Corporate Profit Tax and Strategic Corporate Social Responsibility Under Foreign Acquisition

1 Introduction

As globalization increasingly prevails, domestic industries in most countries are concentrated by a few large foreign-owned firms, which account for a substantial share of aggregate international trade.^[1] The acquisition of domestic firms’ stocks by those firms is also a widespread, visible phenomenon.^[2] For example, the French automotive company Renault acquired a 36.8% equity stake in Nissan Motor in 1999. There are more recent examples in the global energy, airline, and steel industries in the world. In the last decade, we have witnessed a rapid development of new energy vehicles. According to the electric vehicle world sales database, the world annual sales volume was 10,000 units in 2012, while it quickly increased to two million units in 2018. In particular, China’s new energy vehicle sales accounted for 56% of global sales, which can be attributed to the sustainable fiscal subsidies provided by the Chinese government since 2013. As the champion in global energy vehicle sales ranked by OEM group 2018, the American Tesla Motors decided to build factories in China in 2018 to compete with some local new energy vehicle companies, such as BYD, Basic BJEV, et al.

In the process of globalization, on the other hand, the popularity of corporate social responsibility (CSR) by global firms has also grown rapidly in recent years.^[3] Some practical examples include GE’s Ecomagination program, Nestlé’s Creating Shared Values, and Unilever’s Simple Living Plan. Furthermore, it is becoming more common to suggest global standards of international CSR for global firms. For example, the European Commission promotes CSR in the EU and encourages foreign-owned firms to adhere to international guidelines and principles. The Global Reporting Initiative provides a globally applicable framework for drawing up sustainability reports in accordance with internationally recognized criteria.^[4]

Both international acquisitions and CSR activities by foreign-owned firms have now become imperative global business strategies. As they have significant welfare implications on the design of government policies, recent research on international oligopoly markets with heterogeneous objective functions has analyzed different forms of market competition where profit-maximizing private firms may compete with other private firms that have adopted various CSR activities.^[5] Accordingly, recent theoretical studies have also examined the effect of CSR on tariffs and welfare in international trade, such as Wang, Wang, and Zhao (2012), Chang et al. (2014), Manasakis, Mitrokostas, and Petrakis (2018), Liu, Wang, and Chen (2018), and Xu and Lee (2019). However, these works took the level of CSR as an exogenously given variable that was a normative goal established in the social contract.

From a shareholder’s viewpoint, CSR is an instrument of the firm’s choice variables to engage in a global business strategy that reflects a management’s incentive contracts. For example, Starbucks increases its demand by buying fair-trade coffee and tea, and other firms heavily advertise their organic products. This enhances their reputations and increases the firms’ values. Similarly, some foreign-owned firms focus a fair amount of attention on image signaling concerns, and thus provide incentives for employee engagement in community service, which boosts their public relations with local communities and attracts motivated employees in the home country.^[6] Accordingly, recent papers have formulated a model of strategic choice of CSR from the strategic motivation of adopting CSR behaviors, and showed that profit maximization could motivate a firm to engage in CSR.^[7] To our knowledge, however, studies on the foreign-owned firms’ strategic utilization of CSR initiatives under international acquisitions and the interactions with governmental policies are limited.

There are several definitions used in the CSR literature, even for the purpose of the profit-maximizing or so-called “business” case.^[8] Moreover, CSR incentive contracts may reflect different corporate governance, resulting from different interest group controls, in which consumer interest is important (Königstein and Müller 2001; Planer-Friedrich and Sahm 2018). As an interesting case of strategic CSR in a market transaction, we regard consumer surplus as a proxy for CSR, which is widely accepted in the literature.^[9] In this case, the firm with CSR activities is defined as a profit-oriented private firm with a concern for consumer surplus as a CSR initiative.

This paper investigates the strategic relationship between consumer-oriented CSR initiatives and international acquisition, and examines the effect of government policies on strategic CSR. In particular, we address the strategic motivations for CSR arising from the interactions between domestic and foreign-owned firms under government public policies such as corporate profit taxes and (uniform or discriminatory) output subsidies.^[10] Interestingly, we show that there exists the strategic effect of corporate profit tax on the strategic CSR and output subsidy policy.^[11] This finding is important to the policymakers because, in the literature of microeconomics, corporate profit taxes are neutral toward firm behaviors.

In a duopoly model of Cournot competition, we examine the governmental policies facing firms’ strategic CSR activities and summarize our findings as follows: First, the strategic level of CSR decreases while social welfare increases with corporate tax. Second, unilateral CSR case in which only one firm adopts CSR leads to a higher level of CSR than that under bilateral CSR case in which both firms adopt CSR. Third, the optimal output subsidy increases with corporate tax while it decreases with foreign penetration, and the optimal output tax is possible when the foreign penetration is high and the corporate tax is low. Fourth, the welfare effects of CSR crucially depend on both corporate profit tax and foreign acquisition, but bilateral CSR always yields the highest welfare irrespective of corporate tax or foreign penetration. Fifth, we consider an endogenous choice game of CSR between the two firms and examine the equilibrium choice of CSR. When each firm decides whether to engage in CSR at the beginning of the game, we show that domestic CSR (no CSR) is a Nash equilibrium when corporate tax is low (high). Finally, we consider a discriminatory subsidy where the government grants different subsidies to the firms. We find that foreign CSR (no CSR) is a Nash equilibrium when corporate tax is low (high) in an endogenous choice game of CSR under the discriminatory subsidy; however, neither is socially desirable. Therefore, an appropriate regulatory framework for CSR guidelines is necessary in certain cases with a lower corporate tax.

The remainder of this paper is organized as follows. Section 2 presents the basic model of Cournot competition in which a domestic firm and a foreign-owned firm compete with CSR initiatives under output subsidy and corporate tax policies. We then analyze the market equilibrium under different choices of CSR in Section 3. We then compare the equilibrium outcomes among the four models and extend to an endogenous choice game of CSR in Section 4. In Section 5, we further examine the discriminatory subsidy. Finally, Section 6 concludes the paper.

2 The Model

We consider a duopoly market with two private firms that produce homogeneous products, but with possibly different objectives. Firm 1 and firm 2 are the pure profit-oriented private firms and both of them might engage in CSR activities. We assume that firm 1 is a domestic firm fully owned by domestic investors, while firm 2 is a foreign firm owned by both domestic and foreign investors.^[12]

Inverse demand is given by: p = 1 − Q, where Q = q ₁ + q ₂ is the market output and q ₁ and q ₂ denote the quantities supplied by domestic firm 1 and foreign-owned firm 2, respectively. The cost function of firm i is identical and given as: C ( q i ) = 1 2 q i 2 , where i = 1, 2. The government imposes a corporate profit tax of τ ∈ (0, 1) on both firms, which is exogenously given.^[13] Further, the government might provide a production subsidy s per unit of output to the two firms in this market.^[14] Note that the output subsidy becomes an output tax when it is negative.

The profits of the firms are as follows:^[15]

It is assumed that each firm maximizes its profit as a pure private firm, and both of them can strategically choose profit-oriented CSRs. In particular, we assume that the firm is in a managerial delegation contract in which output production decisions are delegated to a manager. That is, the owner of the firm specifies a degree of CSR as an incentive contract with the manager to maximize the profit.^[16] In this managerial delegation contract, the manager is assumed to maximize the profit of the firm plus a fraction of consumer surplus in output production that is imposed by the owner. Thus, the objective function of the manager of the firm is given as follows:

where α _i  ∈ [0, 1] represents the level of CSR of firm i and C S = 1 2 Q 2 is the consumer surplus. Note that a consumer-friendly CSR initiative is regarded as that the firm adopts consumer surplus as a proxy for its own CSR concerns. Then, the CSR incentive combines profitability and consumer surplus in a convex combination formula. When the firm engaged in CSR assigns a weight to consumer surplus in its objective function, it is sensible to assume that the firm places a higher weight on output, and that it produces aggressively. Here, α _i  = 0 denotes a pure profit-maximizing private firm. Finally, we take the strategic CSR perspective that the owner strategically chooses its level of CSR in order to maximize its profit π _i in (1). That is, the firms will adopt strategic CSR only when CSR increases its profitability.

Considering the share of foreign ownership, we define producer surplus as: PS = π ₁ + (1 − β)π ₂, where β ∈ (0, 1] is the foreign penetration in the foreign-owned firm, which can be potentially affected by policymakers acting on capital liberalization.^[17] We define domestic welfare as the sum of consumer surplus, producer surplus, and tax revenue, T = τ ∑ ( p i q i − 1 2 q i 2 + s q i ) , minus the subsidy expenditure, S = s∑q _i :

This study considers different scenarios regarding the choice of CSR unilaterally or bilaterally under government policies in a certain industry. In particular, when the two firms decide whether to engage in CSR activities or not in the beginning, we classified with four scenarios: “bilateral CSR” where both firms adopt CSR bilaterally, “domestic CSR only” or “foreign CSR only” where either one of two firms adopts CSR unilaterally, and “no CSR” where no firms adopt CSR. In each scenario, the timing of each game is as follows. In the first stage, the government decides the level of output subsidy. In the second stage, given the level of subsidy s, the firm chooses the level of CSR to maximizes its own profit.^[18] In the final stage, given the level of CSR α _i , both firms compete in quantities. We solve the subgame perfect Nash equilibrium using backward induction.

3 The Analysis

4 Comparisons and Discussions

5 Discriminatory Subsidy

We now consider a discriminatory subsidy according to which the government grants different levels of output subsidies to the firms, s _i , in the first stage. The profit of the firm is π i = ( 1 − τ ) ( p q i − 1 2 q i 2 + s i q i ) , and the total subsidy expenditure is S = s _i ∑q _i where i = 1, 2. For simple comparisons, we assume that β = 1 where the foreign-owned firm is an exclusive foreign-owned enterprise. In the below, we analyze the four models under discriminatory subsidies, respectively, and then examine an endogenous choice game of CSR.

First, we consider a bilateral CSR case. In the last stage, the differentiation of V _i with respect to q _i yields the following outputs:

The profits of the domestic and foreign-owned firms are respectively

In the second stage, the differentiation of π _i in Eq. (35) with respect to α _i yields the following optimal level of CSR of the firm:

where M = 41 + 52 s 1 + 16 s 1 2 + 30 s 2 + 20 s 1 s 2 + 5 s 2 2 and i = 1, 2.

The resulting social welfare is

In the first stage, the government opts for discriminatory subsidies to maximize social welfare. As obtaining the explicit outcomes in the equilibrium is challenging, we use numerical simulations with τ ∈ (0, 1). Table 2 presents the equilibrium outcomes in this model, where superscript “*” represents the equilibrium outcome under the discriminatory subsidy. Note that s 1 B ∗ > 0 and s 2 B ∗ < > 0 when τ < > τ B ∗ = 0.7842 . This implies that under discriminatory subsidies, a domestic firm can increase its competitive advantage when competing with a foreign-owned firm. However, the corporate tax rate directly affects the subsidy decision of the government regarding a foreign-owned firm. In particular, the government taxes the output of the foreign-owned firm when corporate tax is low, and subsidizes the output when corporate tax is high enough.

Second, we consider a domestic CSR case. In the last stage, by substituting α ₂ = 0 into Eq. (35), we calculate the profit of the domestic firm. In the second stage, the differentiation of π ₁ with respect to α ₁ yields α 1 = ( 1 − τ ) ( 2 + 3 s 1 − s 2 ) 11 + 6 s 1 + 5 s 2 . In the first stage, the differentiation of W with respect to s _i yields: s 1 D ∗ = 2 ( 4 − 3 τ ) 9 ( 3 − 2 τ ) and s 2 D ∗ = 3 τ − 2 3 ( 3 − 2 τ ) . Note that s 1 D ∗ > 0 and s 2 D ∗ < > 0 when τ < > τ D ∗ = 2 3 . The implication of discriminatory subsidies is similar to the bilateral CSR case. Then, the resulting optimal CSR is α 1 D ∗ = ( 1 − τ ) ( 4 − 3 τ ) 3 ( 5 − 3 τ ) . The profit of the firm is respectively π 1 D ∗ = 7 ( 4 − 3 τ ) 2 ( 1 − τ ) 54 ( 3 − 2 τ ) 2 and π 2 D ∗ = 1 − τ 6 ( 3 − 2 τ ) 2 . Finally, the social welfare is W D ∗ = 5 − 3 τ 6 ( 3 − 2 τ ) .

Third, we consider a foreign CSR case. In the last stage, by substituting α ₁ = 0 into Eq. (35), we obtain the profit of the foreign-owned firm. In the second stage, the differentiation of π ₂ with respect to α ₂ yields α 2 = ( 1 − τ ) ( 2 + 3 s 2 − s 1 ) 11 + 62 + 5 s 1 . In the first stage, the differentiation of W with respect to s _i yields: s 1 F ∗ = 10 − 7 τ 23 − 14 τ and s 2 F ∗ = 7 τ − 5 23 − 14 τ . Note that s 1 F ∗ > 0 and s 2 F ∗ < > 0 when τ < > τ F ∗ = 5 7 . The implication of discriminatory subsidies is also similar to the bilateral CSR case. The resulting optimal CSR is α 2 F ∗ = 1 − τ 13 − 7 τ . The profit of the firm is respectively π 1 F ∗ = 3 ( 10 − 7 τ ) 2 ( 1 − τ ) 2 ( 23 − 14 τ ) 2 and π 2 F ∗ = 21 ( 1 − τ ) 2 ( 23 − 14 τ ) 2 . Finally, the social welfare is W F ∗ = 13 − 7 τ 2 ( 23 − 14 τ ) .

Fourth, we consider a no CSR case. In the last stage, substituting α ₁ = α ₂ = 0, we confirm the social welfare. In the first stage, the differentiation of W with respect to s _i yields: s 1 N ∗ = 4 − 3 τ 3 ( 3 − 2 τ ) and s 2 N ∗ = 3 τ − 2 3 ( 3 − 2 τ ) = s 2 D ∗ . Note that s 1 N ∗ > 0 and s 2 N ∗ < > 0 when τ < > τ N ∗ = 2 3 . The implication of discriminatory subsidies is still similar to the bilateral CSR case. The profit of the firm is respectively π 1 N ∗ = ( 4 − 3 τ ) 2 ( 1 − τ ) 6 ( 3 − 2 τ ) 2 and π 2 N ∗ = 1 − τ 6 ( 3 − 2 τ ) 2 = π 2 D ∗ . Finally, the social welfare is W N ∗ = 5 − 3 τ 6 ( 3 − 2 τ ) = W D ∗ .

Lastly, we compare the optimal levels of CSR, discriminatory subsidies, profits of the two firms, and social welfare among the four models. Figure 1 indicates the comparisons between the four models under discriminatory subsidies. Then, we obtain the following lemmas and propositions.

Figure 1:

Comparisons among the four models under discriminatory subsidies.

Proposition 6 implies that the discriminatory subsidy policy yields different levels of CSR in the two unilateral CSR cases, which is in contrast to the result under the uniform subsidy in Proposition 1, that is, α 1 D ∗ > α i B ∗ > α 2 F ∗ . While the government always grants (positive) an output subsidy to the domestic firm to increase the firm’s competitive advantage under discriminatory subsidies, it will choose the highest CSR level only when the domestic firm engages in CSR activities. In contrast, the government taxes the output of the foreign-owned firm significantly to decrease the rent-leakage effect from the foreign-owned firm if 0 < τ < 5 7 . Thus, the foreign-owned firm will choose the lowest CSR level under foreign CSR.

Lemma 4 presents the policy relationships between optimal discriminatory subsidies and corporate tax rates. First, we illustrate that the optimal discriminatory subsidy of the domestic firm is independent of corporate tax. In particular, to enlarge market outputs, the government grants the highest subsidy to the domestic firm when none of the firms engage in CSR activities. As domestic CSR leads to the highest CSR level, the government grants the lowest subsidy to the domestic firm under domestic CSR.

Regarding the foreign-owned firm, we summarize the findings of Lemma 4 as follows: (a) min { s 2 D ∗ , s 2 F ∗ , s 2 N ∗ } > s 2 B ∗ , and (b) s 2 F ∗ < > s 2 D ∗ when τ < > 1 4 . First, (a) the optimal discriminatory subsidy of the foreign-owned firm under either unilateral CSR or no CSR is always higher than that under bilateral CSR. In order to decrease the over-production effect of CSR activities, the government will grant the lowest subsidy (or tax) to the foreign-owned firm when both firms engage in CSR activities, depending on the corporate tax rate. Second, (b) the optimal subsidy of the foreign-owned firm under foreign CSR is higher than under domestic CSR when corporate tax is low, while the opposite is found when corporate tax is high. Note that 0 > s 2 F ∗ > s 2 D ∗ when 0 < τ < 1 4 . Thus, when corporate tax is low enough, the government imposes a lower tax on the foreign-owned firm under foreign CSR than under domestic CSR. However, when corporate tax is high, the opposite is found, i.e.,  s 2 D ∗ > s 2 F ∗ > 0 when τ F ∗ < τ < 1 . That is, the government imposes a lower subsidy on the foreign-owned firm under foreign CSR compared to domestic CSR.

Lemma 5 states that the domestic firm is most profitable under no CSR, while it is the least profitable under domestic CSR in contrast to the result under the uniform subsidy in Lemma 3. Further, the foreign-owned firm generates minimum profit under bilateral CSR and maximum profit under foreign CSR (domestic CSR) when corporate tax is low (high). Lemma 5 also implies that irrespective of government policies that include discriminatory subsidies and corporate tax, bilateral CSR yields the highest social welfare, whereas no CSR yields the lowest social welfare. Note that W F * > W D * , which contrasts with the result under the uniform subsidy in Lemma 2. Under discriminatory subsidies, the government can impose a higher output tax on the foreign firm, as per Lemma 4, and thus increase government revenue. As a result, foreign CSR leads to higher social welfare than domestic CSR under the discriminatory subsidy.

Finally, we consider an endogenous choice game of CSR under discriminatory subsidies in which each firm decides whether to engage in CSR activities simultaneously and non-cooperatively before the first stage of the previous analysis.

Proposition 7 illustrates that foreign CSR is a Nash equilibrium when τ is low, that is, 0 < τ < 1 − 3 7 14 , while no CSR is a Nash equilibrium when τ is high, for instance, 1 − 3 7 14 < τ < 1 . Moreover, both foreign CSR and no CSR are the Nash equilibria when τ = 1 − 3 7 14 . Note that this result contrasts with the result under the uniform subsidy in Proposition 5. However, Lemma 5 reveals that neither one of the Nash equilibria under the discriminatory subsidy is socially desirable.

6 Concluding Remarks

In this study, we examined strategic CSR in a Cournot duopoly between domestic and foreign-owned firms in a managerial delegation framework facing the government’s public policies. We then investigated how the government could combine policies to regulate the firms’ CSR behavior and to enhance market performance. Our main findings are as follows: first, the strategic effect of corporate profit tax on strategic CSR and the output subsidy policy, exists. In particular, the effects of corporate tax on strategic CSR and social welfare are conflicting: the strategic level of CSR decreases but social welfare increases with corporate tax. These results are robust under the discriminatory subsidy. This finding is significant for policymakers because corporate profit taxes are not neutral toward firm behavior in the presence of strategic CSR. Second, the optimal unilateral CSR is higher than bilateral CSR under the uniform subsidy, while domestic (foreign) CSR leads to the highest (lowest) CSR level under the discriminatory subsidy. However, irrespective of corporate tax or foreign penetration, social welfare is highest under bilateral CSR. Finally, the Nash equilibrium of an endogenous CSR choice game depends on corporate tax and output subsidy policies. In particular, when corporate tax is low, domestic CSR is a Nash equilibrium under the uniform subsidy, while foreign CSR is a Nash equilibrium under the discriminatory subsidy. However, neither is socially desirable. Therefore, an appropriate policy framework on CSR guidelines is necessary for lower corporate taxes.

Even though our methodology can be applied to different models with other public policies on CSR, future research avenues remain. For example, while we regarded a corporate tax as an exogenously given parameter in this model, the government may determine it endogenously in the general equilibrium model. Alternative scenarios should include product differentiation, Stackelberg competition, and more general specifications for the demand and cost functions among the oligopolistic firms. Extending our analysis to different CSR activities with commitment investment would be another direction for future research.