Return on Cross-Border Investment: Why Does U.S. Investment Abroad Do Better?

Despite the large size of U.S. net financial obligations to foreigners, U. S. residents have continued to earn more income on their assets abroad than foreigners have on their assets in the United States. In other words, the rate of return on U.S.-owned assets abroad is still higher than the rate of return on foreign-owned assets in the United States. The advantageous return gap for U.S. investment has reflected the much greater return on U.S. direct investments abroad than that on foreign direct investments in the United States. We investigate the validity of three major hypothesis advanced to explain the persistent return gap that has been so advantageous to U.S. direct investments: (1) the risk-compensating hypothesis, which claims that U.S. direct investments abroad are riskier than foreign direct investments in the United States and therefore command a higher return to compensate for their higher risks; (2) the age-effect hypothesis, which claims that foreign-owned companies in the United States are temporarily less profitable than U.S.-owned companies abroad because they are relatively new and it takes time for new investment to turn a profit; and (3) the profit-shifting hypothesis, which maintains that the return gap is the net result of multinational companies’ shifting profits through transfer pricing schemes to minimize their overall tax cost. We find that evidence in support of the age-effect hypothesis is the strongest, followed by that for the risk-compensating hypothesis. There is no clear evidence that, on balance, profitshifting activities by multinational companies contributed significantly to the return gap in favor of outward direct investment. Our findings suggest that the extent to which the (reported) return gap will remain favorable to the United States in the future largely depends on the net result of two opposing developments. First, the age effect suggests that foreign-controlled companies’ profitability should improve over time, unless the positive age effect is dominated by the negative effect arising from new flows of inward direct investment. Second, as foreign subsidiaries become more profitable over time, they also are likely to become more active in profit-shifting practices, thereby depressing the reported profits of those companies. The Bureau of Economic Analysis (BEA) measures U.S.-owned assets abroad as the sum of portfolio 1 investment assets and direct investment assets. BEA defines direct investment assets as U.S. investors’ ownership of foreign business which equals or exceeds 10 percent of the value of that business. Foreignowned assets in the United States follow analogous conventions. For further details see, “The Balance of Payments of the United States: Concepts, Data Sources, and Estimating Procedures,” Bureau of Economic Analysis (May 1990). BEA measures the value of U.S. and foreign direct investment by two methods: the current-cost 2 method and the market-value method. The current-cost method measures direct investment assets and liabilities by their current replacement costs, while the market-value method measures direct investment at the current stock-market value of owners’ equity. (All non-banking assets s are reported at their market values, and banking assets at their book values.) At the end of 2003, the U.S. net international investment position amounted to -22.1 percent of GDP based on the current-cost method and -24.1 percent based on the market-value method. For a recent exposition of the relationship between the current account deficit and net international investment position, see Congressional Budget Office (2004). 1