International Tax Research Roundup James R Hines Jr

International Tax Research Roundup James R. Hines Jr. University of Michigan and UC-Berkeley February 2009 1

Research excitement. Featured study: The impact of globalization on tax design. ¡ Others: ¡ l l l ¡ Impact of home country tax regimes on the location of FDI and the location of foreign parent companies. Effects of international taxation on takeover premia. Efficient tax treatment of domestic expenses that generate foreign income. Lots of international tax research excitement these days. 2

Cross-country tax policy comparisons. Paper: “How globalization affects tax design. ” ¡ Authors: James Hines (University of Michigan and UC-Berkeley) and Lawrence Summers (Harvard University and National Economic Council). ¡ NBER Working Paper No. 14664, January 2009. ¡ Forthcoming for publication in Tax Policy and the Economy, volume 23 (University ¡ 3

Problems that governments face (1). ¡ ¡ The same economic forces that bring prosperity also create strong demands for government action. For example, significant changes in domestic income distribution coincide with expansions to international trade and investment. Between 1979 and 2005… l l ¡ ¡ The lowest quintile’s share of U. S. family income fell from 5. 8% to 4. 0%. The highest quintile’s income share rose from 45. 5% to 55. 1%, and the top one percent’s share rose from 9. 3% to 18. 1%. The relative worsening of the positions of the middle class and the disadvantaged relative to the rest of society creates equity-based demands for education and training programs, as well as further redistribution through taxes and transfers. These measures place serious demands on the tax 4

Problems governments face (2). ¡ ¡ ¡ Health care costs have risen sharply in recent decades, a trend that shows few signs of slowing. Recent projections anticipate per capita U. S. health care costs roughly to double over the next ten years, imposing per capita annual costs in 2017 of more than $6, 000 on all levels of government and more than $6, 000 on employers and patients. This is a significant expense for government (almost $1. 5 trillion/year by 2017), and adds to the need to provide security for low income 5

More problems…(3). ¡ ¡ The United States has serious needs for repairs and improvements to highways and roads, airports and ports, sewers and other utilities, telecommunications, and infrastructure generally. International competition only strengthens the need for modern infrastructure. An aging society requires secure funding of social security, disability benefits, and other programs providing equitable treatment and social assistance. The need for national and global environmental protection mandates action that is potentially very expensive. And we will some day need to pay for the current economic stimulus. 6

Problems (4)…: The effects of globalization on tax revenue. ¡ ¡ By contributing to prosperity, greater international economic integration makes it possible to raise significant amounts of tax revenue. At the same time, however… Greater international mobility of goods, people, businesses, intangible assets, and portfolio and direct investment capital increases the mobility of the tax base and the distortions associated with any given level of taxation. International mobility also facilitates the use of exciting new methods to avoid domestic tax liabilities. Globalization turns all countries into small countries. 7

What does theory say? ¡ ¡ There are many realistic scenarios in which competition together with mobility depresses tax rates and erodes tax bases. The efficiency cost of taxing capital income together with avoidance behavior by taxpayers puts upper limits on the income tax rates governments are willing to impose. Countries that maintain high tax rates while others reduce them are apt to lose economic activity and the taxes that go with it. All of this makes it hard to maintain equitable distributions of tax burdens with traditional income-based taxes. 8

American policy. ¡ ¡ ¡ The United States has a relatively small public sector, accounting for about 26% of GDP, significantly lower than the 36% OECD average. (2004 figures) U. S. personal income taxes account for a much higher fraction (35%) of total U. S. taxes than is true of the OECD average (25%). The U. S. gets 8. 7% of its tax revenue from corporate taxes (v. 9. 6% for the OECD average) [2004 data]. Taxes on goods and services are much lower for the U. S. (18% of revenue) than for the OECD (32%). The top U. S. personal income tax rate of 41% is typical of OECD countries, though the U. S. corporate income tax rate of 39% is the highest in the OECD, well above the 30% average. The United States still has a large country tax policy. 9

Tax policies around the world. ¡ ¡ The tax policy challenges facing the United States due to globalization have confronted small open economies for many years; in that sense, large countries are now catching up with them. Globalization is a process that makes every country small, which is why it is interesting to consider the tax policies that small countries use. The evidence indicates that governments of countries with small open economies have relied relatively little on personal income taxes and corporate income taxes, instead using trade taxes and taxes on sales of goods and services. The difficulty and distortions of using income taxes has driven much of the world in the direction of expenditure taxation. 10

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Analysis. ¡ The statistical evidence supports what is apparent from the charts. l l ¡ ¡ In 1999, 10% greater national population is associated with 1% less reliance on corporate and personal income taxes, controlling for economic conditions. Similar conclusions appear in changes over time, as populations rise and fall relative to each other. Some of this pattern reflects the growing popularity of VATs. As the world relies increasingly on expenditure taxation rather than income taxation, countries such as the United States will face intensifying pressures to move its tax policy in that direction. 16

Interpretations. ¡ Globalization increases the costs of using corporate income taxes and personal income taxes. l l ¡ ¡ International cooperation might mitigate these costs. In the absence of cooperation, small countries have responded to these costs by relying less on income taxes and more on taxes that are expenditure based (such as VATs). l l l ¡ Tax base erosion. Economic distortions due to changed behavior. Expenditures are typically less internationally mobile than is income production. Expenditure taxation offers fewer ready avoidance opportunities. Use of VATs in place of income taxes raises important issues of equity. Future tax policies of large countries may more closely resemble those of small countries today, posing significant policy challenges. 17

Home country tax effects on FDI. Paper: “International taxation and multinational firm location decisions, ” Oxford Centre for Business Taxation working paper 08/25, October 2008. ¡ Authors: Salvador Barrios (EC), Harry Huizinga (Tilburg University), Luc Laeven (IMF), and Gaetan Nicodeme (EC). ¡ Data (Amadeus) on European multinationals in 33 European countries, 1999 -2003. ¡ 18

The method of analysis. ¡ The paper takes the sample of all new foreign subsidiaries established between 1999 and 2003, and asks: l l ¡ What factors determine where the subsidiary is located? What factors determine the home country of the parent of that subsidiary. The statistical problems are immense, and the paper takes only a simple pass at them; nonetheless, the results are interesting. 19

Findings. ¡ ¡ ¡ 1% higher local taxes reduce the probability of a subsidiary being located there by 0. 6% (controlling for economic and political conditions, geographic proximity, other factors). Cross-border taxes (dividend withholding taxes and home country taxes on foreign income) have significant and slightly larger negative effects (1% lower probability for 1% higher taxes) than local effective taxes. Turning the method around, the paper considers who owns an affiliate. 1% higher taxes on ownership of an affiliate reduces by 3% the 20

Takeover premia and international taxation. Paper: “International taxation and takeover premiums in cross-border M&As, ” Oxford Centre for Business Taxation working paper 08/26, October 2008. ¡ Authors: Harry Huizinga, Johannes Voget and Wolf Wagner, Tilburg University. ¡ Data (Thompson Financial SDC) on 948 M&As in Europe, U. S. and Japan from 1985 -2004. ¡ Tax effects on acquisition premia (over stock price 4 weeks before ¡ 21

Home country tax burdens. ¡ ¡ ¡ There is considerable variation in new taxes triggered by acquisitions. European acquirers tend to face rather low tax rates (exemption systems and the parent-subsidiary directive), whereas parent companies located in Japan (21%) and the U. S. (11%) face the highest average acquisition-related tax rates. For the whole sample, 51. 4% of acquisitions were associated with higher taxation, but that was true of 100% of the acquisitions involving parent companies from Belgium, France, Japan and the U. S. (Note that the Belgian and French tax rates were rather low. ) The average takeover premium was 47%, but varied by country of parent company. 22

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Target country tax burdens. ¡ ¡ The two most significant locations for target companies are the U. S. and U. K. , accounting for almost two-thirds of total acquisitions, by number and by value. There is considerable variation in new taxes by country of target company. The average tax rate is 3. 95%, with U. S. targets triggering a relatively low 2. 2% additional tax. The average takeover premium for targets located in the U. S. was 53%, the second highest of any country (Denmark was the highest at 67%). (Average is 47%. ) Scatterplots indicate that overall new taxes, and withholding taxes, are negatively related to takeover premia. 24

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Statistical results. ¡ ¡ There are strong tax effects on takeover premia, conditioning on many financial variables. Target shareholders lose between $0. 63 -$1 for every additional $1 of acquisition-related taxes. Distinguishing among taxes, $1 of withholding taxes appears to reduce takeover premia by $1, with very strong statistical significance. Parent company shareholder returns on announcement of takeovers is not systematically related to tax effects, suggesting that target firm shareholders bear the tax costs. 28

Domestic deductions. Paper: “Foreign income and domestic deductions, ” National Tax Journal, September 2008. ¡ Author: James Hines (University of Michigan and UC-Berkeley). ¡ Analyzes the efficient tax treatment of domestic expenses (from the home country perspective) in tax systems that are otherwise efficient. ¡ Reports that, if the taxation of foreign income is otherwise efficient, then full domestic deductibility of domestic ¡ 29

How can that be? ¡ ¡ The most counterintuitive aspect of this finding is the case in which the home country exempts foreign income. Why, then, allow domestic deductions for domestic expenses that generate foreign income? A tax system that allocates expenses based on foreign and domestic activity levels implicitly taxes foreign income by reducing deductions for any increment to foreign activity. Hence a tax system that denies domestic deductions based on levels of foreign activity creates an inefficiency by discouraging foreign operations (conditional on levels of domestic activity). If it is optimal to exempt foreign income from 30

More intuition. ¡ ¡ The key to understanding the case for full deductibility is to ask why the home country exempts foreign income from taxation in the first place. If this is an optimal policy (as it is if there is international competition for capital ownership), then it must be the case that foreign income production indirectly stimulates domestic income production. The standard critique of full domestic deductibility is based on a model in which the home country would never want to exempt foreign income from taxation. The paper says this and more, together with some equations to make it all official. 31