Taxation and Capital Flows in Offshore Financial Companies
Timothy J. Goodspeed
Hunter College - CUNY
Department of Economics
695 Park Avenue
New York, NY 10021
USA
Telephone: 212-772-5434
Telefax: 212-772-5398
E-mail: timothy.goodspeed@hunter.cuny.edu
November, 2002
Abstract: The 1986 Tax Reform Act introduced changes that potentially alter capital flows into
and out of the United States, particularly for financial companies. This paper uses data from
1982 to 1997 to assess the evolution of net U.S. capital outflows (net repatriations) in banking
and finance relative to other industries. The results of this paper indicate that net U.S. capital
outflows in the banking and finance industry were much lower than in other industries after
1986, even after controlling for general finance company differences, a time trend, exchange
rates, tax rates, and country fixed effects. Once controlling for the trend over time, net capital
outflows were not different before and after 1986 for industries other than banking and finance,
but are significantly lower for banking and finance companies after 1986. The results are
interpreted to suggest that TRA86 did not influence net capital outflows for most industries, but
that changes in Subpart F for financial companies lead to a significantly lower outflow in the
banking and finance industry.
Taxation of capital is particularly difficult in a world of increasingly mobile capital flows.
U.S. international tax law limits the tax advantage of moving capital overseas to a low tax
jurisdiction by taxing the worldwide income of U.S. taxpayers (a credit being given for taxes
paid overseas). Unless a company has excess foreign tax credits, the tax savings that would have
been realized because of the low foreign tax ends up being owed to the U.S. government. The
principle of deferral (whereby taxpayers defer payment of U.S. tax until repatriation) limits the
effectiveness of worldwide taxation, but deferral is itself limited in the U.S. by Subpart F
provisions. The 1986 Tax Reform Act resulted in several changes in these laws that affected the
relative attractiveness of investing in or repatriating income to the United States vis a vis other
countries. As noted by Altshuler and Hubbard (2002), the banking industry was differentially
affected compared to other industries.
The goal of this paper is to provide new evidence on whether the 1986 Tax Reform Act
had any aggregate impact on net capital outflows of U.S. multinational companies and whether
that impact differs between industries. A number of papers have examined various aspects of
how the Tax Reform Act of 1986 impacted decisions by multinational companies. For instance,
Swenson (1994) examines whether tax changes in the 1980s stimulated foreign investment in the
United States, Desai and Hines (1999) study whether the increase in foreign tax credit baskets in
TRA86 influenced the number of international joint ventures of American firms, and Altshuler
and Hubbard (2002) study whether Subpart F changes altered the choice of foreign investment
location of banking subsidiaries. I examine the impact of the 1986 Subpart F changes by testing
the influence of those changes on a different aspect of banking and finance companies: their net
repatriation decisions to the U.S. as reflected in net capital flow data relative to net repatriation in
1
other industries before and after the 1986 Tax Reform Act.1
The data on net outflows of U.S. capital is taken from the Bureau of Economic Analysis
(BEA) for the years 1982 - 1997, and is the sum of debt, equity capital, and reinvested earnings
flows between U.S. parents and their foreign subsidiaries.2 This data is described in more detail
below, but is available by country and industry. The country and industry detail is exploited in
the empirical work, which explores whether capital outflows differed systematically before and
after 1986 and whether capital outflows in the financial services industry differed from that of
other industries before and after 1986 controlling for country fixed effects, a time trend,
exchange rates, and tax rates.
The basic result is that net capital outflows in the banking and finance industry were
much lower than those of other industries after 1986 than before 1986. The remainder of the
paper is organized as follows. The next section provides a short discussion of certain changes in
the 1986 Tax Reform Act that likely impact net capital outflows, and certain changes that are
particularly onerous for financial companies. Section III discusses the data. Section IV describes
the econometric approach and presents the results and Section V concludes.
II. 1986 Tax Reform Act Changes
1
As the data is essentially net repatriations, it is related to a literature that has studied
repatriation decisions that is based primarily on U.S. Treasury data. The first modern study of
dividend repatriation decisions is that of Hines and Hubbard (1990), followed by the studies of
Altshuler and Newlon (1993) and Alshuler, Newlon, and Randolph (1995). These papers
generally find that dividend taxes impact the decision on whether to repatriate, at least if the tax
is viewed as temporary. A tangential literature such as Grubert (1998) focuses on the tax
differences between different methods of finance such as debt versus equity finance.
2
Royalty payments are not included in BEA’s definition of capital flows.
2
It is well known that the 1986 TRA lowered corporate tax rates and broadened the base.
These two general changes would have opposite impacts on capital outflows in all industries: the
lowering of the corporate tax rate would be expected to lead to smaller capital outflows, while
the simultaneous broadening of the tax base would be expected to lead to larger capital outflows,
ceteris paribus. These general law changes impact all industries. Moreover, other countries
might counteract any effect of the U.S. rate and base changes on capital outflows by following
the U.S. in lowering corporate tax rates. Altshuler and Goodspeed (2002) provide empirical
evidence that European countries treated the U.S. as a Stackelberg leader and followed U.S.
corporate tax changes after 1986 but not before. Grubert, Randolph, and Rousslang (1996) also
suggest that by 1992 many countries had followed the U.S. in lowering corporate tax rates.
A less well know change in tax laws relates to Subpart F rules and their impact on
financial companies. As mentioned in the introduction, Subpart F essentially repeals the deferral
aspect of U.S. international tax law whereby income is not subject to U.S. tax until it is
repatriated. Subpart F was enacted in 1962 as an attempt to limit avoidance of U.S. tax. Until
1986, Subpart F had concentrated on taxation of passive investments of foreign corporations that
are controlled by U.S. taxpayers. Altshuler and Hubbard (2001) emphasize that Subpart F was
greatly broadened by TRA86 to include current taxation of active financial service income.
Using a sample of financial subsidiaries of U.S. corporations, Altshuler and Hubbard find that
the location of financial subsidiary assets among foreign countries was sensitive to differential
foreign tax rates in 1984, but not in 1992 or 1994. They attribute this to the essential repeal of
deferral for these companies after 1986. After the law change, a U.S. multinational that does not
have excess foreign tax credits would face equal taxation among locations abroad (i.e. it would
3
face the U.S. tax rate on the margin in all locations) and therefore would not respond to tax
differences.
Altshuler and Hubbard (2001) as well as Altshuler, Grubert, and Newlon (2001) focus on
the choice of investment locations across foreign countries. Clearly the essential repeal of
deferral for financial companies in the 1986 Tax Reform Act will impact the relative
attractiveness of both locating investment and repatriating income from abroad to the U.S. as
well as location decisions across foreign countries. Moreover, the 1986 Subpart F change which
taxes active financial service income currently should be felt particularly strongly by banking,
insurance, and other financial companies, and would be expected to lead to smaller capital
outflows (and possibly net inflows) from foreign subsidiaries of U.S. multinational companies in
the financial services sector relative to other industries after 1986.
III. Econometric Approach
The econometric approach is a difference-in-difference analysis.3 Our goal is to test for
evidence of any impact on U.S. net capital outflows resulting from the 1986 law changes outlined
above. As mentioned, the lowering of the corporate tax rate and the simultaneous broadening of
the tax base has an ambiguous impact on capital outflows. These changes would be expected to
affect all industries. However, Subpart F was greatly broadened by TRA86 to include current
taxation of active financial service income. This law change should be felt particularly strongly
by banking, insurance, and other financial companies, and would be expected to lead to smaller
3
Few studies in international taxation use the difference-in-difference approach.
4
capital outflows from (or greater inflows to) the U.S. in the financial services sector relative to
other industries.
To test for any impact of these law change on capital flows, consider the following
estimating equation:
where )Kit is the net capital outflow to country i from industry j in year t, d86 is a dummy that
takes on the value 0 for years prior to 1986 and 1 for years after 1986, and dbank is a dummy that
takes on the value 1 for the banking and finance industry and 0 for other industries. The
inclusion of d86 accounts for any differences in net capital outflows common to all industries after
1986. A positive coefficient can be interpreted as indicating that the net effect of TRA86
resulted in an increase in net capital outflows, while a negative coefficient indicates that the net
result was a decrease in net capital outflows. The inclusion of dbank accounts for any differences
in capital outflows for the banking and finance industry relative to other industries.
The coefficient on the interaction term, b3, will pick up any differences in capital flows
after 1986 in banking and finance relative to other industries that are not picked up by b1 and b2.
If this coefficient is negative, it indicates that capital outflows in the banking and finance industry
increased less than capital outflows in other industries after 1986. This is consistent with the
hypothesis that Subpart F changes in 1986 differentially affected banking and finance and led to
greater repatriations in banking and finance after 1986. Moreover, the differential impact on
banking and finance companies after 1986 would not reflect a general change in capital outflows
after 1986 (picked up by b1) nor simply differences between banking and finance and other
5
industries (picked up by b2).
The basic difference-in-difference estimating equation will be augmented to incorporate
other factors that might influence capital flows that would not otherwise be accounted for. First,
one might consider controlling for any systematic capital flows to particular countries, due for
instance, to favorable regulations for insurance, banking, or other country attributes that are fixed
over time. We will use a random effects estimate to control for this. Second, one might think
that any impact picked up by the 1986 dummy reflects a general trend during the sample period.
A trend variable is used to control for this. Third, nominal exchange rate changes might
influence the timing of repatriation decisions. Since the data relates to income flows, one might
expect a temporary depreciation of the dollar to lead to a greater repatriation of foreign currency
into dollars to maximize the dollar value of the repatriation.4 Finally, one might want to control
for the ratio of U.S. to foreign taxes, particularly in light of the earlier cited evidence that other
countries reacted to the 1986 Tax Reform Act.
IV. Data.
The data on net capital outflows is derived from the Bureau of Economic Analysis (BEA)
statistics on U.S. multinational companies. A useful discussion of this data is Mataloni (1995).
A number of features of the data are important to keep in mind for this study. First, the data used
4
Froot and Stein (1991) indicate that in a model of imperfect information in which
foreigners have difficulty evaluating domestic companies, an exchange rate depreciation may
affect real variables and lead to higher inward direct investment by foreigners. This explanation
seems less likely in explaining the income flows between U.S. multinationals and their
subsidiaries, although the sign of the coefficient would be the same.
6
is the BEA’s capital account flows for U.S. multinationals. Capital outflows as discussed in this
paper “measure funds that U.S. parent companies provide to their foreign affiliates (outflows) net
of funds that affiliates provide their parents (inflows) during a given period.” A foreign affiliate
is defined as a foreign company in which the U.S. parent has a 10 percent or more ownership
stake. The exchange of funds between parent and affiliate includes equity capital, debt, and
reinvested earnings. It does not include royalty payments, which are included in the BEA’s
current account flows.
The data is available by country and by broad industry categories. The data span the
period 1982 to 1997. Since certain countries have little reported net capital outflows in banking
and finance, the country data was consolidated to cover 18 countries.5 An “other” category was
calculated as the total less net capital outflows to the 18 countries. Industry categories differ
slightly from the beginning to the end of the period. The important industry for most of the
analysis is the financial services industry. There are two related industry categories in this
regard, the banking industry and the finance (except banking), insurance, and real estate industry.
Financial companies in this paper are defined as the sum of these two categories. An important
question in this study is whether financial companies differ from other industries, so capital
flows in other industries are summed as a comparison group.
Exchange rate information is taken from the PACIFIC exchange rate service.
Unfortunately, this data is not available for all countries for all years. When the exchange rate
information is used, the sample is therefore reduced by dropping countries without the requisite
5
The specific countries are Argentina, Australia, Bahamas, Bermuda, Brazil, Canada,
Chile, France, Germany, Hong Kong, Italy, Japan, Netherlands Antilles, Netherlands, Singapore,
Switzerland, UK, and UK Islands. These are the countries with non-zero data for all years.
7
information. This reduced sample includes only nine of the countries of the full sample: Canada,
Germany, France, Hong Kong, Italy, Japan, Singapore, Switzerland, and the UK. Tax rate
information is the top marginal corporate tax rate and is taken from the World Tax Database of
the OTPR at the University of Michigan.
V. Results
The basic results are given in Table 1. Banking and finance is the treatment group and
other industries is the control group. The results show a consistent negative coefficient for
banking and finance relative to other industries after 1986 compared to before 1986. That is,
banking and finance companies had less capital outflows than did other industries after 1986 than
before. This result is robust to the two samples and to the inclusion of a time trend, exchange
rates, foreign tax rates, and country effects. A more detailed discussion follows.
The first three columns of Table 1 use the whole sample. The first column is the most
basic form of the difference-in-difference approach. The second column adds a trend variable,
and the third column adds random effects as well as a trend. Although the dummy for 1986 is
significant and positive in the first column, it loses its significance when the trend is added. This
suggests that the 1986 Tax Reform Act had no overall impact on U.S. net capital flows before
and after TRA86 that cannot be explained by a general increase in net capital outflows over the
period. This is perhaps not totally unexpected since TRA86 resulted in two changes with
countering effects, a broadening of the tax base together with a reduction in tax rates, and since
other countries reacted to U.S. changes.
8
The coefficient on the banking and finance dummy variable is insignificant, but the
coefficient on the interaction of the after 1986 and banking and finance industry dummies is
negative and significant across all three columns. This indicates that capital outflows in banking
and finance were not on average different from other industries over the sample period, but were
lower after 1986 relative to other industries. This is consistent with changes in capital flows that
would be expected from the 1986 legal changes to the Subpart F provisions. It is also consistent
with the results found by Altshuler and Hubbard (2001) concerning the location of finance
company assets across foreign countries after 1986. Moreover, the coefficient is unaffected by
the inclusion of the trend in the second column. The statistical significance of the result is
strengthened by the inclusion of random effects in the third column although the point estimate is
unchanged.
The second three columns use the reduced sample for which exchange rate and tax
information is available. The fourth column repeats the second column with a smaller sample
and adds both the exchange rate and the ratio of U.S. to foreign tax rates as additional
independent variables. The tax ratio variable is negative as expected, but is insignificant. The
exchange rate variable is negative and significant. The negative sign is consistent with the
greater repatriation of profits when the dollar is low in value and also with Froot and Stein’s
(1991) hypothesis. The interaction of the after 1986 dummy and the banking and finance dummy
is again negative, but marginally insignificant.
The fifth column runs the fourth column regression using random effects. This results in
insignificance for both the exchange rate and tax ratio variables, and leads to a significant
coefficient for the interaction term. This suggests that the random effects are largely controlling
9
for exchange rate changes and well as foreign tax changes. Hence the results of column three
become stronger even though column three does not explicitly control for exchange rates or
foreign taxes. The random effects estimates largely control for the effect of these variables. The
last column repeats the regression of the fifth column but drops the exchange rate and tax ratio
variables. This results in a regression identical to column three, but for the smaller sample. The
results of this column are essentially unchanged from column five. This suggests that if
exchange rate and tax rate information were available for the whole sample, the results would
closely resemble those of column three.
IV. Conclusions.
The 1986 Tax Reform Act introduced several changes in international tax law that
potentially alter capital flows between U.S. multinational parents and their foreign subsidiaries,
particularly in banking and finance. I investigate whether changes in Subpart F that essentially
repealed deferral for financial companies, and were enacted as part of the 1986 Tax Reform Act,
altered net capital flows (net repatriation) by banking and finance companies relative to other
industries after 1986 compared to before 1986.
The basic result is that net capital flows of banking and finance companies were much
lower than other industries after 1986. This result is robust to controls for a time trend, exchange
rates, tax rates, and country effects. Once controlling for the trend over time, net capital outflows
were not different before and after 1986 for industries other than banking and finance.
10
References
Altshuler, Rosanne and R. Glenn Hubbard. 2001. “The Effect of the Tax Reform Act of 1986
on the Location of Assets in Financial Service Firms.” Forthcoming, Journal of Public
Economics.
Altshuler, Rosanne and Scott Newlon 1993. “The Effects of U.S. Tax Policy on the Income
Repatriation Patterns of U.S. Multinationals.” in Studies in International Taxation, ed. by Alberto
Giovannini, R. Glenn Hubbard and Joel Slemrod. Chicago: University of Chicago Press.
Altshuler, Rosanne and Timothy J. Goodspeed. 2002. “Follow the Leader?: European and U.S.
Tax Competition.” Draft.
Alshuler, Rosanne, Harry Grubert, and Scott Newlon. 2001. “Has U.S. Investment Become
More Sensitive to Tax Rates?” in J. R. Hines, ed., International Taxation and Multinational
Activity, Chicago: University of Chicago Press.
Alshuler, Rosanne, Scott Newlon, and William Randolph. 1995. “Do Repatriation Taxes Matter?
Evidence from the Tax Returns of U.S. Multinational Companies.” in The Effects of Taxation on
Multinational Corporations, ed. by Martin Feldstein, James R. Hines, Jr., and R. Glenn Hubbard.
Chicago: University of Chicago Press.
Ault, Hugh J. 1997. Comparative Income Taxation: A Structural Analysis. Den Haag, The
Netherlands: Kluwer Law International.
Desai, Mihir and James R. Hines, Jr. 1999. “Basket Cases: Tax Incentives and International
Joint Venture Participation by American Multinational Firms.” Journal of Public Economics.
March, 1999. 71(3): 379-402.
Froot K. and J. Stein. 1991. “Exchange Rates and Foreign Direct Investment: An Imperfect
Capital Market Approach.” Quarterly Journal of Economics. 106: 1191-1217.
Gordon, Roger and James R. Hines, Jr. 2002. “International Taxation.” NBER Working Paper
#8854.
Grubert Harry. 1998. “Taxes and the Division of Foreign Operating Income Among Royalties,
Interest, Dividends, and Retained Earnings.” Journal of Public Economics. May. 1998, 68(2):
269-290.
Grubert, Harry, William Randolph and Donald Rousslang. 1996. “The Response of Countries
and Multinational Companies to the Tax Reform Act of 1986.” National Tax Journal. 49(3):
341-58.
11
Hines, James and R. Glenn Hubbard. 1990. “Coming Home to America: Dividend Repatriations
by U.S. Multinationals.” in Assaf Razin and Joel Slemrod, eds., Taxation in the Global
Economy. Chicago: University of Chicago Press.
Mataloni, Raymond J. 1995. “A Guide to BEA Statistics on U.S. Multinational Companies.”
Survey of Current Business, March. Washington: U.S. Department of Commerce, Bureau of
Economic Analysis.
Swenson, Deborah. 1994. “The Impact of U.S. Tax Reform on Foreign Direct Investment in the
United States.” Journal of Public Economics. 54: 243-266.
12
Table 1
Regression Results
(dependent variable: net U.S. capital outflows)
Estimates
Constant
1006
(0.88)
-1102213
(-3.39)
-1102213
(-4.51)
-570533
(-3.17)
-538338
(-3.41)
-549518
(-3.54)
After 1986 dummy
5004
(3.63)
556
(0.29)
556
(0.39)
109
(0.1)
954
(0.49)
311
(0.34)
Banking and Finance dummy
-729
(-0.45)
-729
(-0.45)
-729
(-0.60)
-264
(-0.3)
-265
(-0.35)
-265
(-0.35)
After 1986*Banking and Finance
-3269
(-1.68)
-3269
(-1.69)
-3269
(-2.25)
-1625
(-1.52)
-1625
(-1.76)
-1625
(-1.76)
556
(3.4)
556
(4.51)
288
(3.18)
271
(3.4)
277
(3.54)
U.S. tax rate/Foreign tax rate
-370
(-1.31)
609
(0.76)
exchange rate (per U.S. dollar)
-1.14
(-2.13)
-0.73
(-0.44)
No
Yes
Yes
288
288
Trend
Country (Random) Effects?
No
No
Adjusted R-squared
.04
.06
Number of Observations
608
608
F
8.53
9.39
Yes
.09
608
288
5.9
13
14