U.S. Inflows of foreign direct investment and worldwide versus territorial taxation in capital exporting nations

Financial accountants and economists have long understood that the delineation of the tax base of a capital-exporting country has the potential to significantly influence its residents’ decisions regarding foreign direct investment (FDI). On the one hand, a capital-exporting nation’s government’s national tax bases can be worldwide (or residence-based). Or, on the other hand, it can be territorial (or source-based) taxation by assessing taxes solely on income that residents earn domestically. Thus, from the U.S. point of view as an FDI host country, the tax rates that are relevant in determining FDI inflows from capital-exporting nations abroad depend on whether these nations’ governments utilize worldwide (residence-based) or territorial (source-based) tax systems. Many governments had in past years taxed their residents’ worldwide incomes, so that the most relevant tax rates influencing those residents’ FDI choices had been their home tax rates. Recently, however, a number of countries whose residents export capital to the United States have switched to territorial taxation; indeed, the United States is now the only G-7 nation employing a worldwide system. The consequence has been that an expanding number of residents of capital-exporting nations are weighing the U.S. tax rate against those established by governments in alternative destination countries. In principle, therefore, U.S. inflows of FDI are now likely more sensitive to the relevant U.S. tax rate than previously had been the case. We examine Bureau of Economic Analysis data on US FDI inflows from 52 countries for the period 1982 to the start of the recession in 2008. The data includes standard variables in FDI models (see, for example, Daniels, O’Brien, and von der Ruhr, 2015, “Bilateral Tax Treaties and US Foreign Direct Investment Financing Models,” International Tax and Public Finance, 22(6): 999-1027.), such as GDP growth, population, financial openness, trade openness, corporate tax rates, the real bilateral exchange rate, and a dummy variable accounting for countries adapting a territorial tax system. Preliminary results from a difference-in-difference estimator imply that adoption of a territorial tax system does alter the sensitivity of U.S. FDI inflows to the U.S. corporate tax rate as these inflows decline when a nation adopts a territorial tax system.