Tax policy and foreign direct investment

Abstract

This paper examines the implications of the most common system of taxing foreign source income. It is argued that, because the repatriation of earnings to the home country investor and not the earnings themselves are typically the source of tax liability, the foreign source income tax should affect foreign investment differently depending on the required transfers of funds within the firm. One implication of viewing the tax in this fashion is that in order to maximize after tax profits, a firm should finance its foreign investment out of foreign earnings to the greatest extent possible. That is, a firm's required foreign return jumps at the point at which desired foreign investment just exhausts foreign earnings. This allows us to draw a distinction between "mature" foreign operations, which are at any point in time financed at the margin by reinvested earnings (and perhaps also pay dividends to their parent firm in the home country), and "immature" foreign affiliates, which rely on funding from their parents (and should not be paying dividends). It is noted that survey evidence on multinational firm behavior is consistent with this distinction. Direct investment data indicate that mature foreign operations probably account for nearly ninety percent of U.S. foreign direct investment. The discussion then turns to investment incentives. It is shown that the home country's rate of tax on foreign source income and the presence or absence of a foreign tax credit should be irrelevant to a mature foreign operation's investment and dividend decisions. This conclusion, which conflicts sharply with the conventional wisdom, follows because the home country tax acts as an unavoidable cost. New firms' investment decisions are, on the other hand, influenced by home country taxes.

Real Effects of Accounting Rules: Evidence from Multinational Firms’ Investment Location and Profit Repatriation Decisions

“…General considerations include relative domestic and foreign rates of return and local politics. In general, there is mixed evidence about whether and the extent to which the repatriation tax matters when companies make repatriation decisions (see Hartman [1985], Altshuler and Newlon [2003], Grubert and Mutti [1995], Desai, Foley, and Hines [2001], Altshuler and Grubert [2003], Foley et al [2007], U.S. Treasury [2007], U.S.…”

The impact of endogenous tax treaties on foreign direct investment: theory and evidence

“…The profit condition for NEs, therefore, implies Vertical and horizontal MNEs are able to finance fixed costs via operating profits of both the domestic and the foreign activities. We maintain that the foreign subsidiary fully (and immediately) repatriates its profits to the domestic parent (see Hartman 1985 and Sinn 1993 for a discussion of alternative assumptions). Without a tax treaty, operating profits from foreign affiliates are exposed to double taxation.…”

Using Financial Accounting Data to Examine the Effect of Foreign Operations Located in Tax Havens and Other Countries on U.S. Multinational Firms' Tax Rates

“…In addition, U.S. firms may operate in tax havens and choose to reinvest pretax profits so as to defer U.S. tax liability. Hartman [1985] shows that U.S. firms should be indifferent between repatriating and deferring the repatriation of foreign earnings if foreign and domestic tax rates are intertemporal constants known by the firm, the after‐tax returns on foreign and domestic profits are equal, and firms must eventually repatriate foreign profits subject to potential incremental federal taxation. If the assumptions in Hartman [1985] are not empirically valid, U.S. firms may have incentives to defer the incremental federal tax on foreign earnings 13…”