James R. Hines, Jr.

Martin S. Feldstein

R. Glenn Hubbard

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: The Effects of Taxation on Multinational Corporations
Volume Author/Editor: Martin Feldstein, James R. Hines Jr., R. Glenn Hubbard
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-24095-9
Volume URL: http://www.nber.org/books/feld95-2
Conference Date: January 13-15, 1994
Publication Date: January 1995
Chapter Title: Introduction to "The Effects of Taxation on Multinational Corporations"
Chapter Author: Martin S. Feldstein, James R. Hines, Jr., R. Glenn Hubbard
Chapter URL: http://www.nber.org/chapters/c7737
Chapter pages in book: (p. 1 - 6)Introduction 
Martin Feldstein, James R. Hines, Jr., 
and R. Glenn Hubbard 
The growing worldwide importance of international business activities has in 
recent years lead to serious reexaminations of  the ways that governments tax 
multinational corporations. In the United States, much of the debate concerns 
the competitive positions of  U.S. firms in international product and capital 
markets. In addition, there are those who agree that U.S.  international tax rules 
have become more complex and more distorting in recent years, particularly 
since the passage of the Tax Reform Act of  1986. Discussions in the U.S. Con- 
gress and the administration since 1992 reveal a willingness to consider sig- 
nificant  reforms.  In  Europe,  increased  liberalization  of  capital  markets 
prompted discussions by  the European Commission of harmonization of cor- 
porate taxation. These policy developments around the world not only suggest 
dissatisfaction with certain features of  modem tax  practice, but  also raise 
deeper questions of whether current systems of taxing international income are 
viable in a world of significant capital-market integration and global commer- 
cial competition. 
Academic researchers have expressed renewed interest in studying the ef- 
fects of  taxation on capital formation and allocation, patterns of  finance in 
multinational companies, international competition, and opportunities for in- 
come shifting and tax avoidance. This research program brings together ap- 
proaches used by  specialists in public finance and international economics. 
The studies presented in this volume analyze the interaction of international 
tax rules and the investment decisions of multinational enterprises. The 10 pa- 
Martin Feldstein is the George F.  Baker F’rofessor of  Economics  at Harvard University and 
president of the National Bureau of Economic Research. James R. Hines, Jr., is associate professor 
of public policy at the John F.  Kennedy School of Government of Harvard University and a faculty 
research fellow of the National Bureau of Economic Research. R. Glenn Hubbard is the Russell 
L. Carson Professor of Economics and Finance at the Graduate School of Business of Columbia 
University and a research associate of the National Bureau of Economic Research. 
1 2  Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard 
pers fall into three groups: (1) assessing the role played by multinational firms 
and their foreign direct investment (FDI) in the U.S. economy and the design 
of international tax rules for multinational investment, (2) analyzing channels 
through which international tax rules affect the costs of international business 
activities such as FDI, and (3) examining ways in which international tax rules 
affect financing decisions of multinational firms. The results suggest that there 
are likely to be significant effects of  international tax rules on firms’ invest- 
ment  decisions and  provide  analytical input for  future  discussions of  tax 
reform. 
The Context: Multinational Firms, FDI, and International Tax Rules 
Robert Lipsey’s paper provides a review of evidence concerning the impact 
of outbound FDI on employment and economic activity in the United States. 
Lipsey notes that most “industrial organization” explanations for the rise of 
multinational firms are based on the notion that multinational enterprises pos- 
sess specific assets or marketing skills that can be exploited most profitably by 
producing in many markets. Lipsey argues that the use of foreign production 
locations helped U.S. multinationals retain global market shares in spite of the 
decline in the U.S. share of world trade. In addition, the extensive empirical 
evidence analyzed by  Lipsey offers no empirical support for the proposition 
that overseas production by  U.S.  multinationals reduces employment in the 
United States. Instead, the evidence supports the idea that firms experiencing 
an increase in their multinational activity increase their managerial and techni- 
cal employment at home. 
In  the volume’s second background paper on  FDI, Martin Feldstein ad- 
dresses the longstanding question of whether outbound FDI by  U.S. multina- 
tionals reduces domestic investment in the United States. Feldstein’s research 
uses aggregate evidence on investment flows in the OECD countries during the 
1970s and 1980s in order to provide information on the general equilibrium 
effects of FDI. Extending the analytical approach he developed with Charles 
Horioka to study cross-country correlations of domestic saving and investment 
(Feldstein and Horioka 1980), Feldstein finds that, holding constant domestic 
saving, outbound FDI reduces domestic investment by significantly less than 
one for one. Indeed, his results suggest that each dollar of  assets in foreign 
affiliates reduces the domestic capital stock by between 20 and 40 cents. This 
finding can be explained by  the use of  local debt to finance firms’ overseas 
investment. Feldstein argues that  local debt finance is available in foreign 
countries primarily to firms that invest in capital in those countries, due to 
transaction and information costs associated with financing direct investment. 
Feldstein’s paper makes clear that domestic policymakers might consider the 
advantages associated with the local financing that accompanies FDI when 
evaluating the effect of outbound FDI on the domestic economy. 
Standard models of optimal taxation predict that small open economies will 
not impose source-based taxes on capital income. This theoretical prediction 3  Introduction 
is inconsistent with observed tax rules in most developed countries, in which 
corporate tax  rates are high-indeed,  comparable to maximum tax  rates on 
individuals. Roger Gordon and Jeffrey MacKie-Mason argue that this apparent 
inconsistency is not surprising if the principal task of  the corporate tax were 
not so much to raise revenue, but instead to discourage income shifting be- 
tween the individual and corporate tax bases (and between domestic and for- 
eign subsidiaries). In an international taxation setting, a country needs to tax 
the overseas incomes of domestically owned subsidiaries in order to prevent 
firms from facing tax incentives to exploit technologies abroad rather than do- 
mestically. Moreover, if  the tax rates imposed by  foreign governments were 
lower than the domestic corporate tax rate, multinationals would face incen- 
tives to circumvent domestic taxes by  shifting their profits abroad through ag- 
gressive transfer pricing even if the firms that own the profitable technologies 
remain at home. Gordon and MacKie-Mason extend their research on the con- 
sequences of income shifting for the design of domestic capital taxes to show 
that avoidance of  income shifting can explain a number of features of  actual 
international tax rules, including transfer-pricing regulations and enforcement 
penalties, allocation rules for interest and R&D expenses, and the foreign tax 
credit. Their research suggests the potential importance of considering income 
shifting in any normative analysis of international tax rules, as well as the im- 
portance of  studying empirically the extent to which income shifting occurs in 
response to tax rate differences. 
International Tax Rules and the Cost of Capital for FDI 
Tax  policy influences investment decisions through its effects on cost of 
capital and the returns to different activities. Tax systems influence the invest- 
ment decisions of  multinational firms through a complicated interaction of 
home- and host-country taxation and differences across countries in the tax 
treatments of debt and equity finance. Joosung Jun’s paper estimates the extent 
to which international tax rules affect the cost of capital for transnational in- 
vestment, focusing on a comparison of  the costs of capital incurred by  U.S. 
firms and their competitors in major markets. Junk calculations suggest that 
foreign subsidiaries of U.S. firms that are financed by parent equity generally 
face higher costs of capital than do local firms in major foreign markets. These 
US.-owned  subsidiaries  generally  are  disadvantaged  vis-i-vis  competing 
firms from countries in which some form of  corporate tax integration is in 
place. The increasing internationalization of  capital markets implies that dif- 
ferences in tax rules play an important role in explaining differences in the cost 
of capital faced by firms investing overseas. 
Many policy discussions focus on the sensitivity of  FDI to changes in the 
cost of  capital for FDI. That cost of capital is affected not only by  pretax fi- 
nancial costs of capital, but also by tax parameters in “home” (residence) and 
“host” (source) countries. Jason Cummins and R. Glenn Hubbard use pre- 
viously unexplored (for this purpose) panel data on outbound FDI by several 4  Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard 
hundred subsidiaries of U.S. multinational firms during 1980-91  to measure 
more precisely the effect of taxation on FDI, and to analyze subsidiaries’ in- 
vestment  decisions.  The authors  consider  tax  incentives  created  by  host- 
country tax rates, investment incentives, and depreciation rules, and by varia- 
tion (over time and across firms) in the tax cost of repatriating dividends from 
foreign subsidiaries. The authors fit a neoclassical model with tax considera- 
tions to the data on U.S. subsidiaries’ investments in Canada, the United King- 
dom, Germany, France, Australia, and Japan. The results reject a simple speci- 
fication in which taxes do not influence investment. The estimated tax effects 
are economically important: Each percentage-point increase in the cost of cap- 
ital reduces by  1-2  percentage points a subsidiary’s annual rate of investment 
(investment during the year divided by the beginning-of-period capital stock). 
As it does in the domestic corporate tax system, the alternative minimum 
tax (AMT) complicates the foreign investment incentives of U.S. corporations. 
The presence of the AMT is not merely a wrinkle: in 1990, 53 percent of all 
assets, and 56 percent of the foreign-source income of U.S. multinational cor- 
porations, was accounted for by firms subject to the AMT. The AMT’s restric- 
tions on deductions, inclusion of  certain income excluded under the regular 
tax, lower tax rate than that in the regular tax system, and limitation on foreign 
tax credits modify the incentives for subsidiaries to invest and to repatriate 
dividends. In their paper, Andrew Lyon and Gerald Silverstein analyze these 
incentives. The authors show that the AMT may strengthen the incentive for 
AMT firms to invest abroad rather than in the United States. In addition, the 
AMT may create a temporary timing opportunity in which firms may repatriate 
overseas income at lower cost than if the firms were subject to the rules of the 
regular system. Using Treasury tax return data for 1990, Lyon and Silverstein 
analyze the prevalence of AMT status among U.S. multinationals, their receipt 
of foreign-source income, and the tax prices faced by these firms on additional 
foreign-source income. The results suggest that repatriation decisions respond 
to AMT incentives. Future research using tax return data over many years is, 
of course, necessary to determine whether these patterns persist over time. 
Most empirical analyses of business fixed investment assume that firms ex- 
ploit fully incentives for investment offered by the tax code, whether or not tax 
rules differ from those used to measure income for financial accounting pur- 
poses. Jason Cummins, Trevor Harris, and Kevin Hassett investigate the rea- 
sonableness of this assumption by comparing the responsiveness of investment 
to tax incentives in countries with different tax accounting and financial ac- 
counting  reporting  requirements  (“two-book”  countries)  with  the  respon- 
siveness in  countries in  which  tax  accounting  and financial  accounting  re- 
porting are identical (“one-book‘’ countries). The United States is an example 
of the first type of country, while Germany is an example of the second. Cum- 
mins, Hams, and Hassett formulate a neoclassical model of domestic invest- 
ment using  firm-level panel data from  13 countries to test whether, all else 
equal, firms in one-book countries are less responsive to tax incentives than 5  Introduction 
are firms in two-book countries. The empirical results suggest that differences 
in accounting regimes generate significant differences in the responsiveness of 
investment to tax policy; in particular, firms operating in “pure” one-book sys- 
tems behave as though they face additional costs when taking advantage of 
investment incentives.  The research program begun in this paper suggests fruit- 
ful extensions to studies of the impact on investment of interactions of account- 
ing and tax regimes. 
Economists and  policymakers often  argue that  the  presence of  techno- 
logically advanced industries enhances national prosperity, in part due to the 
spillover  effects  of  research  and  development (R&D)  activities. Because 
externality-generating R&D activities may be underprovided by  private mar- 
kets, many governments subsidize R&D in some form. Whether these sub- 
sidies in fact stimulate additional R&D activity is the subject of  a vigorous 
debate. James Hines analyzes the impact of withholding taxes on cross-border 
royalty payments on the R&D activities of multinational firms. High withhold- 
ing tax rates make it costly for foreign subsidiaries to import technology from 
their U.S. parents. The high cost of technology should stimulate local R&D if 
local R&D is a substitute for imported technology, or dampen local R&D if it 
is a complement for imported technology. Hines tests a model of subsidiary 
R&D activity using country-level data on tax rates and R&D expenditures by 
U.S. subsidiaries. He examines the effect of royalty taxes on the local R&D 
intensities of foreign affiliates of multinational corporations, looking both at 
foreign-owned affiliates in the United States and at U.S.-owned affiliates in 
other countries. He finds that higher royalty taxes are associated with greater 
R&D intensity on the part of affiliates, suggesting that local R&D is a substi- 
tute for imported technology. 
International Tax Rules and Financing Decisions 
A longstanding question in the analysis of taxation of multinational corpora- 
tions is whether home-country taxes due on repatriation of foreign-source in- 
come affect subsidiaries’ repatriation decisions. In principle, as long as the 
home-country tax does not change, and parent firms derive no value from a 
particular pattern of repatriations, taxes due upon repatriation are unavoidable 
costs. Hence, neither the investment decisions nor the repatriation decisions of 
mature foreign subsidiaries should be affected by  home-country taxation of 
repatriated earnings. Studies using cross-sectional data on firms indicate, how- 
ever, that U.S. subsidiaries’ dividend remittances are sensitive to the U.S. repa- 
triation taxes. Panel data are needed to proceed further in this line of inquiry 
because such data allow an investigator to distinguish between effects of tran- 
sitory and permanent variation in U.S. tax rates on repatriations. This is pre- 
cisely the agenda pursued by  Rosanne Altshuler, Scott Newlon, and William 
Randolph. These authors analyze a data set consisting of U.S.  tax return infor- 
mation for a large sample of  foreign subsidiaries and their U.S. parent firms 
for the years 1980, 1982, 1984, and 1986. The empirical tests exploit informa- 6  Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard 
tion about cross-country differences in tax rates to estimate separate effects on 
remittances attributable to the permanent and transitory components of  tax 
prices of dividend repatriations. The intuition is that, while cross-country dif- 
ferences in average repatriation tax prices or statutory tax rates are correlated 
with permanent components of tax price variation, they are uncorrelated with 
transitory variations. Hence, these measures can be used to construct instru- 
mental variables for tax prices that permit separate identification of permanent 
and transitory tax price effects. Altshuler, Newlon, and Randolph find that the 
transitory tax price effect is larger than the permanent effect, suggesting that 
subsidiaries concentrate repatriations to U.S. parents in periods in which the 
tax prices of repatriations are transitorily low. 
Kenneth Froot and James Hines argue that the investment and financing of 
multinational firms may be affected by the changes in interest allocation rules 
introduced by the Tax Reform Act of 1986. The rules reduce the tax deductibil- 
ity of  interest expenses for firms in excess foreign tax credit positions. The 
resulting increase in the cost of debt finance gives firms incentives to use forms 
of financing other than debt. Furthermore, to the extent that perfect substitutes 
for debt are not available, the overall cost of capital rises. Froot and Hines test 
this proposition by  comparing investment before and after 1986 by  firms in 
deficit credit and excess credit positions, holding constant other determinants 
of investment.  The study analyzes data on 416 firms with international business 
operations. The authors find that, over the 1986-91 period, firms that could not 
fully deduct their U.S. interest expenses both borrowed less (on average, 4.2 
percent less debt measured as a fraction of  firm assets) and invested less in 
property, plant, and equipment (on average, 3.5 percent less) than firms whose 
deductions were not affected by the interest allocation rules. These results sug- 
gest that firms substitute away from debt as it becomes more expensive, and 
that firms reduce their capital investments in response to higher borrowing 
costs produced by the change in interest allocation rules. 
Reference 
Feldstein, Martin, and Charles Horioka. 1980. Domestic saving and international capi- 
tal Rows. Economic Journal 90: 314-29. 

The Effects of Taxation on Multinational Corporations

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