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Taxes, Institutions and Foreign Diversification Opportunities

35 Pages Posted: 16 May 2007 Last revised: 15 Jan 2009

Mihir A. Desai

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Dhammika Dharmapala

University of Chicago Law School

Multiple version iconThere are 2 versions of this paper

Date Written: November 16, 2008

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 U.S. 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.

Keywords: Foreign Portfolio Investment, Foreign Direct Investment, Taxes, Investor Protections

JEL Classification: F21, F23, G31, H25

Suggested Citation

Desai, Mihir A. and Dharmapala, Dhammika, Taxes, Institutions and Foreign Diversification Opportunities (November 16, 2008). 2nd Annual Conference on Empirical Legal Studies Paper. Available at SSRN: https://ssrn.com/abstract=986322 or http://dx.doi.org/10.2139/ssrn.986322

Mihir A. Desai

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6693 (Phone)
617-496-6592 (Fax)

Dhammika Dharmapala (Contact Author)

University of Chicago Law School ( email )

1111 E. 60th St.
Chicago, IL 60637
United States

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