The Effects of the Taxation of Dividends on the Allocation of Foreign Portfolio Investment Around the World

Abstract

Using a new bilateral international tax database, we investigate the effects of dividend taxes on foreign equity portfolio holdings. Extending a model of capital market equilibrium with dividend taxation to an international setting, we provide intuition for a new, seemingly counter-intuitive empirical prediction. The model predicts that a change in the tax rate on dividends from risky assets, which is faced by a country’s domestic investors, is positively related to changes in foreign investors’ portfolio holdings in that country. The evidence from two unique research settings, which exploit changes in the national tax policies of different countries, strongly supports this prediction. These policy changes affected the dividend taxes faced by the country’s domestic investors but not the taxes faced by its foreign portfolio investors. More generally, the model predicts that a foreign investor’s equilibrium holdings in a country is negatively related to the dividend tax rate that she directly pays on assets in that country and positively related to the weighted-average dividend tax rate of worldwide investors in that country. Results from analysis using panel data provide strong empirical support for these predictions. These analyses also provide clarity regarding the mixed findings in the prior literature on the negative relation between withholding taxes and foreign portfolio investment. Combining the evidence across all analyses, the results are consistent with a country’s weighted-average dividend tax rate of worldwide investors affecting foreign investors’ portfolio allocations.