Tax Effects Of Foreign Direct Investment In The U.S.: Evidence From A Cross-Country Comparison

This paper investigates how the tax system of the U.S. and the capital— exporting country combine to affect the flow of foreign direct investment (FOl) into the U.S. First, using aggregate data, it corroborates earlier work suggesting that the U.S. effective tax rate does influence the amount of FO! financed by transfers of funds, but not the amount financed by retained earnings. The data are then disaggregated by major capital—exporting countries to see if, as theory would suggest, FO! from countries which exempt foreign—source income from taxation is more sensitive to U.S. tax rates than FOl from countries which attempt to tax foreign-source income. The data ana'ysis does not revea' a c'ear differentia' responsiveness between these two groups of countries, suggesting either difficulties in accurately measuring effective tax rates or the availability of financial strategies which render the home country tax system immaterial in affecting the return on FDI. Joel Slemrod Department of Economics Larch Hall University of Michigan Ann Arbor, MI 48109 1. tntroduction The magnitude and financing of foreign direct investment in the U.S., which totalled more than S40 billion in 1987, is potentially influenced by the tax systems of both the U.S. and the investor's country. Nevertheless, all recent studies of foreign direct investment (henceforth FM) in the U.S. have investigated only the impact of U.S. taxation. The home country's tax system has been ignored either because the appropriate data is unavailable or, on theoretical grounds, it is deemed to be irrelevant to FDI. This paper investigates the impact of both the U.S. and home country taxation on FM in the U.S. It does this by first extending and updating the standard model of aggregate FM in the U.S., and then disaggregating FIJI by the country of the investing firm so as to facilitate the study of home country in— fluences, including taxation. The results of this new empirical approach are generally supportive of a negative impact of U.S. effective rates of taxation on total FM and new transfers of funds, but not on retained earnings. The disaggregated analysis does not, though, provide much support for several propositions about the impact an FIJI in the U.S. of foreign countries! tax rates and systems of taxing foreign— source income. The remainder of the paper is organized as follows. Section 2 reviews the existing empirical literature, and Section 3 discusses some of the important issues regarding data on FM in the U.S. The next two sections present the results of the data analyses——in Section 4 for aggregate FDI and In Section 5 separately for each of seven major investing countries. Section 6 concludes. 2. Review of the Existing Empirical Literature It is generally accepted that foreign direct investment is primarily an issue of industrial organization. Dunning (1985, p. 6—7) has argued that FUt by firms of country A in country B is more likely if A's firms (i) possess ownership—specific advantages relative to B's firms in sourcing markets, (ii) find it profitable to use these advantages themselves rather than lease them to B's firms, and (iii) find it profitable to utilize their omership specific advantages in B rather than A. A large body of empirical literature has been addressed to testing this theory of international production, usually referred to as the "eclectic" theory. Much of this research has been cross— sectional, relating the extent of foreign investment in a given sector to characteristics of that sector that represent ownership—specific and location— specific comparative advantages. Several examples of this type of analysis are contained is Dunning (198-5). Studies of the effects of taxation on FM have generally taken the perspective that whatever its benefits to firms are, they must be balanced against the tax consequences of carrying out FifE. The tax systems of both the firm's home country and potential host countries can affect the incentives concerning FDI as well as how to finance a given pattern of Ff1. Theoretical treatments of these questions are presented in Alworth (1988) and Gersovitz (1987). The limited empirical literature on the impact of taxes on multinationals' behavior is summarized in Caves (1982). Empirical study focusing on the effect of taxation on the time series of FDI in the U.S. was pioneered by Hartman (1984). Using annual data from 1965 to 1979 he estimated the response of FDI, separately for investment financed by retained earnings and transfers from abroad, to three variables: the after—tax rate of return realized by foreign investors in the U.S., the overall after—tax