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Barriers to portfolio investments in emerging stock markets

Author

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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.

Suggested Citation

  • Demirguc-Kunt, Asli & Huizinga, Harry, 1992. "Barriers to portfolio investments in emerging stock markets," Policy Research Working Paper Series 984, The World Bank.
  • Handle: RePEc:wbk:wbrwps:984
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Eijffinger, Sylvester C. W. & Huizinga, Harry P. & Lemmen, Jan J. G., 1998. "Short-term and long-term government debt and nonresident interest withholding taxes," Journal of Public Economics, Elsevier, vol. 68(3), pages 309-334, June.
    2. Huizinga, Harry, 1996. "The incidence of interest withholding taxes: Evidence from the LDC loan market," Journal of Public Economics, Elsevier, vol. 59(3), pages 435-451, March.
    3. 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.
    4. Guesmi, Khaled & Nguyen, Duc Khuong, 2011. "How strong is the global integration of emerging market regions? An empirical assessment," Economic Modelling, Elsevier, vol. 28(6), pages 2517-2527.
    5. Andrew Baum & Claudia Murray, "undated". "Understanding the Barriers to Real Estate Investment in Developing Economies," Real Estate & Planning Working Papers rep-wp2011-08, Henley Business School, Reading University.
    6. Mishra, Anil V. & Ratti, Ronald A., 2014. "Taxation of domestic dividend income and foreign investment holdings," International Review of Economics & Finance, Elsevier, vol. 31(C), pages 218-231.
    7. repec:eee:revfin:v:33:y:2017:i:c:p:41-54 is not listed on IDEAS
    8. Huizinga, Harry, 1996. "The incidence of interest withholding taxes: Evidence from the LDC loan market," Journal of Public Economics, Elsevier, vol. 59(3), pages 435-451, March.
    9. 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.
    10. 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.
    11. Christian Wildmann, 2011. "What drives portfolio investments of German banks in emerging capital markets?," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 25(2), pages 197-231, June.
    12. repec:eee:finana:v:51:y:2017:i:c:p:54-68 is not listed on IDEAS
    13. 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.
    14. Mishra, Anil V., 2014. "Australia's home bias and cross border taxation," Global Finance Journal, Elsevier, vol. 25(2), pages 108-123.
    15. Mishra, Anil V. & Ratti, Ronald A., 2013. "Home bias and cross border taxation," Journal of International Money and Finance, Elsevier, vol. 32(C), pages 169-193.

    More about this item

    Keywords

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

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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