Technical Paper Series

Congressional Budget Office

Washington, D.C.

Return on Cross-Border Investment:

Why Does U.S. Investment Abroad Do Better?

Juann H. Hung 

(Email: Juannh@cbo.gov)

and

Angelo Mascaro 

(Email: Angelo.mascaro@cbo.gov)

Macroeconomic Analysis Division

Congressional Budget Office

Washington D.C.

December 2004

2004-17

Technical papers in this series are preliminary and are circulated to stimulate discussion and

critical comment. These papers are not subject to CBO’s formal review and editing processes. 

The analyses and conclusions expressed in them are those of the authors and should not be

interpreted as those of the Congressional Budget Office. References in publications should be

cleared with the authors. Papers in this series can be obtained at www.cbo.gov/tech.cfm. 
Abstract

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

1. Introduction

When the United States runs a current account deficit, its residents spend more than they

earn. To pay for that extra spending, the nation must borrow from foreigners or sell them some

assets. That is, Americans have to reduce their holdings of assets abroad or allow foreigners to

increase their holdings of assets in the United States. (U.S. holdings of assets abroad consist of

portfolio investment assets—such as stocks and bonds, bank loans and deposits, and government

securities—and direct investment assets. Foreign holdings of U.S. assets have analogous

components. ) Years of running persistent current-account deficits have caused a more rapid 1

accumulation of foreign-owned assets in the United States than of U.S.-owned assets abroad

(Figure 1). The net international investment position of the United States—the difference

between U.S.-owned assets abroad and foreign-owned assets in this country—turned negative in

1987; by the end of 2003, that position dropped to -24 percent of GDP.2
U.S. international investment income consists of (1) dividends and interest income on portfolio

3

investment; and (2) direct investment income which is the sum of distributed earnings (dividends),

reinvested earnings, and net interest receipts between U.S. parent companies and their foreign affiliates.

Investment income earned by foreigners on their assets in the United States follows analogous conventions.

2

Figure 1. International Investment Position of the United States: U.S.-owned Assets

Abroad versus Foreign–owned Assets in the U.S., 1982-2003 ($ billions)

Despite the large U.S. net financial obligations to foreigners, according to data reported

by the Bureau of Economic Analysis (BEA), U.S. residents have persistently earned more

investment income on their assets abroad than foreigners have earned on their assets in the

United States (Figure 2). In other words, the rate of return on U.S.-owned assets abroad (the 3

ratio of investment income to assets) has been higher than the rate of return on foreign-owned

assets in the United States. (For more discussion of the measurement of the rate of return on

international assets, see the Appendix.) The rate of return on U.S.-owned assets averaged 5.82

percent per year from 1982 to 2003, while that on foreign-owned assets averaged 4.59 percent

over the same period (Figure 3). The corresponding positive net investment income has meant a
These rates of return are not adjusted for inflation (see the Appendix). The trend decline in the 4

return on both inward and outward investments thus may merely reflect the decline in price inflation both

in the United States and abroad during the 1982-2003 period.

3

higher level of national income for U.S. residents than otherwise. In 2003, for example, this net

income flow added $55 billion, or 0.6 percentage points, to national income.

Figure 2. U.S. Income on Assets Abroad versus Foreign Income on Assets in the U.S., 

1982-2003 ($ billions)

What has caused the positive gap between the returns on U.S.-owned assets abroad and

foreign-owned assets in the United States? That positive gap has stayed relatively constant, even

though both returns have been on a downward trend (Figure 3). Is the persistent return gap to 4

be believed, or does it somehow reflect measurement error? If it is true, how long can it

continue to favor U.S. investment abroad? Answers to these questions will have significant

bearings on the implications of growing U.S. external indebtedness for national income and the

sustainability of the current account deficit.
U.S.-owned stocks and bonds abroad earned a larger rate of return than foreign-owned stocks and

5

bonds in the United States. However, the return on foreign-owned U.S. government securities, which consist

of both Treasury securities as well as riskier securities issued by government-sponsored enterprises such as

4

Figure 3. U.S. Return on Assets Abroad versus Foreign Return on Assets in the U.S.,

1982-2003 (percent)

The answer to the puzzle appears to lie in both the compositions of cross-border assets as

well as the large difference in the returns on cross-border direct investment assets. U.S.-owned

assets abroad are concentrated most heavily in direct investment assets (DIA), which earn a

return rate that is not only much higher than returns on other components of U.S.-owned assets

abroad, but also much higher than the return on inward DIA (i.e., foreign-owned DIA in the

United States). The rate of return on outward DIA (i.e., U.S.-owned DIA abroad) averaged 6.5

percent from 2001 to 2003, contributing 2.2 percentage points to the 3.9 percentage-point return

on overall U.S.-owned assets abroad. In comparison, return on inward DIA averaged 1.9 percent

over the same period, contributing 0.4 percentage points to the 2.7 percentage-point return on

overall foreign-owned assets in the United States. Overall, the return gap between outward and

inward portfolio investments was slightly unfavorable to the United States.5
Fannie Mae, was higher than even that on U.S.-owned stocks and bonds abroad. The puzzling observation

that return on U.S. government securities was higher than that on U.S.-owned bonds and stocks abroad 

could be also partially attributable to measurement issues noted in the next section and in the Appendix.

5

Table 1. Average Rates of Return on U.S.-owned Assets Abroad and Foreign-owned Assets in 

the United States, 2001-2003 (percent)

 

 Rate of

 Return

Share of 

Assets

Contribution

to

 Total Return

U.S. Assets Abroad 3.9 100.0 3.9

 Direct Investment Assets 6.5 34.2 2.2

 Portfolio Assets 2.6 65.8 1.7

 Stocks 2.4 23.7 0.6

 Bonds 4.8 7.3 0.4

 Bank claims 1.8 23.1 0.4

 Other 3.2 11.6 0.4

 

Foreign Assets in U.S. 2.7 100.0 2.7

 Direct Investment Assets 1.9 25.1 0.4

 Portfolio Assets 3.0 74.9 2.3

 Government/Agency Securities 5.5 15.5 0.8 (a)

 Private Securities

 Stocks 1.6 15.0 0.2

 Bonds 3.5 18.3 0.6 (b)

 Claims on banks 1.7 18.4 0.3

 Other 3.6 7.8 0.3

Sources: (1) “U.S. International Transactions, 2003,” by Christopher Bach, Survey of Current Business, April

2004. Bureau of Economic Analysis. (2) “Table 2. International Investment Position of the United States at

Yearend,1976-2003,” from BEA website at http://www.bea.doc.gov/bea/di/intinv03_t2.xls.

Notes: (a) About half foreign-owned U.S. government securities (from 2001 to 2003) are in U.S. Treasury

securities, with the remaining half in securities issued by government agencies and government-sponsored

enterprises. (b) Bonds include foreign governments' holdings of U.S. corporate bonds and stocks. The BEA

does not separate foreign government’s holdings of U.S. corporate stocks from their holdings of corporate

bonds. The dollar value of foreign governments’ holdings of bonds and stocks averaged about 7% of private

foreigners’ holdings of U.S. corporate bonds from 2001 to 2003. 
Other theories that have been advanced include (1) foreign-owned companies’ low profitability in 6

part stems from their access to a lower cost of capital unavailable to U.S. firms, (2) inward FDI is

concentrated in industries that have low or negative profits, and (3) foreign owned companies have tended

to incur heavy debt burdens (and associated interest expenses) when they acquired or established other U.S.

business. These theories seem unlikely to explain the persistence of the return gap exhibited in the data,

even if they have some validity for a period of time. 

6

Clearly, the large gap between returns on outward and inward direct investments and the

large share of outward direct investment assets are responsible for the favorable return gap

between overall outward and inward investments. This observation, however, begs the question

of why this positive return gap has been so large and persistent. Among the various hypotheses

advanced to explain the persistent and positive return gap between outward and inward FDI

assets, three are cited most frequently in public discussion. The first is the risk-compensating

hypothesis, which claims that outward direct investment is riskier than inward investment and

therefore should command a higher return to compensate for its higher risk. The second is 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 relative

newcomers and it takes time for new investment to turn a profit. The third is the profit-shifting

hypothesis, which maintains that the return gap is the net result of multinational companies’

shifting income through transfer pricing schemes to minimize their overall tax cost. 

This paper focuses on examining the evidence for these three hypothesis not only because

they are most often-cited, but also because they have more lasting implications for forecasting

reported net-investment income flows than other hypothesis. We find that evidence in support 6

of the age-effect hypothesis is strongest, followed by that for the risk-compensating hypothesis. 

There is no clear evidence that the profit-shifting hypothesis contributed significantly to the
 It is possible, of course, that a rapid influx of new inward direct investments could, for a time, bring 7

down the average rate of return as their initial loss or low profitability offset the profits of “ older” foreignowned companies.

7

return gap in favor of outward direct investment. Based on our calculations of various measures

of risks attending outward and inward DIA, we find that the risk associated with outward DIA

could be higher than that with inward DIA by enough to account for one-third of the gap, leaving

two-thirds of the return gap unexplained. Nearly all studies that we surveyed find evidence that

newly acquired or established companies tend to have losses or low profits (mainly because of

high start-up costs) initially, but their profitability improves as they “mature” over time. This

finding suggests that the age-effect hypothesis can help close the unexplained return gap to some

extent, if not fully. Regarding the profit-shifting hypothesis, there is only weak and indirect

evidence that foreign-controlled companies have been shifting profits abroad, while the evidence

is somewhat stronger that U.S.-controlled companies’ have used transfer-pricing schemes to shift

profits both out of and into the United States. On balance, there is no decisive evidence that the

net effect of profit-shifting activities is a major reason for the return gap favoring U.S. outward

direct investment.

Our findings suggest that whether, and to what extent, the reported return gap remains

favorable to the United States in the future mostly will depend on two opposing developments. 

First, the age-effect hypothesis suggests that the profitability of foreign-controlled companies

eventually should improve, narrow the favorable gap and possibly even reverse it. Second, the 7

profit-shifting hypothesis suggests that foreign affiliates in the United States may also become

increasingly more active in understating profits through transfer pricing as they become more

profitable. If profit-shifting by multinationals is the main reason that reported U.S. net
8

investment income stays positive, however, the net “gain” in investment income through this

channel will come at the cost of a net “decrease ” in the reported trade balance (by raising

reported imports or lowering reported exports), leaving little net impact on the current account.

2. The Return Advantage Comes from Direct Investment, Not from Portfolio Investment

The return gap favoring U.S. assets abroad has mainly reflected the greater return on

outward DIA relative to the return on inward DIA (see Figures 3 and 4, and Tables 1 and 2). On

average, from 1982 to 2003, the difference in portfolio returns favored foreign investment in the

United States by about 30 basis points (4.98 percent vs. 5.31 percent). For direct investment,

however, the difference favored outward assets by about 550 basis points (7.64 percent vs. 2.09

percent). For combined portfolio and direct investment assets, the difference favored U.S.-

owned assets by about 120 basis points (5.82 percent vs. 4.59 percent), reflecting the fact that the

share of DIA in all outward assets has been greater than that in total inward assets (Figure 5).

Figure 4. U.S. Return on Direct Investment Abroad vs. Foreign Return on Direct

Investment in the U.S., 1982-2003 (percent)
9

 Table 2. Statistics on Returns, U.S. Investments Abroad and Foreign Investments in the U.S. 

1982-2003 1982-1992 1993-2003

U.S. Return: Total 5.82% 7.20% 4.43%

Portfolio Investment 4.98% 6.41% 3.56%

Direct Investment 7.64% 9.16% 6.11%

Foreigners’ Return: Total 4.59% 5.76% 3.42%

Portfolio Investment 5.31% 6.72% 3.90%

Direct Investment 2.09% 2.03% 2.15%

Difference in Returns: Total 1.22% 1.44% 1.01%

Portfolio Investment -0.32% -0.31% -0.34%

Direct Investment 5.55% 7.13% 3.97%

Variability of Returns (Standard Deviation)

U.S. Variability: Total 1.76% 1.42% 0.49%

Portfolio Investment 1.78% 1.29% 0.72%

Direct Investment 2.33% 2.32% 0.92%

Foreigners’ Variability: Total 1.51% 1.19% 0.61%

Portfolio Investment 1.73% 1.18% 0.73%

Direct Investment 1.18% 1.50% 0.81%

Correlation of U.S. and Foreign Returns

Total Return 0.975 0.942 0.940

Portfolio Investment 0.984 0.943 0.978

Direct Investment 0.355 0.530 0.522

Source: CBO calculations based of data from Bureau of Economic Analysis

Figure 5. Shares of Direct Investment Assets in Total Outward Assets and in Total Inward

Assets, 1982-2003 (percent) 
BEA only reports market value of portfolio investment positions, and excludes capital gains in its

8

measure of portfolio investment income.

10

Why is the return gap so advantageous to the U.S. for outward direct investment but not

for outward portfolio investment? One possible explanation is that investors can shift portfolio

investments more easily across countries in response to changes in expected returns than they shift

direct investments. Thus, any return gap between outward and inward portfolio assets will likely

be exploited more rapidly than that between direct investment assets, lowering the measured

return gap between portfolio assets relative to that between direct investment assets. 

Another possible factor in the explanation is simply that the return on international

portfolio assets measured by the BEA data, which is a measure of return on assets (ROA), is a

distorted indicator of the rate of return referred to conventionally (see the Appendix). The former

uses interest and dividend incomes as the numerator and the market value of the assets as the

denominator. In contrast, the later uses the sum of capital gains and interest and dividend 8

incomes as the numerator, and the purchase value of the assets as the denominator. Thus, a

sustained rise in stock prices, which boosts the denominator but not the numerator of ROA, has a

potentially perverse effect of depressing the ROA. (A sustained rise in bond prices would have

the similar result by boosting the denominator but not the numerator because the latter is fixed

income tied to the coupon rates of those bonds.) Moreover, this depressive effect is stronger, the

higher is the share of stocks in the portfolio or the faster stock prices rise. Equities represented a

much greater share of outward portfolio assets than of inward portfolio assets after 1989. Thus,

the general upward trend in stock prices in the United States and abroad in the 1990s is likely to

have a greater depressive effect on ROA of outward portfolio assets than that of inward portfolio
11

assets during that period, helping to explain why ROA on outward portfolio investment is slightly

lower than that on inward investment despite the common perception that outward portfolio

investment is riskier. 

Finally, the significant difference between the return gap in direct-investment assets and

that in portfolio assets is likely to be caused, to a significant extent, by factors responsible for

suppressing earnings of foreign-controlled companies in the United States relative to earnings of

U.S.-controlled companies abroad. The question is, of course, what are the factors that have

suppressed earnings of foreign-controlled companies here? We now turn to addressing that

question.

3. Why Is the Rate of Return Gap Favoring Outward Direct Investment?

Among the hypotheses proposed to explain the persistent and large return gap favoring

U.S. direct investment abroad, three have received most attention. The risk-compensating

hypothesis, which takes BEA’s data at face value, sees the higher return abroad as reflecting the

greater riskiness of outward direct investment relative to that of inward direct investment. The

age-effect hypothesis, which also takes data at face value, maintains that it takes time for

foreigners to learn to manage their new direct investments in the United States and recover the

large setup cost. Finally, the profit-shifting hypothesis claims that cross-country differences in

tax rates have induced foreign multinationals to understate their profits in the United States

through profit-shifting more than U.S. multinationals understate their profits from operations
This claim includes the case that U.S. multinationals understate their profits in the United States and 9

overstate their profits from operations abroad by shifting profits out of the United States through transfer

pricing schemes.

This result holds over the full interval for which data on the market value of direct investment assets

10

are available (1982-2003), and for the half intervals (1982-1992, 1993-2003), even though a substantial

narrowing of standard deviations occurred in the second half interval.

12

abroad; that is, observed returns are simply a measurement mirage, not a true reflection of 9

profitability. We now turn to assess the weight of evidence regarding each hypothesis.

3.1 The Risk-Compensating Hypothesis

The risk-compensating hypothesis claims that the return gap reflects the greater riskiness

of U.S. investment abroad relative to the riskiness of foreign investment in this country. The

premise of this hypothesis is that investors will accept a riskier investment only when they expect

to make a greater return on that investment. To ascertain the validity of this hypothesis, we

investigate whether U.S. direct investments abroad exhibit greater risk, variously measured,

relative to foreign direct investments in the United States We find from a variety of relative risk

measures either contradictory evidence, or evidence that could support this hypothesis and might

explain one-third of the return gap.

Measures drawn from the statistical characteristics of aggregate returns offer little support

for the hypothesis that U.S. direct investments abroad are riskier. One measure of relative risk,

which superficially supports the hypothesis, simply compares the standard deviation of returns on

inward and outward direct investment (Table 2). This measure of risk shows that the return on

U.S. direct investment abroad has had a higher standard deviation, and presumably higher risk,

than has the return on foreign direct investment in the United States. However, measures which

10
The excess return to risk, or reward-to-variability, ratio is originally due to William Sharpe (1966).

11

The excess return to risk ratio is a better ratio for ranking the relative superiority of investments than the

simple ratioof return to standard deviation which, as shown by Sharpe, can often produce erroneous

rankings. See Sharpe (1994).

Using values presented in Table 2 for average returns and variability of direct investment, and letting 12

r denote the benchmark return, the Sharpe ratio for outward investment over 1982-2003 is (7.64-r)/2.33 and

that for inward investment is (2.09-r)/1.18. Manipulation of these two ratios shows that outward investment

has earned a superior risk-adjusted excess return for all values of the benchmark return higher than the value

r = -0.03605. Both Sharpe ratios fall with increasing values of the benchmark, but the ratio for foreign direct

investment falls fastest.

13

take into account returns as well as risk strongly contradict the risk-compensating hypothesis. As

is well know from portfolio selection theory, standard-deviation comparisons alone can be a

misleading measure of relative risk. A preferable measure is the excess return to variability ratio,

or Sharpe ratio, which in the present context is calculated as the ratio of the difference between

the direct-investment return and a benchmark return to the standard deviation of the direct

investment return. Investments with the higher Sharpe ratio have lower risk per unit of excess 11

return. For all nonnegative values of the benchmark return and using the data in Table 2, the

Sharpe ratio on outward direct investment is higher than that on inward investment, strongly

contradicting the risk-compensating hypothesis. For example, if the benchmark return is taken 12

as zero, the Sharpe ratio is simply the ratio of average return to the standard deviation of average

return. In that case the Sharpe ratio for U.S. direct investment is 3.28 (=7.64/3.33) and that for

foreign direct investment is 1.77 (= 2.09/1.18). That result means outward investment received

almost twice the return per unit of risk, or faced almost half the risk per unit of return, compared

to inward direct investment.

Because relative risk measures which use aggregate returns and standard deviations of

aggregate returns may miss some important differences across industries, we next apply Standard
The Standard & Poor’s industry betas are available at:

13

http://www2.standardandpoors.com/spf/xls/index/GICS_500_Scorecard.xls. For a given industry, beta is

computed over a 60-month span using the capitalization-weighted monthly returns for firms in the industry

versus the capitalization-weighted return on the S&P500 index.

Strictly speaking, in the theory of finance beta refers to“systematic”risk that is thought to be common 14

to all investments in the set being studied, such as the risk of economic recession, or other macroeconomic

risks. These risks are notable because they cannot be completely eliminated by increasing the diversity of

a portfolio of investments (though diversification does help to minimize risk). Other risks, deemed

“idiosyncratic,” are those unique to a particular investment and which theoretically can be eliminated through

ever greater diversification.

14

& Poor’s industry betas as a way to estimate the industry-weighted risk of outward and inward

direct investment. As developed in the literature on finance, beta is a numerical measure of the 13

riskiness, or variability, of the return on a given investment relative to the riskiness of the return

on the totality of available investments. The higher is an investment’s beta, the riskier it is

relative to the total set of investments. For example, if an investment has the same riskiness as the

riskiness in the total set of investments under study, its beta would have a value of unity. If it is

riskier, its beta would be above unity; if it is less risky, its beta would be below unity.14

An estimate of relative risk based on the industry composition of inward and outward FDI

assets finds that outward investment is negligibly riskier than inward investment. The beta for

inward investment is estimated to be 0.91, which is only marginally lower—or, less risky—than

the estimated beta of 0.92 for outward investment (Table 3). Part of the reason for the closeness

of the risk measure between inward and outward investment may simply be that, on balance, the

industry mixes of inward and outward direct investment are roughly similar (Figure 6).
15

Table 3. Sovereign Credit Risks and Regionally Aggregated Industry Betas of Outward and 

Inward Direct Investments, Based on 2003 data.

Share of U.S.

Direct Investment

Sovereign CreditRisk Rating:

Numeric Estimate

(“letter equivalent”)

Industry-weighted

Beta

U.S. Direct Investment Abroad:

Canada 11% 21(“AAA”) 0.986

Latin America and

 other Western Hemisphere 17% 11(“BB ”) 0.916 +

Europe 54% 20(“AA ”) 0.897 +

Asia, Pacific 16% 15(“A ”) 0.922 -

Africa 1% 12(“BBB ”) 1.189 -

Middle East 1% 14(“BBB ”) 1.092 +

Total/weighted average 100% 14(“BBB ”) 0.919 +

Foreign Direct Investment in the

United States 21(“AAA”) 0.906

 Sources: Authors’ calculations based on data from BEA and Standard & Poor’s.

Figure 6. Industry Composition of Inward and Outward Direct Investment Assets, 2003

 

 *Finance, Insurance, Real Estate

 

Next, we compare the sovereign credit-risk of inward and outward direct investments as

one way to help correct for the potential distortion that may exist in the comparison just made
Both Fitch and Standard & Poor’s ratings range from D (for default rating) to AAA with additional,

15

plus and minus ratings for letters CCC through AA. In all, there are 22 letter/plus/minus ratings. Details of

Standard & Poor’s ratings are available at the web page: http://www2.standardandpoors.com; those for

Fitch ratings are at http://www.fitchratings.com. Generally, sovereign credit ratings attempt to gauge the

likelihood that governments will honor their financial obligations and, as such, take into account political

and economic factors within the country and between the country and the rest of the world.

We wish to thank Ufuk Demiroglu, our colleague at CBO, for pointing out that, given the non-linear 16

relationship between default probabilities and credit ratings, we need to adjust credit ratings with default

probability associated with those credit rating to estimate the overall riskiness of outward direct investment.

The table containing the country-industry breakdown of U.S. direct investment abroad is available

17

at the BEA web page: http://www.bea.gov/bea/di/usdpos/pos_03.htm.

16

from the assumption that an industry is subject to the same degree of risk no matter where it is

located. For this comparison we use sovereign credit-risk ratings available at Standard & Poors.

We first convert letter ratings to number ratings by assigning the D rating (in default) the value

zero, adding 1 to each ascending letter rating, and ending with assigning the value 21 to the

highest rating, AAA. The sovereign credit-risk of inward FDI is assigned the numerical rating of 15

21 to reflect the sovereign credit rating of AAA for the United States. We then apply a non-linear

relationship between Standard & Poor’s sovereign ratings and default probabilities to the

sovereign risk rating of each host country to derive a numerical estimate of the riskiness of direct

investment in that country. The overall sovereign risk of outward direct investment is then the

FDI-weighted average of those numerical estimates of (default-probability-adjusted) riskiness of

major host countries. That average is converted back to the implied numerical equivalent of 16

sovereign rating, and then to the implied letter rating. We show the weighted average of

sovereign risks, along with the weight of each region in Table 3; each region was grouped

according to the country-regional pairings used in the international economic accounts of the

BEA. A country’s weight is its share of U.S. direct investment within that country’s region, and 17
17

a region’s weight is its share of total U.S. direct investment. For purposes of comparison, Table 3

also shows the industry-weighted betas for each regional grouping of countries.

On average, U.S. direct investments abroad are subject to higher sovereign risk than

foreign direct investments in the United States; such a difference can account about one-third of

the return spread shown in Table 2 and Figure 4. The sovereign risk ratings in Table 3 show that

the risk of outward direct investment is 14 (equivalent to 14=BBB . This is considered to be a +)

somewhat low investment-grade rating, with speculative-grade ratings beginning 3 steps lower at

11 or BB . In contrast, inward direct investment has a rating of 21 (equivalent to AAA), which is +

considered to be the strongest investment-grade rating. The benchmark spread of long-term

corporate bonds rated BBB, slightly below BBB versus those rated AAA averaged 136 basis +

points over the past 5 years (1999-2003). By comparison, the difference in average returns

between outward and inward direct investment over those years was 409 basis points. Thus,

based on the benchmark spread, the difference in the sovereign risk between inward and outward

direct investment can explain about one-third of difference in returns (136/409=0.334).

Overall, the above findings suggest that risk-compensation contributed, but only to a

limited extent, to the large return gap between outward and inward direct investment. The fact

that the return gap in favor of outward FDI assets appears to persist whether the host country has a

high or low credit-risk rating also suggests that risk-compensation is far from the main reason for

the large and sustained return gap. For example, the return on U.S. direct investment in

Canada—which has a 21, or AAA, rating—exceeded the return on Canada’s direct investment in

the United States by 5.47 percentage points on average over 1999-2002 (Table 4). The return on

U.S. direct investment in Latin America—which has a rating of 11, close to BB (the highest +
In a least squares regression of outward investment returns (column 2 of Table 3) on regional credit- 18

risk rating(column 1), the negative slope coefficient has a t-statistic of 1.6 (a coefficient of -1.89 and a

standard error of 1.18) but the equation’s F-statistic of 2.56 is below the critical F(1,4) value of 4.54 at the

10 percent confidence level and, thus, unable to reject the null hypothesis of no relationship.

18

speculative-grade as opposed to investment-grade ratings)—exceeded the return on Latin

America’s direct investment in the United States by almost the same amount, 5.27 percentage

points, on average over the same period. The average return on U.S. outward FDI assets in each

region (shown in column (2) of Table 3) does exhibit a roughly inverse relationship with that

region’s sovereign risk rating. However, that relationship is not statistically significant.18

Table 4. Sovereign Credit-Risk Ratings versus Average Percentage Return on 

Inward and Outward, Nonbank FDI Assets, 1999-2002

 

Sovereign

Credit Risk

Rating

Return on

Outward

FDI

Return on

Inward

FDI

Return 

Gap

 (1) (2) (3) (4)

All countries 3.63% -0.09% 3.72%

Canada 21.0 3.62% -1.86% 5.47%

Europe 20.7 3.44% 0.12% 3.32%

Latin America and Other Western 13.4 4.09% -1.19% 5.27%

Africa 12.1 5.47% 0.44% 5.02%

Middle East 15.6 6.43% 1.69% 4.75%

Asia and Pacific 17.8 3.60% -0.30% 3.90%

 Sources: Authors’ calculations based on data from BEA and Standard & Poor’s.

Admittedly, to the extent that the preceding analysis does not include the assessment of

currency risk, this conclusion may be biased against the risk-compensating hypothesis. Currency

risk is an important risk consideration in investors’ mind. Many analysts have observed that the

dollar’s unique role as the reserve currency and the main medium of international exchange is a
As noted in the Appendix, the return on international portfolio assets (ROA) measured by BEA data

19

is a distorted indicator of the true rate of return. To the extent that the ROA underestimates the return on

outward portfolio assets relative to that on inward portfolio assets during most of the 1990s because of the

stock market boom both in the United States and abroad (as noted in the preceding section), it could lead to

an underestimate of the “risk premium” for the greater risk of outward portfolio investment.

For example, as pointed out by Mataloni (2000), foreign owned nonfinancial companies that acquired 20

or established a US business in the 2 years preceding 1996 had an average capital-spending-to-sales ratio of

8.4 percent, compared with 5.1 percent for other foreign-owned nonfinancial companies.

19

primary reason that the United States is an attractive location for international investment. The

fact that many external debts of foreign companies’ and governments are denominated in dollars

may also enhance the value they assign to holding assets in the United States. Nevertheless,

given that currency risk should matter for portfolio investment as for direct investment, the fact

that the return gap in portfolio investments is actually slightly disadvantageous to the United

States suggests that currency risk is unlikely to have had a significant effect on the return gap in

direct investments. 

19

3.2 The Age-Effect Hypothesis

Until the early 1980s, U.S. direct investment outflows had consistently outpaced foreign

direct investment inflows to the United States, even though that pattern has since disappeared (see

Figure 7). Based on this observation, the age-effect hypothesis maintains that the return gap

favors U.S. affiliates abroad, which on average are older than foreign affiliates in the United

States, because young companies tend to be less profitable than mature companies for at least

three reasons. First, profits of newly acquired or established companies tend to be dampened by

high startup costs such as spending for capital equipment or advertising. These costs may be 20

particularly high for foreign firms that must get to know a market that is outside of their home
20

bases. Second, young companies tend to have a lower return on assets (ROA) than mature

companies because they are less experienced; over time, they should become more profitable as

they learn to operate in the newer environment (marketing, streamlining, restructuring, etc.). 

Finally, accounting returns on newly acquired companies also may be depressed because mergers

and acquisitions tend to increase the book value of assets initially while operating profits are not

yet affected. 

 Figure 7. Outward and Inward Direct Investment Flows as Percent of U.S. GDP, 

 1960-2003

 

On the whole, research has found a significant amount of evidence in support of the age

effect. Lupo, Gilbert, and Liliestedt (1978) found a significant age effect among U.S.-owned

manufacturing companies abroad. They examined company-level data for 4507 foreign

manufacturing affiliates of U.S.-owned companies and found that the average ROA of those

affiliates increased steadily with age, at least for the first 10 years. Grubert, Goodspeed and

Swenson (1992), using a 1980-87 panel data set, also find that there seemed to be a “maturation”
They find that, during the 1980's, three-fourths of all inward FDI was for acquiring existing

21

companies and about one-fourth was for establishing new companies.

The authors also point out several other reasonsthat helped explain the phenomena: (1) foreigners 22

paid full price for sub-par performers, mainly because takeovers—by foreign or domestic acquirers—tend

to require a premium to be paid over usual share prices; (2) foreign-owned manufacturing companies have

generally operated with more debt than have U.S. firms; and (3) newly acquired firms sometimes increase

their depreciation/amortization expense by revaluing (tangible and intangible) assets. 

21

effect in foreign-owned companies in manufacturing. They find that those companies’

profitability increased over time, even though they find no significant tendency for newly acquired

foreign-owned companies to be those with low or negative rates of return. 

 Landefeld, Lawson and Weinberg (1992) find that, for the companies that were newly

acquired by foreigners, rates of return were already low or negative: between 1982 and 1990, the

rate of return on assets for U.S. companies in the year before their acquisition by foreigners was

1.0 percent, compared with 4.6 percent for all U.S. nonfinancial companies. The authors thus 21

speculate that the return on such newly acquired companies would be lowered further as owners

restructured these companies by investing in new plant and equipment and in modernizing older

plants, increasing marketing efforts, and aggressively pricing their products to regain market

share. Laster and McCauley (1994) find that the low rate of return on foreign-owned companies

in the United States was largely due to a late-1980s’ surge in foreign acquisition activity. They

conclude that the sharp decline in profitability of newly acquired firms in the late 1980s seems to

derive largely from a rise in operating costs, and observe that the return on direct investment

improves over time as the initial step-up in investment pays off and unsuccessful enterprises are

divested.22

More recently, Mataloni (2000) also finds an unmistakable age effect in a panel of 749

foreign-owned manufacturing companies that existed throughout 1988-97. The author detects a
22

significant relationship between the age of a foreign-owned manufacturing company and the gap

between its ROA and that of U.S.-owned companies in the same industry. For example, for all

manufacturing industries combined, the median ROA gap, which was -2.7 percentage points in

1988, had been completely eliminated by 1997. A particularly strong relationship between age

and the ROA gap was found in motor vehicles and equipment manufacturing: the median ROA

gap was -6.5 percentage points in 1988, but became a positive 3.0 percentage points in 1997

(Table 5). In addition, the author finds that, while the ROA of all foreign-owned nonfinancial

companies was consistently below that of U.S.- owned counterparts from 1988 to 1997, that gap

narrowed over time, from nearly 2 percentage points in 1988 to 1 percentage point in 1997. He

suggests that this narrowing of the gap is related to age effects.

Table 5. The Median Gap between Returns on Foreign-Owned and U.S.-

Owned Companies in the United States (percentage points)

 

All Manufacturing 

Industries

Motor Vehicles and 

Equipment

1988 -2.7 -6.5

1989 -2.6 -6.4

1990 -3.5 -2.2

1991 -3.0 -3.9

1992 -2.0 -1.0

1993 -1.4 -0.7

1994 -0.3 1.5

1995 -1.9 3.5

1996 -0.2 -1.8

1997 1.0 3.0

Source: All data on this table are taken from Table 6 in Mataloni (2000).

The above findings indicate that “age” has a significant and positive effect on a company’s

profitability. These findings are consistent with the fact that the gap between the ROAs (of U.S.
The tax burden on foreign direct investment is usually determined by three elements: (1) the 23

domestic corporate tax systems of home and host countries, (2) the taxation of cross-border flows of income,

and ( 3) the interaction of tax systems of home and host countries. The host country, besides imposing

statutory corporate taxes on a subsidiary’s profits, may levy withholding taxes on a subsidiary’s payments

of dividends or interest to the parent company. The home country may also levy the corporate income tax

on the parent firm’s receipts of dividends and interest from its foreign subsidiaries. Whether this leads to

double taxation on repatriated income depends on whether the home country has adopted an exemption

system or a credit system for repatriated income and, in the later case, on whether the tax paid abroad is

bigger or smaller than the total tax liability of the parent firm. 

The United States generally taxes income from active business operations (as opposed to financial

operations) abroad only when it is repatriated. A credit is given for foreign taxes paid, including the

underlying foreign corporate tax on direct dividends, but the credit is limited to U.S. taxes on that income.

23

outward and inward direct investments) widened in the late 1980s, a period with very heavy

inward FDI in the United States, narrowed significantly in the second half of the1990s as FDI

inflows subsided, then widened again during 1999-2001 as FDI inflows surged (Figures 4 and 7).

3.3 The Profit-Shifting Hypothesis

The profit-shifting hypothesis consists of two sub-hypotheses. The first sub-hypothesis is

that multinational corporations have the incentive and ability to minimize their overall tax

payments by shifting profits among affiliated companies located in countries with different tax

rates through transfer prices (i.e, the price charged by one company for a product or service it

supplied to an affiliated company). Although tax regulations generally require that intra-firm

transactions be at “arms-length” prices (i.e., prices charged between unrelated companies), crosscountry differences in tax rates create incentives for foreign-controlled companies to deviate from

this standard, particularly for goods and services that do not have well-established, or marketbased, reference prices. Multinational corporations will shift income not only to reduce the tax

cost of current operating income but also to lower the cost of repatriating income to the parent

companies.23
So far, efforts to test the profit-shifting hypothesis are generally undertaken to uncover reasons why 24

foreign-controlled companies in the United States tend to have much lower profitability than U.S.-owned

companies (in the United States) in the same industries. Since it is difficult to test the hypothesis directly,

researchers have generally resorted to testing it indirectly. 

24

The second sub-hypothesis is that foreign affiliates in the United States have, on balance,

understated their profits through profit-shifting schemes by much more than U.S. affiliates abroad

have. Admittedly, both foreign and U.S. multinationals could shift profits into and out of the

United States through transfer pricing schemes, and the balance of profit-shifting will depend on

the distribution of profits and losses between the parent and affiliates located in different countries

as well as the tax rates and the interaction of tax rates among the countries where the affiliates are

located; moreover, U.S. affiliates abroad may even have additional (or, non-tax) incentives—such

as avoiding capital controls or political instability—to shift profits to their parents in the United

States. However, given that some foreign tax havens impose virtually no tax on corporate profits,

both U.S. and foreign multinationals have strong incentives and opportunities to shift profits out

of the United States. Therefore, on balance foreign affiliates in the United States are likely to

under-report profits by more than do U.S. affiliates abroad.

At best, the balance of studies we survey provides only weak and indirect evidence that

foreign-controlled companies have been shifting profits abroad. The evidence is somewhat 24

stronger that U.S. multinationals have engaged in shifting profits through transfer prices.

However, there is evidence that U.S. subsidiaries shift income to their parents in the United States

as well as evidence that U.S. parent companies shift income to their subsidiaries abroad. It thus

appears that profit-shifting activities are not likely to be a major reason for the return gap favoring
Based on the first assumption, Grubert (1997) infers that income shifting would make the distribution 25

of foreign-controlled companies’ profitabilitymore concentrated near zero than that of domestic companies.

With a panel data from 1987 to 1993, the author finds that the distribution of the return on assets (ROA) of

foreign-controlled companies displayed a very clear concentration near a mean of zero, while the distribution

of U.S. companies’ ROA had a mean higher than zero and was flatter in the central range than the foreign

distribution. He interprets this finding to be supportive of the profit-shifting hypothesis. Based on the

second assumption, he finds that companies with foreign ownership of between 25 and 50 percent exhibit

the same low profitability as those with 100 percent foreign ownership, even though the latter group would

be more likely to shift profits out of the United States. The author presents this result as evidence that profitshifting is not a major factor behind the low profitability of foreign-controlled companies in the United

States.

25

U.S. outward direct investment. 

Studies ascertaining whether profit-shifting is an important reason of the low profitability

of foreign-controlled companies in the United States include Grubert (1997), Laster and

MaCauley (1994), and Mataloni (2000). Grubert (1997) tests the hypothesis based on two

assumptions. The first is that foreign-controlled companies with higher U.S. profitability have

greater incentive and opportunity to shift profits through transfer-pricing schemes without

arousing the suspicion of tax authorities. Conversely, unprofitable foreign-controlled companies

have the incentive to transfer losses to jurisdictions in which they have positive taxable income. 

The second is that income shifting is less likely when there are more U.S. shareholders. He finds

no evidence in support of the profit-shifting hypothesis based on the second assumption, even

though there is some supporting evidence based on the first assumption. 25

Laster and MaCauley (1994), with an analysis of 19 major manufacturing industries for the

period of 1977-92, find that industries in which affiliates import a higher fraction of their sales

from their parent group report lower returns on sales. That is, reported profits vary inversely with

the opportunity to transfer income. However, the authors caution against relying too much from

this finding as an empirical support for the profit-shifting hypothesis, noting that imports from
26

parents may simply proxy for overall imports; in that case, the observed relationship could mean

only that a weak dollar crimped the profits of manufacturing industries heavily dependent on

imports.

Mataloni (2000) tests the profit-shifting hypothesis based on the assumption that foreigncontrolled companies with a higher percentage of their sales accounted for by intra-firm imports

have greater opportunities to shift profits through manipulating transfer prices. Under this

assumption, a significant relationship detected between the share of sales accounted for by intrafirm imports and the return gap provides an indirect evidence for the profit-shifting hypothesis. 

However, the author finds no clear relationship between the return gap and the intra-firm-import

content of sales at the industry-level. 

Studies ascertaining whether U.S. multinationals engage in profit-shifting through transfer

prices include Grubert and Mutti (1991), Hines and Rice (1990), Harris, Morck, Slemrod, and

Yeung (1993), and Grubert (1998). All of these studies’ findings are consistent with the

hypothesis that U.S. multinationals engage in profit-shifting to minimize their overall tax cost. 

Grubert and Mutti (1991) find that multinational firms declare more income in low-tax foreign

jurisdictions than in high-tax foreign jurisdictions, suggesting that U.S. affiliates abroad shift

income from high-tax jurisdictions to low-tax ones. Hines and Rice (1990) find a negative

relation between U.S. multinationals’ profits and average tax rates in host countries. Harris,

Morck, Slemrod, and Yeung (1993) find evidence suggesting that U.S. multinationals shifted

income from the United States to low-tax regions, and shifted income from high-tax regions to the

United States. Moreover, they find that multinationals shift income from low-tax regions to the

United States, suggesting income shifting could be motivated by non-tax reasons such as avoiding
27

capital controls, currency risk, or political instability. On balance, they do find that incomeshifting by U.S. multinationals has a net effect of reducing their tax payments to the United States,

even though that net effect cannot be estimated precisely.

Grubert (1998) finds indirect evidence of profit-shifting in a study that tests the effect of

dividend taxes on the distribution of U.S. subsidiaries’ income among dividend, royalties, interest

payments, and retained earnings. He finds that an increase in the U.S. dividend tax rate

discourages dividend repatriations from a U.S. subsidiary abroad, but it does not increase that

subsidiary’s retained earnings. In supplemental regressions, the author finds that a decline in

dividend payments induced by a hike in dividend tax rate tends to be made up by increases in

interest payment or royalties and license fees. The author interprets this as evidence that U.S.

subsidiaries abroad engage in income-shifting (through interest and royalty payments to the parent

or to another affiliate in third countries with lower tax rates) to minimize the overall tax cost of

repatriations. 

In sum, so far there is not sufficient evidence to conclude that profit-shifting schemes, on

balance, are an important factor underlying the large gap favoring U.S. outward direct

investments. If a U.S. subsidiary abroad under-reports its profits by shifting income via either

paying royalties or interest payments to its parent, it would even mean that the return gap would

be even bigger than that based on reported data once that under-reporting is corrected. Indeed, the

return gap between outward and inward direct investments is amplified if royalties and license

fees are counted as investment income, adding about 2 percentage points to U.S. returns and less
BEA treats receipts of royalties and license fees as exports of services, and payments as imports of 26

services.

28

than one percentage point to foreigners’ returns on average since the mid-1970s (Figure 8).26

While this piece of data does not prove that on balance U.S. subsidiaries shifted income to their

U.S. parents by more than foreign subsidiaries shifted income out of the United States, it does

indicate that we are far from being sure that reported data have exaggerated the return gap in favor

of outward FDI assets.

Figure 8. Returns on Cross-Border Direct Investments, including Royalties and License 

Fees, 1982-2003 (percent)

 

Two possible factors may help explain why the evidence for profit-shifting by foreign

subsidiaries appears to be weaker than that for U.S. subsidiaries. First, the studies cited above

used data from a time when inward FDI-weighted statutory corporate tax rate of foreign countries

was higher than the U.S. rate (about 40%)—that is, a time when foreign-controlled companies in

the United States had relatively little incentives to shift income back to their parent companies
The inward-FDI weighted foreign corporate tax rate is the weighted average of statutory tax rates 27

of 17 foreign countries (namely, Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany,

Ireland, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, and Norway.), with each

country’s weight being the share of DI assets from that country in total inward DI assets. The outward-FDI

weighted foreign corporate tax rate is obtained with each country’s weight being the share of DI assets that

country received in total outward FDI assets. Foreign corporate tax rates are obtained from various issues

of KPMG’s corporate tax rate survey.

High statutory tax rates abroad do not necessarily mean that multinationals haves no tax incentives 28

to shift profits out of the United States. This is because (1) statutory tax rates may overstate the effective

tax rate for some multinationals, and (2) multinationals can shift profits to low-tax third countries rather than

to their parents or affiliates in the high tax-rate countries.

29

(Figure 9). Second, on the whole, foreign subsidiaries in the United States are younger and less 27

profitable than U.S. subsidiaries abroad, thus with less incentive to shift income for tax purposes. 

If these two factors are important reasons why foreign subsidiaries have engaged in profit-shifting

by less than U.S. subsidiaries have in the past, then foreign subsidiaries are likely to become 28

more active in profit-shifting schemes in the future as a result of two developments: (1) the inward

FDI-weighted foreign corporate tax rate has fallen below that of the United States, and (2) the

evidence on the age-effect hypothesis suggests that foreign subsidiaries will become more

profitable as they become older.

Figure 9. Statutory Corporate Tax Rates in Foreign Economies, Weighted by Inward and 

Outward Direct Investment Shares, 1996-2004.

 
30

4. Conclusion

The balance of research so far indicates that the positive gap between the return on U.S. 

direct investment abroad and that on foreign direct investment in the United States is most

strongly explained by the age-effect hypothesis, followed by the risk-compensating hypothesis. 

Most studies find that foreign-controlled companies have been less profitable than U.S.-controlled

companies because they are relatively new and it takes time for them to turn a profit. There is

some evidence that about one-third of the return gap is compensation for the higher risk of

outward direct investment than inward direct investment; but that finding is tempered by other

observations that suggest risk-compensation may player an even smaller role than that. There is

some evidence that multinational companies engage in profit-shifting activities for tax purposes. 

However, U.S. multinationals appear to shift profits both into and out of the United States, while

the evidence that foreign multinationals shift profits out of the United States is quite sketchy. 

These findings suggest that profit-shifting activities are unlikely to be a major reason of the return

gap favoring U.S. outward direct investment. 

The evidence so far suggests that the extent to which the (reported) return gap will remain

favorable to the United States in the future will largely depend 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, the prospect that foreign

subsidiaries would become more profitable over time (as they mature) suggests that foreigncontrolled companies are likely to become more actively engaged in profit-shifting practices,

thereby depressing the reported profits of those companies. 
31

Appendix. Rates of Return on International Investments: Data and Measurement

The rates of return on U.S.-owned assets abroad reported in this paper are the ratios of

investment income inflows (i.e., receipts) to U.S.-owned assets abroad. Likewise, the rates of

return on foreign-owned assets in the United States are the ratios of investment income outflows

(i.e., payments) to foreign-owned assets in this country. All data on investment income flows and

cross-border investment positions are obtained from the Bureau of Economic Analysis (BEA). 

This appendix provides a systematic, though simplified, account of measurements of (1) crossborder assets, (2) cross-border investment income flows, and (3) the rate of return on cross-border

assets. (For detailed description of data sources and estimation methods, see BEA [1990].) It

then compare the rates of return studied in this paper with the conventional measure of the rate of

return.

Cross-Border Assets

In BEA’s reporting, U.S. holdings of assets abroad consist of direct investment assets (i.e.,

U.S. investors’ ownership of foreign business which equals or exceeds 10 percent of the value of

that business) and portfolio investment assets (i.e., all that are not counted as direct investment

assets, such as corporate stocks and bonds, bank loans to foreigners, deposits in foreign banks,

and government securities). Foreign-owned assets in the United States follow analogous

conventions. The BEA measures the value of U.S. and foreign direct investment by two methods:

the current-cost 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
32

measures direct investment at the current stock-market value of owners’ equity. All non-banking

portfolios are reported at their market value, and banking portfolios at their book values. As a

result, there are two aggregate measures of cross-border international investment positions: (1) the

current-cost measure which adds up the current-cost measure of direct investment assets, the

market-value of all non-banking portfolio assets, and the book value of all banking assets; and (2)

the market-value measure which adds up the market-value measure of direct investment assets

and all non-banking portfolio assets, and the book value of all banking assets. In this paper, we

use the market-value measure of direct investment assets for the calculation of the rate of return

on direct investment assets.

Cross-Border Investment Income Flows

There is a key difference between portfolio investment income and direct investment

income: the former does not include capital gains while the latter does. Portfolio investment

income is the sum of dividend and interest income, excluding capital gains. Direct investment

income is the sum of dividends (i.e., parent companies’ receipt of distributed earnings less foreign

withholding taxes on distributed earnings), net interest income (i.e., parents’ interest receipts

from foreign affiliates net of their interest payments to those affiliates), and (parents’ share of )

retained earnings and capital gains. 

Rate of Return on U.S.-Owned Assets Abroad

The rate of return on outward portfolio investment assets differ from that on outward

direct investment assets in two ways: (1) portfolio investment income does not include capital
33

gains, while direct investment income does, and (2) portfolio investment income does not include

retained earnings, while direct investment income does. Both rates of return are not influenced by

changes in the exchange rate during the holding period because investment income and

investment assets are translated back to dollar terms with the exchange rate that prevailed at the

end of the period. If we assume that there is no net purchase or net sell of the stock of assets

during period t, then the rate of return on outward portfolio investment (RPI) is expressed as in

equation (1), and the rate of return on outward direct investment (RFDI) in equation (2):

where, the time subscript 0 denotes the beginning of period t, and subscript 1 denotes the end of

period t, and 

D*t is the sum of dividend income (in foreign currency terms) during period t,

t

I* is the sum of interest income (in foreign currency terms) during period t,

RE*t is the sum of retained earnings (in foreign currency terms) during period t.

S0 is the exchange rate (dollar/foreign currency) at the beginning of period t, 

S1 is the exchange rate (dollar/foreign currency) at the end of period t, 

aP*t is the proportionate change in the market value of assets (in foreign currency terms) from the

beginning to the end of period t,
34

V0 is the purchase value of the assets (in dollar terms) at the beginning of period t.

As in the case of outward investment, the rate of return on inward portfolio assets differ

from that on inward direct investment assets in two ways: (1) portfolio investment income does

not include capital gains, while direct investment income does, and (2) portfolio investment

income does not include retained earnings, while direct investment income does. From the

perspective of BEA, both rates of return are not influenced by changes in the exchange rate during

the holding period because both investment income and investment assets are recorded in dollar

terms. If we assume that there is no net purchase or net sell of the stock of assets during period t,

then the rate of return on inward portfolio investment (RPI ) is expressed as in equation (3), and *

the rate of return on inward direct investment (RFDI ) in equation (4): *

where,

Dt is the sum of dividend income (in dollar terms) during period t,

t

I is the sum of interest income (in dollar terms) during period t,

REt is the sum of retained earnings (in dollar terms) during period t.

aPt is the proportionate change in the (dollar) market value of assets from the beginning to the end

of period t,

V0 is the purchase value of the assets (in dollar terms) at the beginning of period t.
35

Rates of Return on Cross-Border Assets versus Conventional Rates of Return

Rates of return on international assets referred to in this paper differ from conventional

rates of return (RPIC) in several ways. To illustrate, compare equation (1) to equation (5) which

expresses a simple version of conventional rates of return (RPIC) in period t:

Comparing equations (1) and (5) makes clear that, for exactly the same basket of portfolio

assets held abroad during period t, the rate of return on that portfolio as calculated in this paper

(RPI) will equal the conventionally measured rate of return on that portfolio (RPIC) only when

both of the following two conditions are true: (1) there is no capital gains during the holding

period (i.e t ., aP* = 0); and (2) there is no change in the exchange rate during the holding period

1 0 (i.e. S = S ). An increase in capital gains during the holding period lowers RPI (because it raises

the denominator but not the numerator), while it increases RPIC (because it raises the numerator

but not the denominator). A dollar 1 0 depreciation (i.e., an increase in S relative to S ) does not

change RPI (because it raises both the numerator and denominator to the same extent), while it

increases RPIC (because it raise the numerator but not the denominator). 
36

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