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

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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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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4924.

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Date of creation: Nov 1994
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Publication status: published as The Effects of Taxation on Multinational Corporations, ed. Martin Feldstein J. Hines, R.G. Hubbard, University of Chicago Press, 1995, pp. 277-307
Handle: RePEc:nbr:nberwo:4924

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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 Working Papers 2931, National Bureau of Economic Research, Inc.
  3. 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.
  4. Hines, J.R., 1990. "The Flight Paths Of Migratory Corporations," Papers, Princeton, Woodrow Wilson School - Discussion Paper 65, Princeton, Woodrow Wilson School - Discussion Paper.
  5. Stiglitz, Joseph E., 1973. "Taxation, corporate financial policy, and the cost of capital," Journal of Public Economics, Elsevier, Elsevier, vol. 2(1), pages 1-34, February.
  6. Smith, Clifford W, Jr & Wakeman, L MacDonald, 1985. " Determinants of Corporate Leasing Policy," Journal of Finance, American Finance Association, American Finance Association, vol. 40(3), pages 895-908, July.
  7. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, American Finance Association, vol. 32(2), pages 261-75, May.
  8. Edwards, J. S. S. & Mayer, C. P., 1991. "Leasing, taxes, and the cost of capital," Journal of Public Economics, Elsevier, Elsevier, vol. 44(2), pages 173-197, March.
  9. Andrew B. Lyon & Gerald Silverstein, 1994. "The Alternative Minimum Tax and the Behavior of Multinational Corporations," NBER Working Papers 4783, National Bureau of Economic Research, Inc.
  10. Hartman, David G., 1985. "Tax policy and foreign direct investment," Journal of Public Economics, Elsevier, Elsevier, vol. 26(1), pages 107-121, February.
  11. Assaf Razin & Joel Slemrod, 1990. "Taxation in the Global Economy," NBER Books, National Bureau of Economic Research, Inc, number razi90-1, July.
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