Foreign Investment and Taxation

Abstract

The relationship between cross border taxation and free float home bias is examined. This explicitly recognizes that insider shares are unavailable to foreigners. Other important explanations for home bias - information asymmetry, behavioural and governance issues – are controlled when examining the impact of cross border tax variables. In our sample of countries about half (three-quarters) withhold taxes on realized capital gains (dividends) of foreign investors and about half of the mature economies provide imputation of taxes paid on dividend income by domestic corporations. A tax credit variable for foreign taxes paid is constructed and found to be statistically significant in reducing home bias. A foreign tax rate too high to be fully offset by tax credits is found to significantly increase home bias. Dividend imputation is a statistically significant impediment to cross border equity flows. The benefit of investor familiarity with foreign opportunities for reducing home bias is found to be mitigated by higher potential for foreign taxation of capital gains.