Hines Jr., James R., NBER Reporter
James R. Hines Jr. [*]
The ability and evident willingness of taxpayers to relocate activity, to shift taxable income between jurisdictions, and to respond to incentives created by the interaction of domestic and foreign tax rules, mean that the tax policies of other countries obviously must be considered in the formulation of domestic policy. In the current environment, almost every U.S. tax provision influences foreign direct investment (FDI) or provides incentives for international tax avoidance.
Research in the field of public finance reflects a growing awareness of the importance of foreign tax policies; over the last ten years, there have been many new quantitative studies of the impact of taxation in open economies.  This research considers how tax policies affect three aspects of economic activity: FDI, international tax avoidance, and economic efficiency.
Foreign Direct Investment
Tax rate differences over time and between countries can be very large, thereby significantly affecting aftertax returns to FDI. By now there is ample evidence that countries with lower tax rates receive much more FDI than do countries with higher tax rates. And, for a given country, FDI is greater in years in which associated tax burdens are lighter.  To be sure, there are important complications to this otherwise very simple story. The ability of taxpayers to adjust the financing of FDI, and the repatriation of profits to home countries, also can affect the magnitude of FDJ.  Furthermore, one of the stumbling blocks confronting efforts to estimate the impact of taxes on FDI is the importance of other nontax considerations--such as market size and proximity, local factor prices, and local infrastructure--and the possibility that they are correlated with tax rates.
There have been several efforts to identify the impact of tax rates on FDI in a way that removes as much as possible of the effect of correlated omitted variables. The U.S. Tax Reform Act of 1986 (TEA) provides one such opportunity, since it was a major tax change with important international repercussions, and it affected certain firms and industries differently than it did others. Firm-and industry-level evidence suggests that American companies concentrating in assets not favored by the TRA reacted by increasing their foreign investment after 1986; furthermore, foreign investors in the United States (for whom the TRA provisions had relatively smaller impact) may have concentrated in these more heavily taxed assets in the years after 1986. 
Mihir Desai and I evaluate the impact of the TRA by comparing its effect on FDI undertaken by joint ventures and FDI undertaken by majority-owned foreign affiliates.  The TRA introduced an important distinction between income received from these two foreign sources by requiring Americans to calculate foreign tax credit limits separately for each joint venture. This change greatly reduced the attractiveness of joint ventures, particularly those in low-tax foreign countries. We find that American participation in international joint ventures fell sharply after 1986, while international joint venture activity by non-American firms rose. The drop in American joint ventures was most pronounced in low-tax countries, which is consistent with the incentives created by the TRA. Furthermore, after 1986 American joint ventures used more debt and paid greater royalties to their American parents, reflecting their incentives to economize on dividend payments.
Other types of comparisons offer useful evidence of the effect of taxation on FDI. The distribution between U.S. states of investment from countries that grant foreign tax credits with investment from all other countries provides one such comparison. The ability to apply foreign tax credits against home-country tax liabilities reduces an investor's incentive to avoid high-tax foreign locations. I find that differences in state corporate tax rates of a single percent are associated with differences between the investment shares of foreign-tax-credit investors and the investment shares of all others of 9 to 11 percent. …