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The
Effects
of
Taxation on
Multinational Corporations
A
National Bureau
of
Economic Research
Project Report
The Effects
of
Taxation on
Multinational
Corporations
Edited
by
Martin Feldstein,
James
R.
Hines,
Jr.,
and
R.
Glenn Hubbard
The
University
of
Chicago

America
04030201 009998979695 12345
ISBN: 0-226-24095-9 (cloth)
Library
of
Congress Cataloging-in-Publication Data
The Effects
of
taxation on multinational corporations
I
edited by Martin
Feldstein, James R. Hines, Jr., and R. Glenn Hubbard.
Papers presented at a conference held in January 1994.
Includes bibliographical references and index.
1. International business enterprises-Taxation-Congresses. 2. Interna-
p.
cm (National Bureau of Economic Research project report)
tional business enterprises-Finance-Congresses. 3. Investments, For-
eign-mation-Congresses. 4. Capital market-Congresses.
1.
Feldstein, Martin
S.
11.
Hines, James
R.
111.
Hubbard, R. Glenn.
IV.
Series
HD2753.A3E33 1995

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Economic Research
Officers
Paul W. McCracken, chairman
John H. Biggs, vice chairman
Martin Feldstein, president and chief
executive ojicer
Directors at Large
Peter C. Aldrich
Elizabeth E. Bailey
John H. Biggs
Andrew Brimmer
Carl
E
Christ
Don R. Conlan
Kathleen
B.
Cooper
Jean A. Crockett
Geoffrey Carliner, executive director
Gerald A. Polansky, treasurer
Sam Parker, director offinance and
administration
George C. Eads
Martin Feldstein
George Hatsopoulos
Karen N. Horn
Lawrence R. Klein
Leo Melamed
Merton H. Miller

Saul H. Hymans, Michigan
Marjorie
B.
McElroy, Duke
Joel
Mokyr, Northwesrern
James
L.
Pierce, California, Berkeley
Andrew Postlewaite, Pennsylvania
Nathan Rosenberg, Stanford
Harold
T.
Shapiro, Princeton
Michael Yoshino, Harvard
Arnold Zellner. Chicago
Technology Craig Swan, Minnesota
Directors
by
Appointment
of
Other Organizations
Marcel Boyer, Canadian Economics
Mark
Drabenstott, American Agricultural
Richard A. Easterlin, Economic History
Gail D. Fosler, The Conference Board
A. Ronald Gallant, American Statistical
Robert
S.

Franklin
A.
Lindsay
Paul W. McCracken
Geoffrey
H.
Moore
James
J.
O’Leary
George B. Roberts
Eli Shapiro
William
S.
Vickrey
Contents
Preface
Introduction
Martin Feldstein, James
R.
Hines, Jr., and
R. Glenn Hubbard
1.
2.
3.
4.
5.
ix
1
Outward Direct Investment and the

Jason G. Cummins and R. Glenn Hubbard
Comment:
David G. Hartman
7
on the Domestic Capital Stock
43
of Capital
95
123
vii
viii
Contents
6.
The Alternative Minimum Tax and the Behavior
of Multinational Corporations
Andrew
B.
Lyon and Gerald Silverstein
Comment:
Alan J. Auerbach
Accounting Standards, Information Flow, and
Firm Investment Behavior
Jason G. Cummins, Trevor
S.
Harris, and
Kevin A. Hassett
Comment:
G. Peter Wilson
Taxes, Technology Transfer, and the R&D
Activities of Multinational Firms

Contributors
Author Index
Subject Index
7.
153
181
225
25
3
10.
217
313
315
319
Preface
The tax rules of the United States and of foreign countries affect multinational
corporations in a variety of ways. Researchers at the National Bureau of Eco-
nomic Research have been studying the impact of taxation on multinational
corporations for several years. From time to time, the results of this research
have been presented at NBER conferences and subsequently published in
NBER volumes. The papers in the current volume, which were presented at
such a conference in January
1994,
were the result of studies during the previ-
ous two years.
During this period, the researchers met several times to present research
plans and to discuss preliminary results. All of those who participated in the
project also benefited from discussions during the NBER Summer Institute
with a wider group of economists interested in these international tax issues as
well as from meetings with tax lawyers from leading international corporations

multinational corporations. In the United States, much of the debate concerns
the competitive positions
of
U.S.
firms in international product and capital
markets. In addition, there are those who agree that
U.S.
international tax rules
have become more complex and more distorting in recent years, particularly
since the passage of the Tax Reform Act
of
1986.
Discussions in the U.S. Con-
gress and the administration since
1992 reveal a willingness to consider sig-
nificant reforms. In Europe, increased liberalization of capital markets
prompted discussions by the European Commission
of
harmonization of cor-
porate taxation. These policy developments around the world not only suggest
dissatisfaction with certain features of modem tax practice, but also raise
deeper questions of whether current systems
of taxing international income are
viable in a world
of
significant capital-market integration and global commer-
cial competition.
Academic researchers have expressed renewed interest in studying the ef-
fects of taxation on capital formation and allocation, patterns of finance in
multinational companies, international competition, and opportunities for in-

of international tax rules for multinational investment,
(2)
analyzing channels
through which international tax rules affect the costs of international business
activities such as FDI, and
(3)
examining ways in which international tax rules
affect financing decisions of multinational firms. The results suggest that there
are likely to be significant effects of international tax rules on firms’ invest-
ment decisions and provide analytical input for future discussions of tax
reform.
The Context: Multinational Firms, FDI, and International Tax Rules
Robert Lipsey’s paper provides a review of evidence concerning the impact
of outbound FDI on employment and economic activity in the United States.
Lipsey notes that most “industrial organization” explanations for the rise of
multinational firms are based on the notion that multinational enterprises pos-
sess specific assets
or
marketing skills that can be exploited most profitably by
producing in many markets. Lipsey argues that the use of foreign production
locations helped U.S. multinationals retain global market shares in spite of the
decline in the U.S. share of world trade. In addition, the extensive empirical
evidence analyzed by Lipsey offers no empirical support for the proposition
that overseas production by U.S. multinationals reduces employment in the
United States. Instead, the evidence supports the idea that firms experiencing
an increase in their multinational activity increase their managerial and techni-
cal employment at home.
In the volume’s second background paper on FDI, Martin Feldstein ad-
dresses the longstanding question of whether outbound FDI by
U.S.

so
much to raise revenue, but instead to discourage income shifting be-
tween the individual and corporate tax bases (and between domestic and for-
eign subsidiaries). In an international taxation setting, a country needs to tax
the overseas incomes of domestically owned subsidiaries in order to prevent
firms from facing tax incentives to exploit technologies abroad rather than do-
mestically. Moreover, if the tax rates imposed by foreign governments were
lower than the domestic corporate tax rate, multinationals would face incen-
tives to circumvent domestic taxes by shifting their profits abroad through ag-
gressive transfer pricing even if the firms that own the profitable technologies
remain at home. Gordon and MacKie-Mason extend their research on the con-
sequences
of income shifting
for
the design of domestic capital taxes to show
that avoidance of income shifting can explain a number of features of actual
international tax rules, including transfer-pricing regulations and enforcement
penalties, allocation rules for interest and
R&D
expenses, and the foreign tax
credit. Their research suggests the potential importance of considering income
shifting in any normative analysis of international tax rules, as well as the im-
portance
of
studying empirically the extent to which income shifting occurs in
response to tax rate differences.
International Tax Rules and the Cost
of
Capital for
FDI

FDI
by several
4
Martin Feldstein, James
R.
Hines, Jr., and
R.
Glenn Hubbard
hundred subsidiaries of U.S. multinational firms during 1980-91 to measure
more precisely the effect of taxation on FDI, and to analyze subsidiaries’ in-
vestment decisions. The authors consider tax incentives created by host-
country tax rates, investment incentives, and depreciation rules, and by varia-
tion (over time and across firms) in the tax cost of repatriating dividends from
foreign subsidiaries. The authors fit a neoclassical model with tax considera-
tions to the data on U.S. subsidiaries’ investments in Canada, the United King-
dom, Germany, France, Australia, and Japan. The results reject a simple speci-
fication in which taxes do not influence investment. The estimated tax effects
are
economically important: Each percentage-point increase in the cost of cap-
ital reduces by 1-2 percentage points a subsidiary’s annual rate of investment
(investment during the year divided by the beginning-of-period capital stock).
As it does in the domestic corporate tax system, the alternative minimum
tax (AMT) complicates the foreign investment incentives of U.S. corporations.
The presence of the AMT is not merely a wrinkle: in 1990,
53
percent of all
assets, and
56
percent of the foreign-source income of U.S. multinational cor-
porations, was accounted for by firms subject to the AMT. The AMT’s restric-

5
Introduction
are firms in two-book countries. The empirical results suggest that differences
in accounting regimes generate significant differences in the responsiveness of
investment to tax policy; in particular, firms operating in “pure” one-book sys-
tems behave as though they face additional costs when taking advantage
of
investment incentives. The research program begun in this paper suggests fruit-
ful extensions to studies of the impact on investment of interactions of account-
ing and tax regimes.
Economists and policymakers often argue that the presence of techno-
logically advanced industries enhances national prosperity, in part due to the
spillover effects of research and development (R&D) activities. Because
externality-generating R&D activities may be underprovided by private mar-
kets, many governments subsidize R&D in some form. Whether these sub-
sidies in fact stimulate additional R&D activity is the subject of a vigorous
debate. James Hines analyzes the impact of withholding taxes on cross-border
royalty payments on the R&D activities of multinational firms. High withhold-
ing tax rates make it costly for foreign subsidiaries to import technology from
their U.S. parents. The high cost of technology should stimulate local R&D if
local R&D is a substitute for imported technology, or dampen local R&D if it
is a complement for imported technology. Hines tests a model of subsidiary
R&D activity using country-level data on tax rates and R&D expenditures by
U.S. subsidiaries. He examines the effect of royalty taxes on the local R&D
intensities of foreign affiliates of multinational corporations, looking both at
foreign-owned affiliates in the United States and at U.S owned affiliates in
other countries. He finds that higher royalty taxes are associated with greater
R&D intensity on the part of affiliates, suggesting that local
R&D
is

R.
Glenn Hubbard
tion about cross-country differences in tax rates to estimate separate effects on
remittances attributable to the permanent and transitory components of tax
prices of dividend repatriations. The intuition is that, while cross-country dif-
ferences in average repatriation tax prices or statutory tax rates are correlated
with permanent components of tax price variation, they are uncorrelated with
transitory variations. Hence, these measures can be used
to
construct instru-
mental variables for tax prices that permit separate identification of permanent
and transitory tax price effects. Altshuler, Newlon, and Randolph find that the
transitory tax price effect is larger than the permanent effect, suggesting that
subsidiaries concentrate repatriations to U.S. parents in periods in which the
tax prices of repatriations are transitorily low.
Kenneth Froot and James Hines argue that the investment and financing of
multinational firms may be affected by the changes in interest allocation rules
introduced by the Tax Reform Act of 1986. The rules reduce the tax deductibil-
ity of interest expenses for firms in excess foreign tax credit positions. The
resulting increase in the cost of debt finance gives firms incentives to use forms
of financing other than debt. Furthermore, to the extent that perfect substitutes
for debt are not available, the overall cost
of
capital rises. Froot and Hines test
this proposition by comparing investment before and after 1986 by firms in
deficit credit and excess credit positions, holding constant other determinants
of investment. The study analyzes data
on
416 firms with international business
operations. The authors find that, over the 1986-91 period, firms that could not

Any judgment about the wisdom of tax changes that raise or lower the profit-
ability of American firms’ foreign operations must involve some judgment as
to the desirability of increasing or decreasing the extent of these operations.
The purpose of this paper is to review past research on the effects of U.S.
firms’ overseas activities on the U.S. economy and to report some further anal-
ysis with more recent data.
The first question to be answered
is
what we mean by the U.S. economy.
The ambiguity of the term troubles appraisals of many policies. One way of
looking at it is to ask whether the object is to maximize gross national product
or gross domestic product. The former is an ownership-based concept that in-
cludes the profits from overseas operations of US. firms and other income
earned overseas by U.S. residents, but excludes profits earned in the United
States by foreign residents. The latter is a geographically based concept that
covers production that takes place in the United States, regardless of owner-
ship. It thus excludes profits and other income earned overseas (from overseas
production), but includes all income earned in the United States (from produc-
tion in the United States) by both U.S. and foreign residents. One way in which
the distinction surfaces in policy discussions is over whether various types of
assistance or preferences are to be applied to U.S controlled firms, regardless
of where they operate, or to firms producing in the United States, whether
domestically or foreign owned.
I
will
try
to construe the issue broadly. That means
I
will consider effects of
outward foreign direct investment on the labor employed in the United States

a decline in that share. The inadequacy of the fixed-market assumption is obvi-
ous in any attempt to examine the impact of direct investment in service indus-
tries since the nature
of
most of these industries precludes substantial exporting
from one country to another and market share is almost completely contingent
on production at the site of consumption. While this is most obvious for service
industries, it applies equally to the service component of manufacturing indus-
tries, a major part of the final value of sales of manufactured products.
1.1
The
Growth
of
Internationalized Production
The establishment of foreign operations by American firms-and the estab-
lishment by any country’s firms of production, including sales and service ac-
tivities, outside the home country-is often referred to as the internationaliza-
tion of production. In order to understand the process, and the reasons behind
it, it is useful to ask whether it is uniquely or mainly an American phenomenon
or is, under some circumstances, common to foreign firms as well.
The studies
of
Cleona Lewis (1938) and Mira Wilkins (1989) on foreign
investment in the United States make
it
clear that direct investment and interna-
tionalized production were not an American invention. When the United States
lagged technologically in many fields, foreign firms found it profitable to de-
velop marketing and production facilities in the United States to exploit their
superior sophistication. The industrial distributions of these operations from

Not only was direct investment the dominant form of U.S. outward invest-
ment, but the United States was the dominant source of the world’s direct in-
vestment for a long period. The U.S. share of the world’s stock of outward
direct investment was over half around
1970,
with the United Kingdom, the
next most important investor, far behind at about
15-17
percent and no other
single country the source of more than
6
percent. The share of the developed
countries’ outward direct investment flows originating in the United States was
well over half in the
1960s
and still over
40
percent in the
1970s.
In the late
1980s,
however, less than
20
percent of the world’s outward flows originated
in the United States, and in a reversal of roles, the United States absorbed over
40
percent of the flows from other countries (Lipsey
1993).
In the early
1990s,

The peak in the extent of internationalization in this sense for the US. econ-
omy as a whole was reached some time in the late
1970s
(we cannot date it
more closely because comprehensive data exist only for occasional foreign
investment census years). For example, employment in all overseas affiliates
of U.S. firms was almost
11
percent of total U.S. nonagricultural employment
in
1977,
but only
7.5
percent in
1989.
Plant and equipment expenditures by
majority-owned foreign affiliates were over
15
percent of domestic U.S. plant
and equipment expenditures in U.S. dollars in
1974-76
but fell below
10
per-
cent from
1984
to
1988
and have not recovered their earlier levels. Since the
exchange value of the U.S. dollar was low in the late

so
far not to earlier peak levels.
Within those U.S. firms that are multinational, the changes have not been
so
sharp, partly because of the importance of manufacturing firms in the universe
of multinationals. However, the time pattern has been similar since
1977
(there
is little parent firm information available before that).
Within manufacturing multinationals, foreign affiliate net sales, a crude
measure of production, were larger in the late
1980s
relative to parent sales
than in
1977,
and affiliate employment was close to the earlier levels relative
to parent employment. Thus, this group of firms has not exhibited the shift
away from internationalized production that has characterized U.S. multina-
tionals in general or the U.S. manufacturing sector as a whole. The affiliate
share of production may even have increased (though it is too volatile to pro-
vide a quick judgment that there is an upward trend), and the affiliate share of
employment has not changed much since
1977.
The strongest case for increased internationalization in U.S. manufacturing
is in exports. Affiliates accounted for less than
a
third of U.S. multinationals’
worldwide exports in
1966,
but for more than half in the second half of the

to a little over
50
percent in
1988-90.
Thus, the
shrinking of many large, established
U.S.
manufacturing firms affected both
their domestic and their foreign employment. The many anecdotes about the
shifting of domestic employment abroad do not seem to add up to much in the
aggregate, especially for the U.S. economy as a whole.
There is one reason why it is as yet difficult to judge whether the apparent
retreat of
U.S.
firms from foreign operations during the
1980s
is a long-term
trend. The enormous shift in direct investment toward
the
United States by
foreign firms, to the point where the United States absorbed an unprecedented
share of the rest of the world’s outflow of direct investment, suggests that the
United States was an exceptionally attractive location for investment during
this period. If that was the case, it might have been particularly attractive, rela-
tive to locations in other countries, to American firms
as
well as to foreign
11
Outward Direct Investment
and

rising, but that rise has been offset by the fall in the much larger
U.S.
share.
Internationalized production by firms from other countries has almost certainly
been rising, but it is starting from too low
a
level to have much impact on the
total. The share of such production in worldwide GDP may have been in the
range of 10-15 percent in 1990. The U.S. companies accounted for half or
more of this total, and if the rise from the recent low point in 1988 continues,
internationalized production will again be of growing importance.
A less equivocal story can be told about the share of production outside
home countries in world trade in manufactured goods. That share is clearly
over 10 percent and seems to have risen even since 1977, mainly because of
the growth of Japanese affiliate exports, but also because U.S. affiliates have
held on to or even increased their shares since 1977. Thus, world trade in man-
ufactures, if not necessarily aggregate world production or employment, is in-
creasingly made up of exports from internationalized production.
What can we conclude from these trends in the extent of internationalized
production? The practice of producing outside the home country is well en-
trenched, especially in manufacturing, not only for US based companies but,
increasingly, for firms based in other countries. It is increasingly common for
firms in at least the more successful developing countries, such as Korea and
Taiwan. Presumably, it is an avenue for increasing profitability, probably
through increasing market shares that provide economies
of
scale in the exploi-
12
Robert
E.

1990s retained a share a little above that
of
1966. How was this relative sta-
bility achieved? Performance was very different for the parent firms,
exporting from the United States, and the affiliates, exporting from other
countries.
Until at least 1985, the parent firms lost less of their world export shares
than did nonmultinational U.S. firms (table
1.3).
Then the parent share fell
sharply, more rapidly than that of other U.S. firms. In the meantime, more and
more
of
multinational exports were supplied by their overseas affiliates, more
than half since 1986, and a record high proportion in 1990-92. Thus, one way
the U.S. multinationals kept their export markets, as the United States lost
Table
1.1
U.S.
Share
of
World"
Exports
of
Manufacturedb Exports
(%)
Year Share
1966 17.1
1977 13.2
1982 14.6

Economy
Table 1.2
Exports
by
U.S.
Manufacturing Multinationals" as a Share of World
Manufactured
Exports
(%)
Year Share
1966 15.8
1977 15.5
1982 17.4
1985 18.1
1986 16.6
1987 15.6
1988 16.1
1989 16.4
1990 16.1
1991 16.4
1992 16.0
Source:
United Nations trade tapes and Lipsey
(1995).
Nore:
For
other definitions,
see
table
1.1.

Nore:
For
definitions,
see
tables
1.1
and
1.2.
competitiveness in their industries, was by supplying these markets increas-
ingly from overseas operations, a strategy obviously not available
to
nonmulti-
national
U.S.
firms. (The affiliate shares included in this calculation are only
shares of export trade and exclude the much more important affiliate sales in
their host-country markets.)
This
rise
in the importance of exporting from foreign affiliates was not