Taxes, Institutions and Foreign Diversification Opportunities

35 Pages Posted: 27 Jun 2007 Last revised: 17 Aug 2007

See all articles by Mihir A. Desai

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: May 2007

Abstract

Investors can access foreign diversification opportunities through either foreign portfolio investment (FPI) or foreign direct investment (FDI). By combining data on US outbound FPI and FDI, this paper analyzes whether the composition of US outbound capital flows reflect efforts to bypass home country tax regimes and weak host country investor protections. The cross-country analysis indicates that a 10% decrease in a foreign country's corporate tax rate increases US investors' equity FPI holdings by 21%, controlling for effects on FDI. This suggests that the residual tax on foreign multinational firm earnings biases capital flows to low corporate tax countries toward FPI. A one standard deviation increase in a foreign country's investor protections is shown to be associated with a 24% increase in US investors' equity FPI holdings. These results are robust to various controls, are not evident for debt capital flows, and are confirmed using an instrumental variables analysis. The use of FPI to bypass home country taxation of multinational firms is also apparent using only portfolio investment responses to within-country corporate tax rate changes in a panel from 1994 to 2005. Investors appear to alter their portfolio choices to circumvent home and host country institutional regimes.

Suggested Citation

Desai, Mihir A. and Dharmapala, Dhammika, Taxes, Institutions and Foreign Diversification Opportunities (May 2007). NBER Working Paper No. w13132. Available at SSRN: https://ssrn.com/abstract=988942

Mihir A. Desai (Contact Author)

Harvard Business School - Finance Unit ( email )

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

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Dhammika Dharmapala

University of Chicago Law School ( email )

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

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