Ebook Corporate Taxation, Debt Financing and Foreign Plant Ownership
There is a large body of literature indicating that the financial decisions of firms are systematically affected by company taxation (see Graham, 2003, for a comprehensive survey). Most importantly, interest on debt is deductible from the tax base, while the return on equity is not and, therefore, firms have an incentive to raise leverage above the optimal level without taxation.
The tax-induced advantage of debt increases with the statutory corporate tax rate, and it exists irrespective of whether a firm is owned by a domestic or a foreign shareholder. A multinational firm, however, is able to minimize its tax payments by allocating debt over all locations where it operates. The tax savings due to debt shifting depends on the differential between the parent and the host country statutory corporate tax rates. Accordingly, multinationals can reduce their tax payments by shifting debt from a low-tax jurisdiction to a high-tax jurisdiction taking advantage of the high-interest deduction in the high-tax jurisdiction (see, e.g., Mintz and Smart, 2004, for a theoretical analysis).
To identify the existence and the extent of debt shifting, previous empirical research relied on a sample of multinational firms exclusively (Hines, 1997, and Devereux, 2006, provide comprehensive surveys). For instance, Desai, Foley, and Hines (2004) use a dataset of U.S.-owned foreign companies, and Huizinga, Laeven, and Nicod`eme (2006) focus on a large dataset of European multinationals. Both studies find that the financing decisions of multinational firms are systematically affected by corporate taxation. One concern with this evidence is that the estimates might have been influenced by the non-random selection of a sample of multinational firms.
This paper is rooted in the above mentioned research, but the identification strategy is different. Taking into account that multinational firms have more opportunities to exploit tax-induced advantages of debt financing than national firms, we argue that a comparison of the DR of comparable foreign and domestically-owned firms provides an estimate of the extent to which debt financing is influenced by foreign-plant ownership. Hence, in contrast to previous empirical work, we explicitly use national firms as a reference category to assess the effect of foreign plant ownership on debt financing decisions. We adapt a standard model of taxation and financing decisions of firms for the case of international debt shifting activities of foreign-owned firms.
The theoretical framework delivers testable hypotheses on the average difference between the DR of national and multinational firms, and how this difference is influenced by the corporate tax burden in the host country. We test these predictions using a large data-set of 32,067 European firms. In line with a large body of theoretical and empirical research, we treat foreign plant ownership as endogenous. Technically, we use propensity score matching techniques to avoid the potential bias of the treatment effect of foreign plant ownership on firm level DR. Our findings suggest that foreign-owned firms have higher DR than their domestically-owned counterparts. Further, we observe that this difference increases with the corporate tax burden of the host country. These results point to the potential importance of debt shifting as a widely used practice in international tax planning of multinational firms.
The remainder of the paper is organized as follows. In the next section we employ a model with financing decisions to derive the main hypothesis regarding the effects of taxation on the debt policy of domestically and foreign-owned firms. Section 3 discusses the estimation approach, presents the data and the estimation results. Finally, Section 4 concludes.
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