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This paper analyzes the marginal source of funds for foreign investment using both aggregate and micro data on the intrafirm transactions of U.S. international firms. Tax arbitrage regarding the form and timing of transactions, combined with risks involved with foreign operations and the desire of the parent to control subsidiaries, suggests that parent transfers provide the marginal source of funds for most foreign investment. Our conclusion is consistent with the seemingly puzzling evidence that some subsidiaries have positive dividends and transfers simultaneously despite the associated tax penalties, and others neither pay dividends nor receive transfers. Our analysis and empirical evidence are in sharp conflict with the widely-held tax capitalization view that retained subsidiary earnings are the marginal source of financing foreign investment.

International business enterprises.

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The effects of taxes on direct investment capital outflows are investigated using a theoretical model which integrates the investment and financial decisions of the parent and subsidiary. The resulting marginal qs and costs of capital show that intrafirm investment allocation and tax neutrality results critically hinge on the marginal financing regime. By identifying a channel(s) through which a specific tax policy affects firm decisions, the model evaluates the combined effects of the home country tax system on direct investment. Out analysis suggests that while the 1986 U.S. Tax Reform Act may have an ambiguous effect on the overall level of capital outflows, it may induce more equipment investments to be undertaken abroad.

Investments, Foreign. --- Investments, Foreign --- Decision making.

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The evidence presented in this study confirms that tax-induced changes in the profitability of investment have had a powerful effect on the share of GNP devoted to nonresidential fixed investment. More specifically, we have reestimated two models of aggregate investment initially presented in Feldstein, "Inflation, Tax Rules and Investment: Some Econometric Evidence,"(Econometrica, 1982). The present study extends the previous analysis byusing revised national income accounts, by improving the estimation of the effective tax rate and the profitability of new investments, and by extending the sample to include the years 1978 through 1984. Despite these changes, the new statistical estimates are remarkably close to the previous results. The statistical estimates are also very robust with respect to sample period, estimation method, and the presence of other variables.The first model relates the investment-GNP ratio to the real net-of-tax rate of return received by the providers of debt and equity capital to the nonfinancial corporate sector and to the rate of capacity utilization. Our estimates imply that each percentage point increase in the real net return raises the investment-GNP ratio by 0.4 percentage points. A one percent age point increase in the net return is equivalent to a ten percentage point reduction in the overall effective tax rate. Since the net nonresidential fixed investment averaged 3 percent of GNP during the past three decades, a ten percentage point tax reduction induces a 13 percent rise in the investment-GNP ratio.Our second model relates the investment-GNP ratio to the difference between the maximum potential net return that firms can support by investing in a "standard investment project" and the net cost of debt and equity capital. The statistical estimates imply that each percentage point change in this measure of the rate of return over cost raises the investment-GNP ratio by 0.3 percentage points or 10 percent of its three-decade average.The estimates imply that the 1985 tax bill passed by the House of Representatives would reduce the investment-GNP ratio by between 10 percentand 15 percent of its average value, depending on the model used to make the calculation. Such reductions would represent between one-half and three-fourths of the rise in the investment-GNP ratio since the 1981 investment incentives were adopted.

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