Trans-Atlantic Public Economics Seminar

NBER Reporter: Summer 2000

Trans-Atlantic Public Economic Seminar

The NBER's annual Trans-Atlantic Public Economics Seminar, on "Taxation of Financial Income," took place in Gerzensee, Switzerland, on May 22-4. Roger H. Gordon, NBER and University of Michigan, and Philippe Bacchetta, Studienzentrum Gerzensee, organized the conference and selected the following papers for presentation:

Lars P. Feld and Gebhard Kirchgassner, Universität St. Gallen, "The Impact of Corporate Income Taxes on Employment: Some Panel Evidence for the Swiss Cantons"

Discussants: James M. Poterba, NBER and MIT, and Lans Bovenberg, Tilburg University

Christian Keuschnigg, Universität des Saarland, and Søren Bo Nielsen, Copenhagen Business School, "Tax Policy, Venture Capital, and Entrepreneurship"

Discussants: Thomas Gehrig, Universität Freiburg, and Kevin A. Hassett, American Enterprise Institute

Rosanne Altshuler, Rutgers University, and Harry Grubert, U.S. Department of the Treasury, "Repatriation Taxes, Repatriation Strategies, and Multinational Financial Policy"

Discussants: Mihir A. Desai, NBER and Harvard University, and Michael Devereux, Warwick University

Rosanne Altshuler, and R. Glenn Hubbard, NBER and Columbia University, "The Effect of the Tax Reform Act of 1986 on the Location of Assets in Financial Services Firms"

Discussants: Henry Tulkens, CORE, and Bernd Huber, Universität Munchen

Eric Engen, Federal Reserve Board of Governors, and William Gale, Brookings Institution, "Effects of 401(k) Plans on Household Wealth" (NBER Working Paper No. 7392)

Discussants: R. Glenn Hubbard, and Andrew A. Samwick, NBER and Dartmouth College

James M. Poterba and Andrew A. Samwick, "Taxation and Household Portfolio Composition: U.S. Evidence from the 1980s and 1990s"

Discussants: William Gale and Rosanne Altshuler

Harry Huizinga, Tilburg University, and Søren Bo Nielsen, "Withholding Taxes or Information Exchange: How to Tax International Interest Flows"

Discussants: Alan J. Auerbach, NBER and University of California, Berkeley, and Philippe Bacchetta

Alan J. Auerbach and Kevin Hassett, "On the Marginal Source of Investment Funds" (NBER Working Paper No. 7821)

Discussants: Søren Bo Nielsen, and William M. Gentry, NBER and Columbia University

Thomas Gehrig, "Capital Income Taxation in Frictional Asset Markets"

Discussants: Eckhard Janeba, NBER and University of Colorado, and Christian Keuschnigg

Clemens Fuest and Bernd Huber, Universität Munchen, and Søren Bo Nielsen, "Why Is the Corporate Tax Rate Lower than the Personal Tax Rate?"

Discussants: Roger H. Gordon and Lars P. Feld

The impact of corporate income taxes on the location decisions of firms is a frequent subject of discussion. While there has been some evidence of personal income tax competition between the Swiss states (cantons), little information has been available on the impact of differences between cantons in corporate income taxes on the location decisions of businesses within Switzerland. Using a panel dataset of the 26 Swiss cantons from 1984 to 1997, Feld and Kirchgassner present econometric evidence on the influence of corporate income taxes on the location of firms and on cantonal employment. They show that corporate income taxes deter firms with above average rates of return from locating in a canton and reducing cantonal employment.

Keuschnigg and Nielsen study the effects of tax policy on venture capital activity. In their model, entrepreneurs pursue their own single high-risk project but have no resources of their own. Financiers provide equity finance. In addition to providing equity finance, venture capitalists assist with valuable business advice to enhance survival rates. This paper investigates the effects of taxes on the equilibrium level of entrepreneurship and managerial advice. The authors consider differential wage and capital income taxes, a comprehensive income tax, incomplete loss offset, progressive taxation, and investment and output subsidies to the entrepreneurial sector.

The literature on the behavior of multinational corporations (MNCs) tends to focus on a limited range of financial flows between foreign affiliates and parents. In the standard model, the MNC chooses between direct dividend distributions to the parent and further real investment in the foreign affiliate. However, real investment in the foreign affiliate is only one of many alternatives to direct dividend repatriations. The MNC can engage in a variety of other strategies that have the effect of achieving the equivalent of repatriation without incurring the home country tax on direct repatriations of low-tax income. Altshuler and Grubert explore several of these strategies. They show how the availability of different strategies can have an effect on real investment both for a low-tax subsidiary and throughout a worldwide corporation. Using firm level data for U.S. MNCs and their affiliates, they conclude that controlled foreign corporations that face high repatriation taxes make larger investments in related affiliates and send a greater share of their dividends to other foreign affiliates. In addition, those corporations pay off more local debt as they accumulate retained earnings.

Altshuler and Hubbard examine the effects of the Tax Reform Act of 1986 on the international location decisions of U.S. financial services firms. Among other changes, the act made it substantially more difficult for U.S. MNCs to defer U.S. taxes on overseas financial services income. The same rule changes were not applied to other forms of income, though. In particular, income generated from active manufacturing operations was still eligible for deferral after the act was passed. Using information from the tax returns of U.S. corporations for 1984, 1992, and 1994, Altshuler and Hubbard find that, before the 1986 act, the location of assets in financial subsidiaries responded to differences in host-country effective tax rates across jurisdictions. After the act, however, differences in host-country effective tax rates no longer explained the distribution of assets held in financial services subsidiaries abroad. At the same time, the assets held in manufacturing subsidiaries became more sensitive to variations in effective tax rates over time. Taken together, these results suggest that the tightening of the antideferral provisions applicable to financial services companies has been successful in neutralizing the effect of host country income taxes on the investment location decisions of financial firms.

Engen and Gale provide a new econometric specification and new evidence on the impact of 401(k) plans on household wealth. Allowing the impact of 401(k)s to vary over both time and earnings groups, and including the impact of 401(k)s on wealth, wealth-earnings ratios, and the natural logs of these values, their specification generalizes earlier work in the literature. Using data from the Survey of Income and Program Participation, they show that the impact of 401(k)s on wealth varies significantly by earnings level; 401(k)s held by groups with low earnings or low saving in other forms are more likely to represent net wealth than 401(k)s held by high-earnings or high-saving groups; and, between 0 and 30 percent of 401(k) balances represent net additions to saving.

Poterba and Samwick explore the relationship between household marginal income tax rates, the set of assets that households own, and the portfolio shares accounted for by each of these assets. They use data from the 1983, 1989, 1992, and 1995 Surveys of Consumer Finances and develop a new algorithm for imputing federal marginal tax rates to households in these surveys. They find that a household's marginal tax rate has an important effect on its asset allocation decisions. The probability that a household owns tax-advantaged assets is related strongly to its tax rate on ordinary income. In addition, the amount of investment through tax-deferred accounts, such as 401(k) plans and Individual Retirement Accounts, is an increasing function of the household's marginal tax rate. Holdings of corporate stock -- which is taxed less heavily than interest-bearing assets -- and of tax-exempt bonds also increase along with the household's marginal tax rate. Holdings of heavily taxed assets, such as corporate bonds and interest-bearing accounts, decline as a share of wealth as the household's marginal tax rate increases.

Huizinga and Nielsen consider withholding taxes and information exchange as alternatives for taxing international interest income. For each regime, they consider the maximum level of taxation of foreign-source income that can be sustained as the equilibrium of a repeated game. The "best" regime is the one that brings the level of taxation in the repeated game closest to the cooperative level of interest taxation. Sustainable levels of taxation in either regime depend, among other things, on the importance of bank profits and on the marginal cost of public funds. There also is an explicit possibility of the emergence of a mixed regime, with one country imposing a withholding tax and the other country providing information. The authors' basic model is extended to allow for size differences between the two countries and to incorporate a third, outside country.

Few important issues in corporate or public finance have remained unsettled for as long as the related questions of how corporations finance their new investment projects and how taxes affect their investment decisions. In particular, there is a long-standing controversy over the extent to which taxes on dividends affect investment. To address these issues, Auerbach and Hassett find evidence that dividends do respond to investment and cash flow for the nonfinancial corporate sector as a whole. They also find that this dividend pattern varies according to firm characteristics that relate to capital market access. These results suggest that the impact of taxation may vary across firms of different types.

Gehrig shows that capital income taxation does affect information aggregation in frictional markets. He provides conditions under which a tax increase raises or reduces the transparency of prices and market depth. Gehrig shows that tax policies incorporate implicit subsidies or taxes on informed traders and hedgers. A welfare assessment of capital income taxes thus has to explicitly consider the differential effects of capital income taxes on investors with different degrees of proprietary information.

In many OECD (Organization for Economic Cooperation and Development) countries, statutory corporate tax rates are lower than personal income tax rates. Fuest, Huber, and Nielsen suggest that this tax rate differentiation is optimal if there are problems of asymmetric information between investors and firms in the capital market. The reduction of the corporate tax rate below the personal tax rate encourages equity financing and thus mitigates the excessive use of debt financing induced by asymmetric information. This theoretical result stands in marked contrast to the traditional view of corporate taxation and corporate finance theory, according to which there is a tax disadvantage to equity financing. However, more recent empirical evidence on this issue is in line with the authors' result.

These papers will be published in an upcoming issue of the Journal of Public Economics. In advance of publication of the journal, these papers are available at Books in Progress.

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