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Topics in the Economics of International Taxation (1): Taxes and Foreign Portfolio Investment Center for Economic Studies Ludwig-Maximilians-Universität Munich 26 July, 2011 Dhammika Dharmapala University of Illinois at Urbana-Champaign Introduction Cross-border investment flows are large and are growing rapidly Cross-border flows in 2006: $8 trillion (17% of global GDP); a 20-fold increase since 1980 This phenomenon is of interest to economists across a wide range of fields Public Finance → Role of taxation? International Economics Financial Economics Law and Economics 2 Two Forms of Cross-border Flows US MNC Controlling stake FDI F Sub Direct Investment Buys shares US Investor FPI Portfolio Investment F Corp FPI v. FDI Until recently, cross-border investment flows have primarily taken the form of FDI (direct investment by multinational firms) As a result, most of the economic literature on cross-border flows (esp. in relation to taxes) has focused only on FDI 4 Table 4: Governance and the Tax Elasticity of FDI by US Firms (1) All Countries and Territories Tax Rate faced by US Firms Governance Index Tax Rate* Governance Index Log of GDP per capita Log of Population -0.042 (0.018)** 0.186 (0.412) (3) (2) (4) (5) Tax Elasticity of FDI WellLess WellAll Countries All Countries Governed Governed and and Countries Countriesearly Territories Territories Hines (1999) reviews studies: Dependent Variable: Log of US FDI Elasticity = - 0.6 -0.064 0.007 0.022 0.002 10% ↓in tax rate (e.g. from 35% to 31.5%) (0.031) (0.017)*** (0.019) (0.023) 0.124 0.371 1.643 1.616 (0.534) (0.543) (0.429)*** (0.587)** → 6% ↑ in FDI -0.069 -0.057 Y Y Y Y (0.022)** 2.052 (0.524)*** 0.960 (0.151)*** 0.449 (0.537) 0.544 (0.401) 0.142 (0.372) -0.546 (0.444) 0.00002 (0.00001)* 0.764 (0.493) -0.00005 (0.00006) Y 55 0.62 28 0.81 27 0.70 55 0.72 46 0.85 1.540 (0.418)*** 0.604 (0.153)*** Coastal Population British Legal Origins (=1) English as Official Language (=1) Log of Telephone Mainlines p. c. Subsoil Assets 4.321 (0.754)*** 0.914 (0.149)*** 1.087 (0.408)** 0.613 (0.167)*** (0.016)*** 1.779 (0.351)*** 0.665 (0.141)*** More recent studies find higher elasticities e.g. Altshuler and Grubert (2004): -3.5 Another example: Dharmapala and Hines (2009) Dep. Variable: log of FDI by US firms Contiguous to US (=1) Distance from US Regional Dummies? Observations R2 The Changing Nature of International Investment, 1976-2006 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 1976 1980 Dramatic shift from FDI to FPI as vehicle for cross-border flows (esp. in the form of equity 1984 1988 1992 1996 holdings) 2000 2004 Ratio of FDI (Current Cost) to Sum of FDI and FPI Ratio of FDI (Market Value) to Sum of FDI and FPI Share of FPI in Stocks 6 Two Forms of Cross-border Flows US MNC Controlling stake FDI F Sub Direct Investment Buys shares US Investor FPI Portfolio Investment Motivations? F Corp Equity Home Bias French and Poterba (1991): 8 Holdings of Domestic and Foreign Equity by US Portfolio Investors, 2004 Foreign Stocks 12% US Stocks 88% 9 Increases in Holdings of Domestic and Foreign Equity by US Portfolio Investors, 2004-2005 Increase in Holdings of US Stocks Relative to Increase in Total Holdings 57% Increase in Holdings of Foreign Stocks Relative to Increase in Total Holdings 43% Equity home bias is now eroding 10 Taxes and Foreign Portfolio Investment Based on: “Taxes, Institutions and Foreign Diversification Opportunities” Journal of Public Economics, 93, 703-714 (2009) “Dividend Taxes and International Portfolio Choice” Review of Economics and Statistics, 93, 266-284 (2011) Both coauthored with Mihir Desai, Harvard University 11 Background: US International Tax System Controlling stake US MNC Repatriates $80 Owes US tax of $35, with foreign tax credit of $20 → additional US tax = $15 F Sub Earns $100 Pays $20 to F Assume tax rates are: tFC = 20%; tUSC = 35% Deferral: US tax is imposed only when Sub pays a dividend to US parent 12 Investor Choice Between FPI and FDI Consider a US investor who wants exposure to the Chinese economy for portfolio diversification Two choices: FDI: Invest in a US MNC that acquires a controlling stake in a Chinese corporation, or FPI: Buy a minority stake in a Chinese corporation How do corporate taxes affect this choice? 13 Investor Choice Between FPI and FDI Buys shares Investor US MNC Controlling stake F Sub rF(1 - tUSC) rF(1 - tFC) Buys shares F Corp rF(1 - tFC) rF: foreign pretax rate of return; tFC: foreign corporate tax rate; tFC ≤ tUSC 14 Investor Choice Between FPI and FDI Buys shares Investor US MNC Controlling stake F Sub r*(1 - tUSC) (1 - tFC) r* Buys shares F Corp r* r*: world rate of return after local corporate taxes; tFC ≤ tUSC 15 Hypothesis FPI provides a means of “bypassing” the additional US tax on the foreign income of US multinationals This additional tax is more important for income earned in low-tax countries Hypothesis: The ratio of equity FPI to FDI should be higher in low-tax countries Implications: Efficiency consequences if ownership affects productivity of assets 16 Data FPI: Treasury International Capital System (TIC) – based on a series of surveys by the US Treasury of holdings of foreign securities by US investors Surveys use a defined panel of banks, other financial institutions, brokers, dealers etc. Excludes direct investment activity Reports equity and debt FPI by country Available for: 1994, 1997, 2001, 2003, 2004, 2005 FDI: Bureau of Economic Analysis (BEA) Corporate tax rates: OTPR, PricewaterhouseCoopers 17 Sample Countries Argentina Finland Korea (South) South Africa Australia France Malaysia Spain Austria Germany Mexico Sri Lanka Belgium Greece Netherlands Sweden Brazil Hong Kong New Zealand Switzerland Canada India Norway Taiwan Chile Indonesia Pakistan Thailand Colombia Ireland Peru Turkey Denmark Israel Philippines United Kingdom Ecuador Italy Portugal Venezuela Egypt Japan Singapore Zimbabwe 18 Ratio of US equity FPI to total US investment (FPI + FDI) by country, 2005 19 The ratio is higher for low-tax countries, as expected 20 Panel Analysis Use panel data for all available years: 1994, 1997, 2001, 2003, 2004, 2005 Control for country and year fixed effects, focusing on the effects of changes in a given country’s tax rate Control for country-specific time trends US FPI may have grown faster (for other reasons) in those countries in which corporate tax rates fell 21 Panel Analysis Log of Rit = β1τit + β2Invit + Xitγ + μi + νt + μi*(t – 2000)) + εit where: Rit: Ratio of US equity FPI to (FPI + FDI) τit: Corporate tax rate Invit: Longitudinal investor protection index Xit: Controls μi*(t - 2000): Country-specific time trends 22 Negative effect of changes in tax rates on US equity FPI No effect on US debt FPI Implications We find a strong and robust negative effect of corporate tax rates on the location of US equity FPI, relative to FDI A 10% decrease in a foreign country’s corporate tax rate increases US investors’ equity FPI holdings by about 10% This evidence is consistent with a distortion to the “organisational form” of US investment Tax system may create a bias towards FPI 24 Second Paper: Taxes and Portfolio Choice Analyzes the impact of taxes on portfolio choice Focus on dividend taxation and FPI Previous literature examines asset holdings across households with different tax characteristics: Feldstein (1976); King and Leape (1998); Poterba and Samwick (2002); Scholz (1994) But, identification is complicated by: Links between tax rates and unobservable characteristics Asset supply responses 25 Second Paper: Taxes and Portfolio Choice Ideally, we need a “natural experiment” that: changes taxes on a subset of otherwise similar assets, but does not generate an endogenous supply response We use a quasi-experiment (2003 US tax reform, known as JGTRRA) that: changed the tax treatment of a subset of otherwise similar assets – equity held in some foreign countries and not others is unlikely to have generated endogenous supply responses We use a difference-in-difference approach to find a large portfolio response to the tax reform, and investigate potentially confounding explanations 26 JGTRRA and International Dividends Prior to 2003, dividends were taxed at ordinary income tax rates (up to 38.6%) JGTRRA reduced the dividend tax rate to 15% for: dividends from US corporations dividends from “qualified” foreign corporations How did foreign dividends “qualify”? Three tests: Possessions test Market test test Treaty 27 The Effects of JGTRRA Pre: $0.614 Post: $0.85 $1 of Dividends T Corp US Investor Pre: $0.614 Post: $0.65 $1 of Dividends T is located in a treaty country, N in a nontreaty country The US investor is assumed to be in the top marginal tax bracket N Corp 28 Treaty Classification: Sample Countries Treaty Countries Nontreaty Countries Australia Greece Netherlands Switzerland Argentina Austria Hungary New Zealand Thailand Brazil Belgium India Norway Turkey Chile Canada Indonesia Pakistan United Kingdom Colombia China Ireland Philippines Venezuela Hong Kong Czech Republic Israel Poland Jordan Denmark Italy Portugal Malaysia Egypt Japan Russia Peru Finland Korea (South) France Mexico Germany Morocco Many significant destinations for South Africa investment are Spain nontreaty countries Sweden Singapore Sri Lanka Taiwan Would the Treaty Test Necessarily Matter? Evasion of US taxes on foreign income Tax irrelevance (e.g. ex-dividend day trading) Nontax factors But, anecdotal evidence suggests it was highly salient Why did JGTRRA impose a treaty test? Why do only some countries have tax treaties with the US? Note: these factors are unlikely to be related to changes in investment opportunities in 2003 30 JGTRRA and Portfolio Choice After-tax CAPM framework: Brennan (1970); Auerbach and King (1983) Extended to open-economy setting: Bond, Devereux and Klemm (2007) Period 1: Risk-averse investors allocate portfolios among 3 assets: - Riskless bonds - Treaty country equity (T) - Nontreaty country equity (N) Period 2: - (Riskless) interest and dividend payments - (Stochastic) prices of T and N are realized 31 JGTRRA and Portfolio Choice: Equilibrium Portfolio allocations: risk-averse investors trade off tax advantages v. diversification benefits → Hypothesis: US investors switch towards T after JGTRRA Equity prices: depend on the global average of investors’ dividend tax rates, weighted by wealth → equity price effect of JGTRRA depends on the wealth of (taxable) US investors relative to global wealth, and applies to all T (not just US stocks) . . . but there is little we can say about this empirically . . . 32 Data FPI: Treasury International Capital System (TIC) – Treasury surveys of a panel of U.S. banks, other financial institutions, brokers, dealers etc. Excludes direct investment activity Reports equity and debt FPI by country Available for: 1994, 1997, 2001, 2003, 2004, 2005 FDI: BEA - direct investment position, by country World Bank’s WDI database: GDP pc, population, aggregate stock market capitalization Total Stock Return Index: Morgan Stanley Capital International (through Datastream) Various additional controls . . . 33 Empirical Specification Indicator for treaty countries Log of US Equity FPIit= β(Treatyi*PostJGTRRAt) + Xitγ + μi + νt + εit Controls: GDP pc, population, aggregate stock market capitalization, total stock return index Year effect Country effect Indicator for years 2003-2005 35 Basic Results Dependent Variable: Log of US Equity FPI (2) (3) (1) (Treaty=1)* (Post-JGTRRA) Log of GDP per capita (PPP) Log of Population Log of Aggregate Market Capitalization Log of Stock Market Return Index Additional Controls? Country and Year Effects? Sample Period Observations Countries R-squared ** 0.649 (0.234) *** US equity FPI increased in treaty countries (relative to nontreaty countries) after JGTRRA 1.635 (0.874) * 0.758 (0.151) N *** 0.691 (0.303) N 1.544 (2.227) 0.46 *** 1.906 (1.145) 2.466 (1.998) 0.714 (0.109) *** 0.569 (0.166) *** 0.302 (0.143) * 0.430 (0.171) ** Y N Y Y Y Magnitude is large; elasticity: 1994-2005 1994-2005 1994-2005 -1.6 1259 w.r.t. tax rate 291 283 2.8 w.r.t. 213 the net-of-tax 49 share 48 0.15 (4) 0.811 (0.237) 0.72 Y 1994-2005 227 45 0.76 Caveats Some firms do not pay dividends Dividend tax cut was (ostensibly) temporary Some US investors are tax-exempt Corporations in nontreaty countries can qualify under the market test But, all these factors create a bias against finding an effect → estimates should be viewed as lower bounds 37 Alternative Explanations Preferences of US investors may have shifted towards treaty countries in 2003 Global opportunities for FPI may have shifted towards treaty countries in 2003 US equity FPI in treaty and nontreaty countries may follow different time trends Results may be driven by tax evasion behavior Results may be driven by influential subsets of countries Financial market conditions may have changed 38 differentially in treaty countries Did Investment Patterns Change? Dependent Variable: Log of US Equity FPI (2) (1) (Treaty=1)* (Post-JGTRRA) Did US investors’ preferences change? Log of Population Robust to inclusion of: Log of Aggregate Market Capitalization - US Debt FPI Log of Stock Market Return - US FDI Index Log of GDP per capita (PPP) Log of US Long-Term Debt FPI Log of US FDI Log of Non-US Equity FPI Country and Year Effects? Sample Period Observations Countries R-squared (3) 0.698 (0.221) *** 0.748 (0.255) *** 0.308 (0.134) 1.534 (0.841) * 2.736 (1.355) ** 0.693 (1.055) 0.895 (2.196) 2.122 (1.841) -0.870 (3.884) -0.058 (0.148) 0.649 (0.107) *** 0.499 (0.334) 0.367 (0.140) ** 0.434 (0.236) 0.158 (0.072) ** * ** 0.612 (0.151) *** 0.159 (0.078) ** -0.091 (0.165) Did global FPI patterns change? Y Y Robust to inclusion of 1994-2005 1994-2005 non-US equity FPI 283 260 (IMF data for 48 2001-2005) 47 0.74 0.71 Y 2001-2005 235 47 0.78 Does US FPI Grow Faster in Treaty Countries? Change in Log of US Equity FPI from 1994 to 1997 (1) Change in Log of US Equity FPI from 1997 to 2001 (2) Change in Log of US Equity FPI from 2001 to 2003 (3) Change in Log of US Equity FPI from 2003 to 2004 (4) Change in Log of US Equity FPI from 2004 to 2005 (5) Treaty (=1) -0.260 (0.319) 0.146 (0.292) 0.351 ** (0.164) 0.269 (0.203) 0.013 (0.137) Change in Log of GDP per capita (PPP) -0.871 (2.402) 2.447 * (1.402) 1.511 (1.666) -1.075 (0.994) 0.206 (1.931) Change in Log of Population -0.451 (3.139) Dependent Variable: Change in Log of Aggregate Market Capitalization Change in Log of Stock Market Return Index Constant Regional Dummies? Observations R-squared 2.118 of cross-sectional -7.123 13.184 -1.329 We run a series regressions: (2.430) (6.234) (10.145) (9.322) Δ(Log of Equity FPI)i = α + βTreatyi + ΔXiγ1 + Riγ2+ εi 0.291 -0.143 0.311 0.143 0.928 *** where: (0.405) (0.105) (0.196) (0.233) (0.171) Treaty -0.438 * 1.193 ***for i: Indicator (0.245) Xi: Controls(0.329) treaty0.739 countries ** dummies Ri:* Regional-0.500 1.107 (0.618) (0.508) (0.308) 0.620 * (0.339) 0.617 * (0.362) 0.136 (0.310) -0.145 (0.216) 0.158 (0.218) Y Y Y Y Y 45 47 48 48 47 0.76 0.65 0.46 0.39 0.54 Does US FPI Grow Faster in Treaty Countries? Change in Log of US Equity FPI from 1994 to 1997 (1) Change in Log of US Equity FPI from 1997 to 2001 (2) Change in Log of US Equity FPI from 2001 to 2003 (3) Change in Log of US Equity FPI from 2003 to 2004 (4) Change in Log of US Equity FPI from 2004 to 2005 (5) Treaty (=1) -0.260 (0.319) 0.146 (0.292) 0.351 ** (0.164) 0.269 (0.203) 0.013 (0.137) Change in Log of GDP per capita (PPP) -0.871 (2.402) 2.447 * (1.402) 1.511 (1.666) -1.075 (0.994) 0.206 (1.931) Change in Log of Population -0.451 (3.139) 2.118 (2.430) -7.123 (6.234) 13.184 (10.145) -1.329 (9.322) Change in Log of Aggregate Market Capitalization 0.928 *** (0.105) Change in Log of Stock Market Return Index -0.438 * (0.245) Constant 1.107 * (0.618) -0.500 (0.508) 0.136 (0.310) -0.145 (0.216) 0.158 (0.218) Y Y Y Y Y 45 47 48 48 47 0.76 0.65 0.46 0.39 0.54 Dependent Variable: Regional Dummies? Observations R-squared The growth of US equity FPI is related to treaty0.291 status only-0.143 in 2003; 0.311 0.143 (0.196) (0.233) (0.171) Also(0.405) suggests rapid adjustment to 1.193 *** 0.739 ** 0.620 * 0.617 * JGTRRA (0.329) (0.308) (0.339) (0.362) Figure 2: The Fraction of US Equity FPI in Treaty Countries, 1994-2005 General downward trend (except in 2003); suggests preexisting trends are unlikely to explain the result 0.88 0.86 0.84 0.82 0.80 0.78 1994 1997 2001 2003 2004 Fraction of US Equity FPI in Treaty Countries 2005 42 Is the Result Due to Changed Tax Evasion Behavior? Dependent Variable: Log of US Equity FPI (Treaty=1)*(Post-JGTRRA) Tax maycapita be falling Logevasion of GDP per (PPP)over Log of Populationa shift in time, generating investment from tax havens Log of Aggregate Market Capitalization → treaty countries Log of Stock Market Return Index Country and Year Effects? Sample Period Observations Countries R-squared Excluding Tax Haven Countries Excluding Treaty Countries with Low Tax Compliance (1) (2) 0.740 (0.261) *** 0.705 (0.268) 1.908 (0.924) * 1.861 (1.365) 0.951 (2.440) ** 1.576 (2.515) 0.696 (0.116) *** 0.628 (0.288) ** 0.339 (0.147) ** 0.409 (0.219) * Y may have US FPI in treaty countries 1994-2005 been underreported pre-JGTRRA, 255 but reported post-JGTRRA 43 (unlikely b/c of info-sharing provisions) 0.75 Y 1994-2005 241 41 0.65 Is the Result Due to Influential Subsets of Countries ? Dependent Variable: Growth in FPI in transition countries? Log of US Equity FPI Excluding Transition Countries Excluding Countries with Recent Tax Treaties Excluding Iraq War Coalition Countries Excluding Europe (1) (2) (3) (4) (Treaty=1)*(PostJGTRRA) 0.662 (0.257) Endogeneity of Log of Population treaties? 1.959 (1.336) Log of GDP per capita (PPP) Log of Aggregate Market Capitalization Log of Stock Market Return Index Country and Year Effects? Sample Period Observations Countries R-squared ** 0.714 (0.290) ** 2.255 (1.623) Did1.268 US FPI switch2.016 (2.343) (2.696) towards 0.673 Iraq War 0.567 (0.389) coalition countries(0.317) 0.325 0.447 in(0.302) 2003? (0.256) * * 0.698 (0.282) ** 0.693 (0.268) 1.631 (1.043) 2.659 (1.717) 1.435 (3.363) 2.687 (3.762) Did US FPI 0.698increase 0.555 (0.122) (0.388) over time in 0.431 0.429 European countries (0.274) (0.203) (all of whichYare Y treaty1994-2005 countries)? 1994-2005 *** ** Y Y 1994-2005 1994-2005 253 194 187 167 43 33 32 28 0.62 0.63 0.67 0.57 ** Evidence from the ADR Market 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 900 800 700 600 500 400 300 200 100 0 Sum Percent Listings by Treaty Status, All Included 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Yes No Sum of All Listings The proportion of cross-listing firms from nontreaty countries ↑ in 2003; But, caveats (e.g. contemporaneous corporate governance reforms) Conclusion Using JGTRRA as a quasi-experiment, we show that taxes have a large effect on portfolio choice Alternative explanations for these results do not appear compelling Provides evidence for large efficiency costs of the taxation of asset returns 46