What is the Marginal Source of Funds for Foreign Investment?
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.
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