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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