The financing and taxation of U.S. direct investment abroad

The author examines the financing of U.S. direct investment abroad. Using a theoretical model, he first examines how home country investors can use debt finance to reduce their host country tax liability and to reduce the capital investment distortion attributable to foreign taxes. Empirically, U.S. affiliates are shown to use leverage in high tax environments and in situations where the affiliates face high foreign wage bills relative to assets. This confirms the notion that leverage can be used to ward off host country tax and wage pressures on the firm. The author examines what characteristics of foreign direct investment determine the average host country tax rate paid. Generally, the taxation of foreign direct investment is positively related to the size of the wage bill. Host countries appear to charge lower taxes in cases where U.S. direct investor abroad pay high wage bills to labor within the host country. Certain trends emerge from the data: there is a relative shift of U.S. direct investment abroad toward the industrial countries; debt finance of direct investment is becoming more important in industrial countries and less important in developing countries; and the tax benefits that industrialand developing countries get from U.S. affiliates, as measured by average income and payroll taxes, are waning. The downward trend in tax rates suggests an increased international competition to attract foreign direct investment. The reduction in average tax rates on U.S. investment abroad and the relative shift toward investment in industrial countries suggests a tougher climate ahead for developing countries that wish to attract foreign direct investment. One strategy for attracting foreign investment would be to deepen the domestic financial market so a multinational can attract additional lending capital in the host country itself. Another approach is local equity participation in foreign direct investment to lessen the incentives for host countries to tax foreign investments highly.