To Invest or not to Invest: A Real Options Approach to FDIs and Tax Competition

Foreign investment decisions of firms are often characterized by investment irreversibility,uncertainty, and the ability to choose the optimal timing of foreign investments.
We embed these characteristics into a real option theory framework to analyze international competition among countries to attract mobile investments when firms, after the investment is sunk, can shift profit to low tax countries by transfer pricing. We find that an increase in the uncertainty of profit income reduces the equilibrium tax rates, whilst lower investment costs or larger profits, counteracts the negative fiscal externality of tax competition leading
to higher equilibrium tax rates.