Affiliates in low-tax jurisdictions use trade credit to lend, whereas those in high-tax jurisdictions use trade credit to borrow.
International tax rate differences are sizeable and apparent. In general, high rates of taxation increase the cost of capital, reducing investment levels and driving up pre-tax returns. As a result, tax rate differences create incentives to transfer capital from low-tax, low-capital-cost, low-return users to high-tax, high capital-cost, high-return users by delaying or accelerating the payment of trade accounts.
In Trade Credit and Taxes (NBER Working Paper No. 18107), authors Mihir Desai, Fritz Foley, and James Hines examine the extent to which taxation influences trade credit practices by affecting the returns to investment. Using comprehensive data collected by the U.S. Bureau of Economic Analysis (BEA) on the operations of U.S. multinational firms, they observe that the foreign affiliates of U.S. multinational firms make extensive use of trade credit: at year end 2004, these affiliates held current accounts receivable of $1.49 trillion and had current accounts payable of $1.39 trillion; each of these exceeded 30 percent of total annual affiliate sales. Their evidence from the worldwide operations of U.S. multinational firms indicates that affiliates in low-tax jurisdictions use trade credit to lend, whereas those in high-tax jurisdictions use trade credit to borrow: 10 percent lower local tax rates are associated with net trade credit positions that are 1.4 percent higher as a fraction of sales.
Managers have incentives to set accounts receivable and accounts payable in a manner that reallocates capital from lightly taxed operations where investment opportunities have dissipated to highly taxed operations in which profitable opportunities remain. This mechanism implies that net working capital positions -- or the difference between accounts receivable and accounts payable -- should be higher for firms facing lower tax rates. In this study, the detailed data on the foreign affiliates of U.S. multinational firms make it possible for the authors to observe affiliates of the same firm operating in different countries and therefore facing different corporate income tax rates.
The authors find several patterns suggesting that firms use working capital positions to reallocate capital in response to taxation. Their data indicate that affiliates in low tax jurisdictions have higher net working capital positions than do other affiliates. The tax pattern is strongest among affiliates with the greatest opportunities to use trade credit to reallocate capital and for affiliates that do not appear to have attractive investment opportunities, specifically those with low capital expenditures and high cash holdings.
The authors closely study firm responses to the Homeland Investment Act, which reduced the tax costs of repatriating foreign earnings in 2005. Foreign affiliates with positive net working capital positions were the most likely to increase their repatriations that year, suggesting that these affiliates used trade credit arrangements to reallocate capital prior to the tax holiday.
Taken together, the authors' findings illustrate the effect of taxes on levels of working capital. Firms use trade credit to mitigate the effect of tax differences on the allocation of capital, and their actions imply that tax rate differences across countries significantly affect capital allocation within firms, depressing investment levels in high tax jurisdictions and introducing differences between the productivity of capital deployed in different locations.