Optimal tax policy and foreign direct investment under ambiguity

We analyze the optimal timing of an irreversible foreign direct investment by a foreign firm and the optimal tax policy by a host country under ambiguity. We derive the optimal GDP level at which the foreign firm switches from exporting to a foreign direct investment. Furthermore, we derive the optimal tax policy by the host country, and analyze the effect of an increase in ambiguity on the optimal tax policy. We show that the host country should reduce the optimal corporate tax rate from the host government’s perspective in response to an increase in ambiguity. Our result is different from the one obtained by Pennings (2005) that shows that an increase in risk induces an increase in the optimal corporate tax rate.