Capital flows, taxation, and institutional variation.

• Author: Desai, Mihir A.
• Position: Research Summaries - Company overview

Tariff reductions, falling transport costs, and reduced barriers to international capital flows have created extensive opportunities for multinational firms and investors in increasingly integrated global markets. For example, the outbound foreign direct investment (FDI) position of American firms grew at an average annual rate of 11 percent to $2.4 trillion from 1982 to 2006 while inbound FDI to the United States grew to $1.8 trillion. Foreign portfolio investment (FPI) has grown similarly. By 2005, 16 percent of all U.S. long-term securities (equity and debt) were held by foreigners. Foreign holdings of American stocks increased from $400 billion to $2.3 trillion over the last decade, while American holdings of foreign stocks increased from $600 billion to $3 trillion.

In the midst of this rapid integration, investors and firms still face tax systems and investor protections that differ across countries, and these differences have the potential to affect major investment and financing decisions. Governments anxious to attract FDI often consider the use of tax incentives to lure multinational firms, and governments of FDI source countries--including the United States--often wonder whether their tax treatment of foreign income is appropriate. Similarly, investor protections and the broader institutional environment remain distinctive around the world and may influence investors' port folio decisions and firms' operational and financing decisions.

Recent research has advanced our understanding of the role of taxation and investor protections on capital flows and patterns of FPI. We also have considered the causes and consequences of tax avoidance activity; we have established how foreign and domestic activity interact in order to inform new welfare measures; and we have elaborated on how investment and financing decisions by multinational firms reflect the effects of taxes and varying institutional regimes.

Portfolio Flows

Empirical efforts to isolate how taxation influences portfolio choice have produced mixed results. Investigating the relationship between cross-sectional differences in marginal tax rates and asset holdings is complicated by the incomplete nature of most household portfolios and the fact that income levels can influence both risk preferences and marginal tax rates. Efforts to examine how portfolios change in response to tax reforms must overcome the possibility that the observed changes reflect endogenous supply responses or other general equilibrium effects that may confound the influence of taxation on portfolio choices.

Dhammika Dharmapala and I attempt to overcome these empirical difficulties by analyzing a tax reform that differentially changed the tax treatment of otherwise similar instruments in a manner that is unlikely to have produced any endogenous supply response. (1) Specifically, we investigate how taxes influence portfolio choices by exploring the response to the distinctive treatment of foreign dividends in the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA). JGTRRA lowered the dividend tax rate to 15 percent for American equities and extended this tax relief only to foreign corporations from a subset of countries. The division of countries into two separate groups was driven by regulatory concerns and was unrelated to future changes in investment opportunities or other regulatory efforts to change investment in these countries differentially. Given the relatively small share of their stocks held by American investors, it is unlikely that supply responses by foreign firms would be large. It is similarly unlikely that the effects of the reform on U.S. investors' portfolios would have been offset by clientele effects in asset markets. JGTRRA applied only to U.S. investor returns, leaving non-U.S. investor tax rates and asset demands unaffected.

This paper uses a difference-in-difference analysis that compares U.S. equity holdings in affected and unaffected countries. The international investment responses to JGTRRA were substantial, implying an elasticity of asset holdings with respect to taxes of -1.6. This effect cannot be explained by several potential alternative hypotheses, including differential changes in the preferences of American investors, or investment opportunities, or time trends in investment, or any changed behavior towards tax evasion. These results show how FPI, and portfolio decisions more generally, are influenced by taxation.

Corporate taxes and investor protections also have the potential to influence FPI by changing the relative attractiveness of FPI and FDI as means of achieving international diversification. Dharmapala and I analyze whether the composition of U.S. outbound capital flows reflects efforts to bypass home country tax regimes and weak host country investor protections. (2) The potential effects of taxation on FPI result from the interaction between home and host country taxes. In particular, the United States taxes multinational firms legally domiciled here on their worldwide income. As a consequence of this policy, U.S. investors should prefer FPI as a means of accessing foreign diversification opportunities, particularly in low-tax countries where the residual tax imposed by the United States will be most burdensome. In effect, FPI allows investors to avoid any residual tax on investment income earned abroad arising from the worldwide tax regime. Conversely, the absence of the residual U.S. tax should make U.S. equity FPI sensitive to variations in foreign corporate tax rates, even after controlling for any effects of corporate taxes on levels of U.S. FDI. As such, the worldwide system of taxing income may vitiate the...