International Taxation and Multinational Activity / Edition 1

by James R. Hines Jr.

Overview

Because the actions of multinational corporations have a clear and direct effect on the flow of capital throughout the world, how and why these firms behave the way they do is a major issue for national governments and their policymakers. With an unprecedented ability to adjust the scale, character, and location of their global operations, international corporations have become increasingly sensitive to the kind and degree of tax obligations imposed on them by both host and home countries. Tax rules affect the volume of foreign direct investment, corporate borrowing, transfer pricing, dividend and royalty payments, and research and development. National governments that tax the profits of international firms face important challenges in designing tax policies to attract them. This collection examines the global ramifications of tax policies, offering up-to-date, theoretically innovative, and empirically sound perspectives on a problem of immense significance to future economic growth around the globe.

Product Details

ISBN-13:	9780226341736
Publisher:	University of Chicago Press
Publication date:	03/15/2001
Series:	National Bureau of Economic Research Conference Report
Edition description:	1
Pages:	288
Product dimensions:	6.00(w) x 9.00(h) x 0.90(d)

About the Author

James R. Hines is Richard A. Musgrave Collegiate Professor of Economics in the department of economics and Professor of Law at the University of Michigan Law School.

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International Taxation and Multinational Activity
The University of Chicago Press Copyright © 2001 the National Bureau of Economic Research
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ISBN: 978-0-226-34173-6



Chapter One Has U.S. Investment Abroad Become More Sensitive to Tax Rates?

Rosanne Altshuler, Harry Grubert, and T. Scott Newlon

This paper attempts to address two related questions. The first question is how sensitive U.S. firms' investment location decisions are to tax rate differences across countries. Finding the answer to this question clearly is important for determining the revenue and efficiency consequences of many tax policies. The second question is whether the location of investment abroad by U.S. firms has become more sensitive to tax rate differences across countries. A finding that investment location decisions have become more sensitive to tax rates would be consistent with the view that technological advances and the loosening of trade restrictions and capital controls have in recent years increased the ease with which capital can cross national borders. If different locations became closer substitutes for the location of production, it would not be surprising if investment location decisions became increasingly responsive to tax considerations.

We use data from the U.S. Department of the Treasury corporate tax return files for 1984 and 1992 to address these questions. The use of these data yields two benefits not available to recent cross-sectional studies of the effect of host-country tax rates on the distribution of U.S. direct investment abroad (e.g., Grubert and Mutti 1991, 1997; and Hines and Rice 1994). The first benefit is that, with the time element in our data, we can examine whether investment location choices abroad have in fact become more sensitive to tax rates over the period spanned by our two sample years. The second benefit is that we can control for unmeasured country fixed effects.

Our data come from the information forms filed with the tax returns of U.S. parent corporations on each controlled foreign corporation (CFC) abroad. This information form, to be described more fully later, includes details from the balance sheets and income statements of CFCs. We aggregate these data up to country level and combine it with information from a variety of other sources to control for nontax features of different locations. The data include information for almost sixty countries. We limit our analysis to the manufacturing CFCs of U.S. manufacturing parents.

Following the earlier studies by Grubert and Mutti (1991, 1997) and Hines and Rice (1994), we regress a measure of U.S. multinational firms' real capital in each country on tax rate variables and measures of nontax characteristics of each country. The focus is on the effect of differences in host-country tax rates on investment choices across foreign locations, not on the choice between investing at home or abroad. Our work has two main findings. First, we find large estimated tax elasticities for investment abroad. Controlling for country fixed effects produces tax elasticities that are slightly larger and more precisely estimated than those from our single-year cross sections. Second, our results suggest that the location of real capital in manufacturing affiliates has become more sensitive to tax rates in the period from 1984 to 1992. Our basic estimates indicate that the elasticity of real capital to changes in after-tax returns increased from about 1.5 in 1984 to 2.8 in 1992 (for countries with the most open trade regimes). Both the elasticities and the difference between them are statistically significant at standard levels.

We perform a variety of tests to check the robustness of our elasticity estimates. With few exceptions, the magnitude and significance of our 1992 and 1984 elasticities changes little when we screen our sample in various ways or change the measure of host-country taxes. The difference between the 1984 and 1992 elasticities is large in absolute terms and is statistically significant; and its absolute and statistical significance is robust to our sensitivity checks.

The remainder of the paper is organized as follows. Section 1.1 contains a brief review of studies using cross-sectional data to estimate tax effects on location decisions of U.S. multinational corporations. We highlight the elasticity estimates in previous studies and note that they provide suggestive but inconclusive evidence that investment location has become more sensitive to tax rates in recent years. Section 1.2 describes the data and how our tax and capital measures are constructed from the U.S. Department of the Treasury tax files. Empirical results are contained in section 1.3, and the final section presents our conclusions.

1.1 A Brief Review of the Recent Literature

While early studies of the responsiveness of U.S. direct investment to after-tax rates of return used aggregate time series data, the most recent work in this area exploits cross-sectional data. In this section, we review the three studies that relate most directly to our approach: Grubert and Mutti (1991), Hines and Rice (1994), and Grubert and Mutti (1997). All three papers contain estimates of the effect of local taxes on the allocation of real capital. While the tax variable in these papers is similar (each uses a measure of average effective tax rates), it appears in different forms in the estimating equations, making the comparison of estimated tax effects difficult.

Both Grubert and Mutti (1991) and Hines and Rice (1994) use the 1982 benchmark data on U.S. direct investment abroad from the Bureau of Economic Analysis (BEA). One important difference between these two papers is the sample studied. Grubert and Mutti analyze the allocation of capital by manufacturing affiliates of U.S. parents across thirty-three host countries; the focus of Hines and Rice is on the activity of U.S. multinationals in tax havens. Their sample includes all majority owned nonbank affiliates of U.S. parents, which results in a larger set of countries (seventy-three), more than half of which (forty-one) are tax havens with little real capital.

Grubert and Mutti (1991) regress the log of the net stock of property, plant, and equipment (PPE) on two different forms of the average effective tax rate: the log of 1 minus the tax rate, and the inverse of the tax rate. The first specification gives a (constant) tax elasticity that measures the sensitivity of the demand for real capital to changes in after-tax returns (for a given pretax return) or, alternatively, to changes in the cost of capital (for given after-tax returns). The second specification allows for larger tax effects at lower tax rates. Using the first specification, Grubert and Mutti estimate tax elasticities that range from 1.5 (for all manufacturing affiliates) to 2 (for majority owned manufacturing affiliates) but that were statistically not highly significant. The inverse formulation, however, produced a highly significant tax coefficient of -0.11. At lower tax rates, this tax effect is particularly strong. Grubert and Mutti report that reducing local tax rates from 20 to 10 percent will increase U.S. affiliates' net plant and equipment in a country by 65 percent.

Hines and Rice (1994) regress the log of PPE on host-country average tax rates. The coefficient on their tax term is -3.3 and is significantly different from 0. This coefficient suggests that at their mean tax rate of 31 percent, a 1 percent increase in after-tax returns leads to a 2.3 percent increase in the real capital stock of U.S. affiliates. Hines and Rice's inclusion of the tax haven countries, as well as their examining the allocation of capital in all nonbank affiliates, may be responsible for their higher estimated elasticity.

The most recent analysis of the effects of taxes on investment location decision of U.S. multinational firms is Grubert and Mutti (1997). They estimate tax elasticities using country- and firm-level cross-sectional data on the manufacturing affiliates of U.S. manufacturing parents in sixty locations from the 1992 U.S. Department of the Treasury tax file. As in their previous study, they enter the tax variable in log (1 - t) form.

When compared to the results of their previous paper, the estimates from Grubert and Mutti (1997) suggest that the location of capital may have become more sensitive to differences in after-tax returns between 1982 and 1992. Using the aggregated country-level data, they estimate a tax elasticity that is greater than 3 (for open economies) and is statistically highly significant. Using the firm-level data, they calculate a combined elasticity measure that takes into account the probability of choosing to locate capital in a country and the amount of capital invested into account. They report a combined elasticity of capital to after-tax returns for open economies of about 3.

To summarize, the results of previous work with cross-sectional data indicate that taxes have a significant impact on the investment location decisions of U.S. multinational firms. In addition, a rough comparison of the elasticity estimates suggests that these decisions may have become more sensitive to host-country tax rates in recent years; however, the validity of this comparison is questionable, since the estimates were derived from different data sources.

1.2 The Data

Our principal source of data is the body of U.S. Department of the Treasury corporate tax files compiled by the Statistics of Income (SOI) division of the Internal Revenue Service. This data set is derived from a variety of tax and information forms filed by U.S. parent corporations. Many of the data necessary for our analysis come from the Form 5471, which reports on the activities of each CFC of a U.S. parent. This form, which U.S. parents must file for each of their CFCs, reports subsidiary-level information on assets, taxes paid, earnings and profits, and other information from balance sheets and income statements.

Information from the Form 5471 is compiled only in even years and was available to us from 1980 through 1992. However, the level of detail recorded from this form on the SOI files differs from year to year. For example, both the 1984 and 1992 files provide information on the composition of assets from the balance sheet portion of the Form 5471, whereas the files from other sample years do not. The interval from 1984 to 1992 is particularly appropriate for our study, since it covers a period of large declines in effective tax rates in some locations abroad. We use the information in the remaining even years between 1980 and 1992 to calculate country average effective tax rates. These effective tax rates are used in various forms as independent variables in our regressions.

We restrict our sample to the manufacturing CFCs of all large U.S. manufacturing corporations. We aggregate the subsidiary-level information from the Form 5471 across parents by country. One advantage of using country-level data is that such data eliminate some of the complicated statistical problems associated with subsidiary-level data-for example, the problems that arise from using data that are truncated at zero when errors may be correlated across observations within a country because of omitted variables. A drawback is that we lose information on the characteristics of the parent corporations that may affect their location decisions.

Aggregating across subsidiaries in each country leaves us with data for fifty-eight locations for 1984 and 1992. Our two cross sections are "unlinked" in that there is no requirement that the same parents (or the same CFCs) appear in both years of data. We also experimented with a sample drawn from a panel that contains only those CFCs associated with parents that appear in both years. We report results using this linked data set in our sensitivity analysis.

We augment the Form 5471 data with country-specific information from some other sources to help control for countries' nontax characteristics that may affect location decisions. We obtained population, GDP, and inflation data from the International Monetary Fund International Financial Statistics (International Monetary Fund 1984, 1992) supplemented in a few cases by information from statistics from the United Nations. As in Grubert and Mutti (1997), we use the trade regime classification developed in the World Development Report (World Bank 1987) to control for the degree of openness of each country's economy. This measure is based on observations from 1973 to 1985 of (1) the country's effective rate of protection, (2) its use of direct controls such as quotas, (3) its use of exports, and (4) the extent of any overvaluation of its exchange rate. The variable runs from 0 (most open) to 3 (most restrictive). Unfortunately, there is only one observation of this measure-it has not been updated for the years after 1985.

Before turning to our empirical results, we briefly discuss how we use the Form 5471 information to calculate effective tax rates and to measure real capital. These variables are reported in appendix tables 1A.1 and 1A.2.

1.2.1 Measuring Assets

Our measure of real capital in each year is composed of end-of-year depreciable assets (plant and equipment) and inventories from the balance sheet information reported on the Form 5471. Because parents are required to report subsidiary assets according to U.S. accounting principles, these figures are not distorted by host-country incentives such as accelerated depreciation. However, the asset measures reflect historical book values and therefore may be affected by local inflation and exchange rates.

Another potential problem with our real capital measure is that the assets reported by a CFC may not be located in the country in which the CFC is incorporated. This problem is especially serious in tax haven countries, which are often hosts to holding companies and financial CFCs. Including only manufacturing affiliates in our country data helps mitigate this problem. In addition, we investigate how our results are affected when we remove countries that are likely to be tax havens from the analysis.

1.2.2 Measuring Effective Tax Rates

We calculated the average effective tax rate for manufacturing CFCs incorporated in each country by dividing total income taxes paid by total earnings and profits. Both variables appear on the Form 5471. Parent corporations must report their CFCs' earnings and profits using the definition provided by the U.S. Internal Revenue Code. This measure of earnings and profits is meant to reflect net economic income, not host-country (or domestic U.S.) taxable income, which would be affected by investment incentives such as accelerated depreciation.

One potential problem with our country average effective tax rate calculations, particularly in small countries with few CFCs, is that they appear to contain noise. We were particularly concerned about the 1984 effective tax rates. Appendix table 1A.3 reports the results of regressing previous-year average effective tax rates on 1986 and 1990 average effective tax rates. We found that the 1982 effective tax rates are better predictors of 1986 effective tax rates than are the 1984 rates. To diminish the role of the 1984 effective tax rates in our analysis, we averaged them with effective tax rates from the previous two even years. For consistency, we average the 1992 effective tax rates with those from 1990 and 1988. We also experiment with using lagged effective tax rates.

Another potential problem with our effective tax rate measures is that they may be correlated with inflation, because depreciation allowances are based on the historic costs of assets. In addition to including inflation as an explanatory variable, we also checked the relation between differences in inflation and differences in effective tax rates. We found that the change in inflation between 1984 and 1992 explains less than 4 percent of the variation in our effective tax rate variables.

A further issue is that average effective tax rates are, to some extent, endogenous to investment decisions. The effective tax rate in a country may be low in a given year because of a recent increase in investment activity in that country that qualifies for investment incentives, such as accelerated depreciation, that accrue early in an investment's life. One approach to avoiding this potential endogeneity problem is to replace average effective tax rates with statutory rates. Although statutory rates have the virtue of being exogenous to investment decisions, they do not reflect all the variation in the tax advantages of investment in different locations because they do not measure tax base differences across countries. Statutory rates also do not capture ad hoc deals between host countries and individual foreign investors. For this reason, statutory rates are better indicators of the advantages of placing financial capital in a location and the gains to income shifting. Nevertheless, we use statutory rates as well as instrumental variable techniques to test the sensitivity of our results to alternative measures of taxes. We collected country statutory tax rates from the Price Waterhouse (1984, 1992) guides.

(Continues...)

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Table of Contents

Acknowledgments
Introduction—James R. Hines Jr.
1. Has U.S. Government Investment Abroad Become More Sensitive to Tax Rates?
Rosanne Altshuler, Harry Grubert, and T. Scott Newlon
Comment: Jack M. Mintz
2. Tax Sparing and Direct Investment in Developing Countries
Comment: Timothy J. Goodspeed
3. Does Corruption Relieve Foreign Investors of the Burden of Taxation?
Shang-Jin Wei
Comment: Bernard Yeung
4. Transaction Type and the Effects of Taxes on the Distribution of Foreign Direct Investment in the United States
Deborah L. Swenson
Comment: William C. Randolph
5. Tax Planning by Companies and Tax Competition by Governments: Is There Evidence of Changes in Behavior?
Harry Grubert
Comment: Joel Slemrod
6. Valuing Deferral: The Effect of Permanently Reinvested Foreign Earning on Stock Prices
Julie H. Collins, John R. M. Hand, and Douglas A. Shackelford
Comment: Kevin Hassett
7. The Impact of Transfer Pricing on Intrafirm Trade
Kimberly A. Clausing
Comment: Deen Kemsley
8. International Taxation and the Location of Inventive Activity
James R. Hines Jr. and Adam B. Jaffe
Comment: Austan Goolsbee
9. Taxation and the Sources of Growth: Estimates from U.S. Multinational Corporations
Jason G. Cummins
Comment: Samuel S. Kortum
Contributors
Author Index
Subject Index