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Taxes, institutions and foreign diversification opportunities

By Mihir A. Desai and Dhammika Dharmapala

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 US 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.Foreign portfolio investment Foreign direct investment Taxes Investor protections

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