International taxation.

• Author: Hines, James, Jr.
• Position: Research Summaries

My research examines the impact of taxation on the level and performance of international business. There are three reasons why international taxation is the focus of a considerable amount of recent research in economics: First, there is growing recognition of the importance of foreign direct investment (FDI) in the lives of modern economies; this heightens concerns about the impact of tax policy on FDI. Second, international aspects of taxation represent some of the most complex and traditionally understudied parts of tax systems. Third, the internationalization of firms and economies raises the prospect that certain international aspects of tax systems may have unrecognized consequences even for the purely domestic parts of tax systems.

Among the important issues in the economics of international taxation are: the impact of tax provisions on the competitiveness of multinational firms in foreign markets, as evidenced by the level and location of FDI; the effect of international tax rules on international research and development; the impact of taxation on the financing of multinational firms; and matters of political concern, such as negotiations over bilateral tax treaties, and the use of tax policy to curtail certain practices in foreign countries. Research on these issues indicates that tax policy has an important effect on the allocation of resources by multinational firms.

Foreign Direct Investment

There is a great deal of interest in, and concern about, the possible impact of tax policy on FDI. High tax rates generally are thought to discourage foreign investment, although there is some controversy over this point. Time-series evidence on this question is typically rather inconclusive, perhaps in part reflecting the infrequency of major tax changes and the correlation of tax changes with movements in important unobservable variables.(1)

However, there are at least two sources of cross-sectional variation in tax rates that offer useful evidence on the impact of taxation on the location of FDI. First is the distribution of tax rates across countries. Analysis of the pattern of outbound investments by U.S. multinationals indicates that high tax rates significantly reduce FDI levels, all else equal.(2)

The second useful source of information on the responsiveness of multinational investors to tax differences is variation in state corporate tax rates within the United States. Foreign firms investing in the United States fall into two broad categories: investors from countries (such as Canada and Germany) that do not tax the American profits of their resident multinationals; and investors from countries (such as Japan and the United Kingdom) that do tax the American profits of their firms, but provide foreign tax credits for the federal and state income taxes these firms pay. To investors from Canada and Germany, state income taxes represent the costs of doing business; to investors from Japan and the United Kingdom, state income taxes also represent costs, but these costs are--at least in part--compensated by their own government's provision of foreign tax credits. Consequently, investors from Canada and Germany have stronger incentives to avoid locating their businesses in high-tax states than do investors from Japan and the United Kingdom, even if the businesses are otherwise identical. Patterns of FDI indicate that high-tax states attract fewer plants and less capital from firms whose home countries do not provide foreign tax credits than from firms whose home countries do. This evidence suggests that high tax rates significantly reduce local investment.(3)

A number of studies find little effect of taxation on FDI, perhaps because of the subtlety of some of the behavioral incentives generated by tax systems in practice. Recent research examines two particular aspects of these tax incentives. First is the effect of differences between countries in their definitions of the tax base; these differences typically appear to attenuate the impact of local investment tax incentives on investment behavior by multinational firms from certain countries.(4)

Second is the effect of taxation on the financing and capitalization over time of foreign subsidiaries. Since foreign owners have incentives to reinvest profits earned by their subsidiaries rather than repatriate the profits as dividends, these owners are encouraged to undercapitalize their subsidiaries initially in order to preserve profitable opportunities for future reinvestment of profits. This incentive is the strongest in countries with low tax rates. As a consequence, American firms may transfer less equity to finance their initial investments in countries with low tax rates than they do to finance investments in countries with high tax rates, even though they plan to maintain higher steady-state capital levels in the low-tax countries. Furthermore, this process encourages firms to finance their subsidiaries in low-tax countries with higher proportions of debt than typically are used in high-tax countries. Evidence indicates that these tax incentives influence the behavior of U.S. multinationals.(5)

Research and Development

There are certain types of activities, such as advertising, central administration, and research and development (R and D) that multinational firms undertake centrally in order to...