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Interest Allocation Rules, Financing Patterns, and the Operations of U.S. Multinationals

In: The Effects of Taxation on Multinational Corporations

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  • Kenneth A. Froot
  • James R. Hines, Jr.

Abstract

This paper examines the impact of the 1986 change in U.S. interest allocation rules on the investment and financing decisions of American multinationals. The 1986 change reduced the tax deductibility of the interest expenses of firms with excess foreign tax credits. The resulting increase in the cost of debt gives firms incentives to substitute away from using debt finance. Furthermore, to the extent that perfect financing substitutes are not available, the overall cost of capital rises as well. The empirical tests indicate that the loss of tax deductibility of parent-company interest expenses appears to reduce significantly borrowing and investing by firms with excess foreign tax credits. The same firms tend to undertake new lease commitments, which may reflect the use of leases as alternatives to capital ownership. In addition, firms affected by the tax change tend to scale back the scope of their foreign and total operations. These results are consistent with the hypothesis that firms substitute away from debt when debt becomes more expensive, and also with the hypothesis that the loss of interest tax shields increases a firm's cost of capital.

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This chapter was published in:

  • Martin Feldstein & James R. Hines Jr. & R. Glenn Hubbard, 1995. "The Effects of Taxation on Multinational Corporations," NBER Books, National Bureau of Economic Research, Inc, number feld95-2, July.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 7747.

    Handle: RePEc:nbr:nberch:7747

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    1. Rosanne Altshuler & Jack Mintz, 1994. "U.S. Interest Allocation Rules: Effects and Policy," NBER Working Papers 4712, National Bureau of Economic Research, Inc.
    2. James R. Hines, Jr. & R. Glenn Hubbard, 1990. "Coming Home To America: Dividend Repatriations By U.S. Multinationals," NBER Chapters, in: Taxation in the Global Economy, pages 161-208 National Bureau of Economic Research, Inc.
    3. Edwards, J. S. S. & Mayer, C. P., 1991. "Leasing, taxes, and the cost of capital," Journal of Public Economics, Elsevier, vol. 44(2), pages 173-197, March.
    4. Assaf Razin & Joel Slemrod, 1990. "Taxation in the Global Economy," NBER Books, National Bureau of Economic Research, Inc, number razi90-1, July.
    5. Hartman, David G., 1985. "Tax policy and foreign direct investment," Journal of Public Economics, Elsevier, vol. 26(1), pages 107-121, February.
    6. Andrew B. Lyon & Gerald Silverstein, 1995. "The Alternative Minimum Tax and the Behavior of Multinational Corporations," NBER Chapters, in: The Effects of Taxation on Multinational Corporations, pages 153-180 National Bureau of Economic Research, Inc.
    7. Hines, J.R., 1990. "The Flight Paths Of Migratory Corporations," Papers 65, Princeton, Woodrow Wilson School - Discussion Paper.
    8. Smith, Clifford W, Jr & Wakeman, L MacDonald, 1985. " Determinants of Corporate Leasing Policy," Journal of Finance, American Finance Association, vol. 40(3), pages 895-908, July.
    9. Stiglitz, Joseph E., 1973. "Taxation, corporate financial policy, and the cost of capital," Journal of Public Economics, Elsevier, vol. 2(1), pages 1-34, February.
    10. James R. Hines, Jr. & Eric M. Rice, 1990. "Fiscal Paradise: Foreign Tax Havens and American Business," NBER Working Papers 3477, National Bureau of Economic Research, Inc.
    11. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
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