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Barriers to portfolio investments in emerging stock markets

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  • Demirguc-Kunt, Asli
  • Huizinga, Harry

Abstract

The authors examine to what extent features of the international tax system and indicators of transaction costs affect the required rates of return on emerging stock markets. They show that the capital gains withholding tax levied on foreign portfolio investors increases required pre-tax rates of return. As countries generally do not index their capital gains taxes, it follows that inflation increases the capital gains tax base, as well as the required rate of return on equity. Dividend withholding taxes instead appear not to increase the required pre-tax equity returns significantly. The differing results for capital gains and dividend taxes reflect the fact that foreign investors generally can receive domestic tax credits only for foreign withholding taxes paid on dividends. The return on equity is part of the issuing firm's cost of capital. So, capital gains withholding taxes imposed on nonresidents increase the cost of capital for domestic firms and discourage physical investment. Private investment levels have tended to be low in developing countries in the 1980's. The cost of equity finance in developing countries has gained in importance inthe last decade, as these countries'access to international lending capital has been limited during most of the decade. What do these findings imply for the design of tax policy in relation to foreign portfolio investment in developing countries? The existence of foreign tax credits for dividend taxes paid suggest that a country should tax capital gains more lightly than repatriated dividends - as do Greece, Pakistan, Portugal, and Venezuela. Each of these countries has positive-dividend withholding taxes but no capital gains taxes imposed on non-residents. Colombia and India do the exact opposite: they tax capital gains far more heavily than dividends. Despite what appears optimal, the trend in developing countries is toward lower dividend withholding taxes, with little change in the average level of capital gains taxation. It appears desirable for developing countries to index their capital gains taxes to prevent them from being higher than anticipated.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 984.

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Date of creation: 31 Oct 1992
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Handle: RePEc:wbk:wbrwps:984

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Keywords: Economic Theory&Research; International Terrorism&Counterterrorism; Banks&Banking Reform; Environmental Economics&Policies; Public Sector Economics&Finance;

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References

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  1. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, 09.
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Citations

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Cited by:
  1. Kane, Edward J., 1995. "Difficulties of transferring risk-based capital requirements to developing countries," Pacific-Basin Finance Journal, Elsevier, vol. 3(2-3), pages 193-216, July.
  2. Mishra, Anil V & Ratti, Ronald A, 2013. "Taxation of Domestic Dividend Income and Foreign Investment Holdings," MPRA Paper 50601, University Library of Munich, Germany.
  3. Huizinga, H.P., 1994. "The incidence of interest withholding taxes: Evidence from the LDC loan markets," Discussion Paper 1994-95, Tilburg University, Center for Economic Research.
  4. Huizinga, H., 1994. "The Incidence of Interest Withholding Taxes: Evidence from the LCD Loan Market," Papers 9495, Tilburg - Center for Economic Research.
  5. Eijffinger, S.C.W. & Huizinga, H.P. & Lemmen, J.J.G., 1998. "Short-term and long-term government debt and non resident interest witholding taxes," Open Access publications from Tilburg University urn:nbn:nl:ui:12-76575, Tilburg University.
  6. Bilson, Christopher M. & Brailsford, Timothy J. & Hooper, Vincent C., 2002. "The explanatory power of political risk in emerging markets," International Review of Financial Analysis, Elsevier, vol. 11(1), pages 1-27.
  7. Andrew Baum & Claudia Murray, . "Understanding the Barriers to Real Estate Investment in Developing Economies," Real Estate & Planning Working Papers rep-wp2011-08, Henley Business School, Reading University.
  8. Boyer, Marcel & Cherkaoui, Mouna & Ghysels, Eric, 1997. "L’intégration des marchés émergents et la modélisation des rendements des actifs risqués," L'Actualité Economique, Société Canadienne de Science Economique, vol. 73(1), pages 311-330, mars-juin.
  9. Christian Wildmann, 2011. "What drives portfolio investments of German banks in emerging capital markets?," Financial Markets and Portfolio Management, Springer, vol. 25(2), pages 197-231, June.
  10. Khaled Guesmi & Duc Khuong Nguyen, 2011. "How strong is the global integration of emerging market regions? An empirical assessment," EconomiX Working Papers 2011-9, University of Paris West - Nanterre la Défense, EconomiX.
  11. Wildmann, Christian, 2010. "What drives portfolio investments of German banks in emerging capital markets?," Discussion Paper Series 2: Banking and Financial Studies 2010,04, Deutsche Bundesbank, Research Centre.

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