Abstract

This article examines the effects of state corporate income taxes on the location of foreign direct investment in the United States, taking into account the endogeneity of taxes and the outside options of investors. States have a set of characteristics that influence investors' decisions; some of them are not observable by a researcher, but states may take them into account when they set taxes. States also can act strategically with respect to other states when setting taxes. Both behaviors bias the estimated tax effects because they create correlation between the error term and the tax rate. I adapt a discrete-choice model of differentiated products to estimate the tax effects. This approach allows me both to control for the outside options of investors and to use instrumental variables to solve the problem of tax endogeneity. I find the tax elasticity to be consistently about 1. © 2007 Sage Publications.