has, and
possible combinations between the two. We have also tested the option of using the number of
treaties signed during the last five years for both home and host countries. The logic behind this
is that those countries that have been more active signing treaties in the last five years are more
likely to conclude such agreements now. The highest correlations between the instruments and
instrumented variables are found for the sum of outside treaties that both host and home
countries have for all years. Previous studies based on IV methodology, use the number of
outside treaties a host country has signed. To test whether the instruments we use (sums) are
stronger than the traditional alternative (outside treaties of hosts) we compare first-stage F-
statistics6. They are significantly higher for the instrument we use, especially for ICT and IT.

It is worth noting that we cannot use measures of openness or the transition index to instrument
for investment treaties because those measures inevitably correlate with the FDI flows.

6
F-statistics reported in the Appendix D.

18
Another potential problem is a statistically significant relationship between two upward trending
variables that is spurious. We deal with this problem by including year dummies to account for
any year-to-year variation in FDI flows unaccounted for by our other explanatory variables.

Finally, we explore the timing of the treaty effects on FDI. A dummy for each of the three years
prior to and after the ratification of the treaties is included. Another dummy takes on the value
of unity for years after the third year from ratification. We estimate the effects of timing in
specifications with host and pair random effects, and pooled OLS. The coefficients on the
timing dummies should be interpreted in terms of difference with the reference period. In our
case the reference period comprises all years up to 4 years prior to ratification. The timing of the
treaty effect has been investigated in a similar fashion by Hallward-Driemeier (2003). The
difference is that we include a separate dummy for all years after three years from ratification of
each treaty. The usefulness of our approach lies in separating the periods before and after the 3
year window, which otherwise are lumped together in the reference category and forces the
effect of treaties to die out. Our approach allows the coefficient on a treaty timing dummy to be
interpreted as the difference between the level of FDI in that year and the level of FDI from
years earlier than 3 years prior to ratification.

We expect that the effect of the third year prior and after the ratification will be estimated less
precisely because there are fewer observations for these dummies.

19
 Results

Table (1) reports pooled OLS estimation results for the logged amount of FDI in US$ of 2000
flowing from OECD country to a transition country as the dependent variable. As a starting date
for our treaty dummies in columns (1) and (2) we use the date of ratification and then the date of
signature as a robustness check in column (3). Almost all control variables are significant and of
expected sign. The larger the home country and the host country, the larger is the FDI flow.
Flows are also higher to host countries with smaller GDP per capita, which makes sense if we
think of GDP per capita as a proxy for production costs.

20
 Table 1. OLS estimation results (logged FDI flows in $US 2000)
Interaction
with
Variables OLS (rat) OLS (sign)
transition
index
lnGDP host 0.71068 0.73006 0.7603
(0.000)*** (0.000)*** (0.000)***
lnGDP home 0.91832 0.9161 0.9478
(0.000)*** (0.000)*** (0.000)***
lnGDPCAP host -0.22465 -0.2749 -0.3485
(0.099) (0.044)** (0.007)**
lnDistance -0.79725 -0.83469 -0.88202
(0.000)*** (0.000)*** (0.000)***
Common language 2.26368 2.2405 2.1495
(0.000)*** (0.000)*** (0.000)***
Contiguity -0.19366 -0.28437 -0.2832
(0.327) (0.152) (0.161)
Transition Index 0.47526 0.6187 0.54209
(0.000)*** (0.000)*** (0.000)***
WTO -0.05892 0.7427 -0.0322
(0.741) (0.681) (0.860)
BIT 0.44207 0.70463 0.2829
(0.001)*** (0.000)*** (0.052)***
ICT 0.93916 0.9908 0.2482
(0.004)*** (0.002)*** (0.380)
IT 0.66218 0.6652 -0.10102
(0.037)** (0.034)** (0.719)
SS -0.5422 -0.5934 -0.5446
(0.001)*** (0.000)*** (0.000)***
BIT*Transition Index -0.22456
(0.000)***
N. Obs 962 962 962
R2 0.4878 0.4832 0.4788
Note: p-values in parentheses; * - significance at 10%; ** - 5%; *** - 1%
Robust standard errors; year dummies not reported.

21
Our distance variable is negative, while having a common language is positive, both are
significant and in accordance with theoretical expectations. Contiguity (common border)
dummy is insignificant. This might be because few neighboring countries are present in our
sample. The transition index as a measure of institutional quality in host countries shows a
positive significant effect. Our variables of interest are significant at least in columns (1) and
(2); in column (3) only the bilateral investment treaty dummy and the social security treaty
dummy remain significant. Since column (3) presents the results based on the date of signature,
this supports the hypothesis that to have an effect on FDI a treaty needs to be ratified. All treaty
dummies but SS have a positive effect. Thus, according to the results in column (1), the
existence of a BIT between two contracting parties increases the FDI flow by 44%. If ICT or IT
is in place we get a 94% or 66% increase correspondingly, while SS treaty decreases FDI flow
by 54%. There could be a possible explanation of this negative effect based on the tax evasion
provisions, which can serve as disincentives to engage in FDI activity.7

In column (2) we interact the existence of a BIT with the institutional quality (proxied by the
Transition Index). We do so to test whether BITs are only valuable within a country with a
certain level of overall institutional development. Two possibilities exist: BITs can act either as
complements or as substitutes for strong domestic protection of property rights. A positive
interaction term on institutional quality and the ratification of a BIT would favor the former
interpretation, while a negative interaction term would favor the latter. The results show a
negative interaction, thus revealing that BITs per se will have a stronger effect in a weak
institutional setting. Since tax treaties are not really aimed at complementing or substituting
domestic protection of property rights, we do not interact them with the institutional quality.

When significant the per capita GDP of the host country negatively affects the investments
inflows. This finding is expected if FDI is carried out to take advantage of the low labor cost,
(vertical FDI) rather than to access the market (horizontal FDI). Producers seeking lower cost
locations are more likely to channel their investments into countries with lower incomes.
Another possible explanation comes from the fact that the low income counties experience
relatively fast growth in the FDI inflows because they start from a lower stock of FDI. In that
case the coefficient on per capita GDP captures the effect of catching up by the lower income
economies.

7
A Detailed explanation can be found below.

22
Table (2) reports panel estimation results. Hausman test fails to reject the random-effects
assumption (time-invariant factors are uncorrelated with the explanatory variables) for country
pair grouping; but rejects this assumption for host country grouping. We therefore present the
random-effects estimation results for pair grouping in column (1) and fixed-effects for host
grouping in column (2). For both of these specifications we interact BIT with Transition Index
in columns (3) and (4). For the random effects pair specification, as a robustness check, we use
the date of signature instead of the date when a treaty was ratified (column 5).

Throughout all the specifications control variables stay significant and of the expected sign with
the exception to host GDP p.c, contiguity, and WTO variables, which are insignificant. The
WTO dummy turns negative significant in host fixed effects specifications. This is rather a
strange result, since the WTO dummy is expected to have a positive effect. But since all
countries in our sample entered WTO in 1995 (except for Bulgaria - 1996; Russia and Ukraine
did not enter WTO so far), variation in this variable is low, and we probably should not pay too
much attention to this. Among the variables of interest only BIT and SS show consistency in the
signs and significance throughout all specifications8.

BITs encourage FDI flows and this effect ranges from 42% to 83%, which is close to what we
get in pooled OLS estimation. All specifications give a negative significant SS result, which is
puzzling because SS should increase FDI if they remove the possibility of paying social security
contributions twice. However, there could be a possible explanation originating from legal
literature on tax treaties, which assumes that treaties are intended to reduce tax evasion by
MNEs, not reduce double taxation. In particular, the matter concerns transfer pricing provisions
and the exchange of tax information between governments. These measures can offset the FDI-
promoting effects of tax treaties.

The ICT dummy displays sufficient consistency too. It is positive and significant in the first four
specifications, and turns insignificant only in the last column, where we do a specification based
on the date of signature. This again supports the hypothesis that to have an effect on FDI a treaty
needs to be ratified. The IT dummy is significant (with positive sign) only in host fixed effects
specifications, but not in country pair random effects specifications.

Including a traditional tax treaty dummy (one if there is any tax treaty and zero if there is no
treaty) like in previous works shows no significant effect.

8
If we use pair Fixed effects, BIT and SS remain significant, while the other tax treaties are insignificant.

23
The interacted BIT*Transition Index gives negative significant result which is consistent with
what we get for pooled OLS specification.

24
 Table 2. Panel estimation results (logged FDI flows in $US 2000)
Pair RE Host FE Pair RE
Variables Pair RE (rat) Host FE (rat)
(interaction) (interaction) (sign)
lnGDP host 0.68945 1.09312 0.7193375 1.276357 0.7201158
(0.000)*** (0.023)** (0.000)*** (0.007)*** (0.000)***
lnGDP home 0.93828 0.93966 0.9390046 0.9360072 0.9555236
(0.000)*** (0.000)*** (0.000)*** (0.000)*** (0.000)***
lnGDPCAP host 0.20578 -0.739452 0.1945107 -0.3901564 0.1449517
(0.300) (0.468) (0.321) (0.699) (0.466)
lnDistance -0.84545 -0.8528 -0.8865569 -0.8995257 -0.8962245
(0.000)*** (0.000)*** (0.000)*** (0.000)*** (0.000)***
Common language 2.4291 1.87444 2.387142 1.881151 2.421931
(0.007)*** (0.000)*** (0.007)*** (0.000)*** (0.009)***
Contiguity -0.49278 -0.04306 -0.5718995 -0.1636568 -0.5446089
(0.232) (0.833) (0.157) (0.421) (0.194)
Transition Index 0.24028 -0.0848 0.3283385 0.0599106 0.2686834
(0.001)*** (0.562) (0.000)*** (0.685) (0.000)***
WTO -0.25549 -0.5515 -0.1929713 -0.5970304 -0.2463965
(0.135) (0.052)* (0.262) (0.034)** (0.150)
BIT 0.42502 0.50338 0.5234234 0.8333026 0.4527339
(0.005)*** (0.000)*** (0.001)*** (0.000)*** (0.006)***
ICT 0.45236 0.79268 0.4807682 0.8302537 -
(0.087)* (0.001)*** (0.067)* (0.000)*** 0.0689651
(0.770)
IT 0.17418 0.55490 0.1947564 0.5394726 -
(0.524) (0.018)** (0.474) (0.020)** 0.3384541
(0.197)
SS -0.62424 -0.50398 -0.6498642 -0.5165181 -
(0.012)** (0.004)*** (0.008)*** (0.003)*** 0.5626095
(0.011)**
BIT*Transition Index -0.140099 -0.294981
(0.012)** (0.000)***
N. Obs 962 962 962 962 962
R2 within=0.35
within=0.35 within=0.41 within=0.35 within=0.43
between=0.
between=0.5 between=0.0 between=0.5 between=0.0
50
2 2 3 7
overall=0.4
overall=0.47 overall=0.22 overall=0.47 overall=0.25
5
Note: p-values in parentheses; * - significance at 10%; ** - 5%; *** - 1%
Year dummies not reported.

25
Table (3) presents Instrumental Variables estimation results. It starts with IV (2SLS) regressions
followed by fixed-effects IV regression. Hausman test suggests country pair random effects, as a
robustness check we also do pair fixed effects (column 5). In column (4) the interacted
BIT*Transition Index is included. We simultaneously instrument four treaty dummies: ICT, IT,
SS, and BIT. As discussed above, the instruments used are the sums of outside treaties that both
host and home countries have corresponding to each treaty type (ICT, IT, SS, BIT). Tax treaty
dummies are insignificant throughout IV specifications, except for SS treaty, which is negative
significant in columns (1) and (2). BIT is the only treaty that stays significant throughout all
specifications, and the effect of BIT is unchangeably positive. As can be seen from the table
below, instrumenting treaties produces a very large coefficient in case we do not control for
country pair effects, while the pair fixed effects and random effects estimates remain fairly
reasonable. Given that the size of the coefficient increases, high FDI flows would decrease the
chances of having a treaty. Indeed, if there is already a high FDI inflow, why would one want to
sign a treaty?

26
 Table 3. IV estimation results (logged FDI flows in $US 2000)
Pair RE IV Pair RE IV
Variables 2SLS (rat) 2SLS (sign) Pair FE IV (rat)
(rat) (interaction)
lnGDP host 0.0318697 0.3938 1.013625 0.4605846 1.4177
(0.905) (0.481) (0.130) (0.058)* (0.071)*
lnGDP home 1.233196 1.1777 0.6852966 1.089217 0.2858
(0.000)*** (0.000)*** (0.614) (0.003)*** (0.850)
lnGDPCAP host 2.3945 1.4212 -0.1580569 0.43603 -1.1032
(0.014)** (0.272) (0.916) (0.374) (0.408)
lnDistance -0.150128 -0.1538 -0.3545127 -0.5040456
dropped
(0.653) (0.723) (0.874) (0.511)
Common language 0.50637 1.7379 3.785506 2.006902
dropped
(0.738) (0.194) (0.611) (0.466)
Contiguity 2.0292 1.7283 -0.4026737 0.1156395
dropped
(0.022)** (0.107) (0.879) (0.912)
Transition Index -.52427 -0.0874 -0.1123104 -0.1554021 -0.18403
(0.152) (0.791) (0.354) (0.483) (0.173)
WTO -0.09522 0.2946 -0.4881483 -0.6211766 -0.45214
(0.816) (0.685) (0.144) (0.025) (0.119)
BIT 6.4553 6.8703 1.672409 1.677447 1.4616
(0.003)*** (0.001)*** (0.009)*** (0.002)*** (0.061)*
ICT -0.18744 -3.6337 0.8162004 -1.605046 0.9662
(0.947) (0.690) (0.946) (0.716) (0.920)
IT -1.55113 -5.0019 -0.9587139 -3.282159 -1.0424
(0.617) (0.566) (0.932) (0.456) (0.901)
SS -5.5825 -3.8844 0.0011532 -1.0321 -0.51178
(0.011)** (0.075)* (0.999) (0.496) (0.760)
BIT*Transition Index 0.3204584
(0.219)
N. Obs 962 962 962 962 962
Note: p-values in parentheses; * - significance at 10%; ** - 5%; *** - 1%
Year dummies not reported.

27
 Timing of the Treaty Effect

There is no clear theoretical prediction about the timing of the treaty effect. A treaty can foster
investment or itself be a response to an increase in the investment activity between two
countries. The exact length of the lag or lead in the treaty effect is also an empirical question.

In order to explore the timing of the treaty effect we augment the parsimonious specification
with the dummies for each of the 3 years prior and each of the 3 years after the treaty was
ratified. All years after the third year are designated with a separate dummy. The three year
window is chosen based on the limited length of our panel because for a wider window the
estimates of the effects closer to the beginning and end of the window become less precise. In
this setup our reference category corresponds to years prior to the third year before the earliest
treaty was ratified. In other words, a positive and significant coefficient on "BIT Yr ratify +1"
implies that in the year after a BIT was ratified there was an increase in annual FDI flows
relative to the period more than 3 years prior to the ratification. The results are presented in table
4.

We estimate three specifications: pair random effects, host random effect, and a pooled OLS
specification. Our findings are catalogued below along with possible explanations.

First, generally our results do not reveal an increase in investment before ratification. If anything,
in one case we observe just the opposite and the levels of FDI drop before ratification, which is
consistent with investors delaying their investments till ratification.

Second, only the BIT's encourage FDI. The FDI flows increase in the year of ratification and
remain higher afterwards. "BIT Yr ratify +3" is significant only at the 10.2% level in the pair
random effect specification. This lower significance could be partially due to lack of variation
because treaties ratified in or after 1999 will not have a Year+3 dummy by construction.

Third, ICT and IT have a similar effect on FDI. Pair RE estimates reveal no effect at
conventional levels of significance in all but one case. There seems to be a drop in FDI 2 years
prior to a ratification of an ICT. The host RE (and OLS) suggest that ICT and IT both have a
positive long term effect on FDI even though the exact timing is not statistically distinguishable.

Fourth, there are indications that the effect of the social security treaty (SS) is negative. The
preferred pair RE estimate picks up a decrease in the year of ratification. All specifications show
a decrease in the level of FDI for the period of 4 years or more after the ratification.

28
 Table 4. Timing of the Treaty Effect
Variables Pair Random Effects Host Random Effects OLS
lnGDPhost 0.712 (0.000) 0.684 (0.000) 0.684 (0.000)
lnGDPhome 0.954 (0.000) 0.886 (0.000) 0.886 (0.000)
lnGDPPChost 0.199 (0.324) -0.206 (0.147) -0.206 (0.147)
EBRD Index 0.259 (0.000) 0.460 (0.000) 0.460 (0.000)
lnDIST -0.797 (0.000) -0.723 (0.000) -0.723 (0.000)
Language 2.467 (0.004) 2.170 (0.000) 2.170 (0.000)
Contiguity -0.356 (0.362) -0.057 (0.788) -0.057 (0.788)
WTO -0.161 (0.399) 0.024 (0.906) 0.024 (0.906)
BIT Yr ratify -3 0.350 (0.203) 0.027 (0.935) 0.027 (0.935)
BIT Yr ratify -2 0.213 (0.423) -0.032 (0.919) -0.032 (0.919)
BIT Yr ratify -1 0.353 (0.166) 0.162 (0.58) 0.162 (0.581)
BIT Year ratify 0.855 (0.000) 0.665 (0.01) 0.665 (0.010)
BIT Yr ratify +1 0.487 (0.044) 0.425 (0.075) 0.425 (0.075)
BIT Yr ratify +2 0.601 (0.011) 0.433 (0.057) 0.433 (0.057)
BIT Yr ratify +3 0.402 (0.102) 0.255 (0.261) 0.255 (0.261)
BIT After +3 0.591 (0.017) 0.538 (0.002) 0.538 (0.002)
ICT Yr ratify -3 -0.549 (0.336) 0.226 (0.741) 0.226 (0.741)
ICT Yr ratify -2 -0.965 (0.042) -0.476 (0.383) -0.476 (0.383)
ICT Yr ratify -1 0.303 (0.497) 0.412 (0.405) 0.412 (0.405)
ICT Year ratify 0.421 (0.350) 0.721 (0.136) 0.721 (0.136)
ICT Yr ratify +1 0.486 (0.270) 0.535 (0.235) 0.535 (0.235)
ICT Yr ratify +2 0.181 (0.679) 0.500 (0.264) 0.500 (0.264)
ICT Yr ratify +3 0.064 (0.876) 0.367 (0.365) 0.367 (0.365)
ICT After +3 0.359 (0.359) 1.226 (0.000) 1.226 (0.000)
IT Yr ratify -3 -0.830 (0.176) 0.025 (0.972) 0.025 (0.972)
IT Yr ratify -2 -0.762 (0.161) -0.535 (0.394) -0.535 (0.394)
IT Yr ratify -1 0.052 (0.918) 0.119 (0.835) 0.119 (0.835)
IT Year ratify 0.367 (0.426) 0.574 (0.255) 0.574 (0.255)
IT Yr ratify +1 -0.278 (0.548) 0.104 (0.832) 0.104 (0.832)
IT Yr ratify +2 0.358 (0.424) 0.679 (0.152) 0.679 (0.153)
IT Yr ratify +3 -0.177 (0.673) 0.321 (0.444) 0.321 (0.444)
IT After +3 -0.160 (0.683) 0.830 (0.007) 0.830 (0.007)
SS Yr ratify -3 -0.090 (0.834) 0.218 (0.685) 0.218 (0.685)
SS Yr ratify -2 -0.141 (0.745) 0.153 (0.777) 0.153 (0.777)
SS Yr ratify -1 -0.220 (0.613) 0.171 (0.751) 0.171 (0.751)
SS Year ratify -0.962 (0.024) -0.639 (0.213) -0.639 (0.213)
SS Yr ratify +1 -0.645 (0.216) -0.071 (0.909) -0.071 (0.909)
SS Yr ratify +2 -0.506 (0.243) 0.044 (0.930) 0.044 (0.930)
SS Yr ratify +3 -0.220 (0.632) 0.126 (0.805) 0.126 (0.805)
SS After +3 -0.769 (0.010) -0.652 (0.001) -0.652 (0.001)
N.obs 962 962 962
R-sq within = 0.369 within = 0.412 0.502
between = 0.520 between = 0.927
overall = 0.470 overall = 0.502
Notes: p-values are in parentheses. All specifications include year dummies. The choice between fixed and
random effects was made based on a Hausman test of null hypothesis that there is no systematic difference
between coefficients.

29
 CONCLUSION

The majority of economic texts stress the intuitive notion that bilateral tax treaties and bilateral
investment treaties should promote FDI. However, not all the empirical studies support either
hypothesis. The most prominent works on tax treaties, on the contrary, even find negative
impacts on FDI. Whether bilateral investment treaties have an impact is more ambiguous.
Papers using a dyadic approach do not find any evidence of BITs effect on FDI, in contrast to
papers that use a non-dyadic approach which tend to find a positive effect on FDI.

Using OECD data we find that transition countries that have BITs with developed countries
receive more FDI inflows from these countries. The effect is robust to various model
specifications. On the contrary, tax treaties do not reveal any robust effect on FDI flows.

This finding is particularly valuable for three main reasons. First, to our knowledge, this is the
first study examining both bilateral investment treaties and tax treaties simultaneously in one
model. Second, it focuses on transition countries, which allows for more homogeneity in the
sample. This is especially important, since then we can account for possible omitted variable
bias. Thirdly we tackle the endogeneity issue.

This study also provides evidence that BITs function to some extent as substitutes for
institutional quality. In the majority of estimations that we do with interaction, the interaction
term between the BIT dummy and a proxy for institutional quality is negative and statistically
significant, implying that the net effect of a BIT is smaller (but still positive) if the quality of a
host country’s institutions is better.

We do not find any robust effect of tax treaties on FDI. When we include a traditional tax treaty
dummy, which is one if there is any tax treaty and zero if there is no treaty, the result is
consistent with what we get in general when doing tax treaty categorization – no significant
effects are found. This can be explained by the two effects of tax treaties on FDI that might
offset each other. One of them reduces double taxation, which should encourage FDI; the other
prevents tax evasion through setting constraints on transfer pricing by MNEs, which might
discourage FDI.

Summing up, the main message we have for policy makers of developed and developing
countries alike is that signing and ratifying BITs with developed countries does have the desired
payoff of higher FDI flows.

30
 Figure 1. Cumulative Number of Bilateral Investment Treaties.

Bulgaria Czech Republic Hungary

10 15
Cumilative number of signed BIT's (by host)
5
0

Poland Romania Russia

10 15
5
0

Slovakia Slovenia Ukraine

10 15
5
0

1990 1995 2000 1990 1995 2000 1990 1995 2000

Year
Graphs by FDI host country

Figure 2. Cumulative Number of Investment and Double Taxation Treaties.

Bulgaria Czech Republic Hungary

0 5 10 15 20
Cumulative number of signed treaties

Poland Romania Russia

0 5 10 15 20

Slovakia Slovenia Ukraine

0 5 10 15 20

1990 1995 2000 1990 1995 2000 1990 1995 2000

Year
IT and ICT BIT
Graphs by FDI host country

31
 Table 3. Cumulative Number of Bilateral Investment Treaties by Groupings of FDI Source
Countries.

Bulgaria Czech Republic Hungary

0 5 10 15
Cumulative number of signed BIT's

Poland Romania Russia

0 5 10 15

Slovakia Slovenia Ukraine

0 5 10 15

1990 1995 2000 1990 1995 2000 1990 1995 2000

Year
total with G7 countries
with adjacent countries with European countries
Graphs by FDI host country

Notes: 1) Canada is not among G7 countries due to availability of FDI flows data; 2) non-
European countries are Korea, Japan, and the USA.

32
Appendices

Appendix A. Number of BITs and DTTs concluded, cumulative and year to year, 1990-2004

Source: WIR 2005

33
Appendix B. Direct investment cumulative outflows from OECD countries 1990-2003.

34
 Appendix C. List of countries included in sample.

Home countries Host countries

Austria, Belgium, Denmark, Finland, France, Bulgaria, Czech Republic, Hungary, Poland,
Germany, Italy, Japan, Korea, Netherlands, Romania, Russia, Slovakia, Slovenia, Ukraine
Poland, Portugal, Spain, Sweden, Switzerland,
United Kingdom, United States of America

Appendix D. First-stage F-statistics

Instruments BIT ICT IT SS

sums 36.21 186.86 132.10 41.95

outside treaties of hosts 23.55 7.99 6.63 31.87

35
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