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Taxes, institutions and foreign diversification opportunities

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  • Desai, Mihir A.
  • Dharmapala, Dhammika

Abstract

Investors can access foreign diversification opportunities through either foreign portfolio investment (FPI) or foreign direct investment (FDI). The worldwide tax regime employed by the US potentially distorts this choice by penalizing FDI, relative to FPI, in low-tax countries. On the other hand, weak investor protections in foreign countries may increase the value of control, creating an incentive to use FDI rather than FPI. By combining data on US outbound FPI and FDI, this paper analyzes whether the composition of US outbound capital flows reflects these incentives to bypass home and host country institutional regimes. The results suggest that the residual tax on US multinational firms' foreign earnings skews the composition of outbound capital flows -- a 10% decrease in a foreign country's corporate tax rate increases US investors' equity FPI holdings by approximately 10%, controlling for effects on FDI. Investor protections also seem to shape portfolio choices, though these results are not robust when only within-country variation is employed.

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  • Desai, Mihir A. & Dharmapala, Dhammika, 2009. "Taxes, institutions and foreign diversification opportunities," Journal of Public Economics, Elsevier, vol. 93(5-6), pages 703-714, June.
    • Handle: RePEc:eee:pubeco:v:93:y:2009:i:5-6:p:703-714
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    2. Riedl, Aleksandra & Rocha-Akis, Silvia, 2007. "Testing the tax competition theory: How elastic are national tax bases in western Europe?," Department of Economics Working Paper Series 112, WU Vienna University of Economics and Business.
    3. Fatica, Serena, 2009. "Taxation and the quality of institutions: asymmetric effects on FDI," MPRA Paper 24179, University Library of Munich, Germany, revised Jun 2010.
    4. Herrmann, Sabine & Kleinert, Jörn, 2014. "Lucas paradox and allocation puzzle: Is the euro area different?," Discussion Papers 06/2014, Deutsche Bundesbank.
    5. Jiandong Ju & Shang-Jin Wei, 2010. "Domestic Institutions and the Bypass Effect of Financial Globalization," American Economic Journal: Economic Policy, American Economic Association, vol. 2(4), pages 173-204, November.
    6. Arulampalam, Wiji & Devereux, Michael P. & Liberini, Federica, 2019. "Taxes and the location of targets," Journal of Public Economics, Elsevier, vol. 176(C), pages 161-178.
    7. Desai, Mihir A. & Dharmapala, Dhammika, 2009. "Taxes, institutions and foreign diversification opportunities," Journal of Public Economics, Elsevier, vol. 93(5-6), pages 703-714, June.
    8. Mihir A. Desai & Dhammika Dharmapala, 2007. "Taxes and Portfolio Choice: Evidence from JGTRRA's Treatment of International Dividends," NBER Working Papers 13281, National Bureau of Economic Research, Inc.
    9. Liberini, Federica, 2014. "Corporate Taxes and the Growth of the Firm," The Warwick Economics Research Paper Series (TWERPS) 1042, University of Warwick, Department of Economics.
    10. Mishra, Anil V. & Ratti, Ronald A., 2013. "Home bias and cross border taxation," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 169-193.
    11. Abid, Fathi & Bahloul, Slah, 2011. "Selected MENA countries' attractiveness to G7 investors," Economic Modelling, Elsevier, vol. 28(5), pages 2197-2207, September.
    12. Dhammika Dharmapala, 2008. "What problems and opportunities are created by tax havens?," Oxford Review of Economic Policy, Oxford University Press and Oxford Review of Economic Policy Limited, vol. 24(4), pages 661-679, winter.
    13. Klimek Artur, 2015. "Institutions and Outward Foreign Direct Investment," International Journal of Management and Economics, Warsaw School of Economics, Collegium of World Economy, vol. 46(1), pages 101-119, June.
    14. repec:onb:oenbwp:y::i:142:b:1 is not listed on IDEAS
    15. Mishra, Anil V. & Ratti, Ronald A., 2014. "Taxation of domestic dividend income and foreign investment holdings," International Review of Economics & Finance, Elsevier, vol. 31(C), pages 218-231.
    16. repec:grz:wpaper:2014-01 is not listed on IDEAS
    17. Mishra, Anil V., 2014. "Australia's home bias and cross border taxation," Global Finance Journal, Elsevier, vol. 25(2), pages 108-123.

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    More about this item

    Keywords

    Foreign portfolio investment Foreign direct investment Taxes Investor protections;

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F23 - International Economics - - International Factor Movements and International Business - - - Multinational Firms; International Business
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • H25 - Public Economics - - Taxation, Subsidies, and Revenue - - - Business Taxes and Subsidies

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