ChainWhat it assumes · how to break it
Start
The government cuts corporation tax, for example from 25% to 20%.
1
As a result, the UK becomes more attractive to multinational firms, so inflows of foreign direct investment rise.
foreign direct investment · financial account
foreign direct investment · financial account
Assumes: Firms choose locations partly on tax.
But: The 15% global minimum corporate tax agreed through the OECD limits how much a tax cut can attract.
2
This means foreign firms build new plants and expand capacity in the UK, raising the economy's capacity to export.
export capacity
export capacity
Best link to attack
Assumes: The FDI creates new export-oriented capacity.
Assumes: The FDI creates new export-oriented capacity.
But: Much FDI is the takeover of existing UK firms, or investment to serve UK consumers, which adds no export capacity.
3
In addition, some goods that were imported are now made in the UK.
import substitution
import substitution
Assumes: The new plants source their inputs in the UK.
But: Foreign-owned plants often import many of their components through global supply chains, which raises imports.
4
Consequently, export earnings rise relative to import spending, so the trade balance improves.
trade balance
trade balance
Assumes: The exchange rate does not move to offset it.
But: FDI inflows raise demand for the pound; if it appreciates, UK exports become dearer, offsetting part of the gain.
5
At the same time, profits earned by foreign-owned firms are paid to their owners abroad, recorded as primary income outflows on the current account.
primary income · current account
primary income · current account
Assumes: Profit outflows are large compared with the trade gain.
But: Wages paid to UK workers and inputs bought from UK suppliers stay in the economy, so the net gain to the current account can still be positive.
End
The trade balance may improve as export capacity grows, but the current account improves by less because profits flow abroad as primary income.
Evaluation chain
- E1However, the effect on the trade balance depends on the type of FDI the tax cut attracts.
- E2If most of it is the takeover of existing UK firms, or investment to serve UK consumers such as retail and property, no new export capacity is created.
- E3As a result, exports barely change, while the profits paid to foreign owners rise.
- E4So the trade balance may not improve at all, and the current account could worsen as primary income outflows grow.
FDI takes years to turn into new capacity and exports; profit outflows continue for as long as the plants operate.
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Questions this answers
- Assess the impact of a cut in corporation tax on the UK's current account.
- Discuss the costs and benefits of inward foreign direct investment for a country's balance of payments.
- Explain how a cut in business taxes might affect the trade balance.
Diagram
No standard diagram. The balance of payments accounts show FDI as an inflow on the financial account and profits paid abroad as a primary income outflow on the current account.
Reverse and related
Corporation tax rise → less inward FDI → slower growth of export capacity, though smaller profit outflows over time.