Domestic Effects of Foreign Direct Investment
With a Keynote Address by N. Gregory Mankiw, Chairman of the Council of Economic Advisers
the International Tax Policy Forum
About This Event

Rising foreign direct investment, U.S. manufacturing job losses, and cross-border outsourcing arrangements have focused attention on how U.S. tax rules influence decisions by multinational companies to create jobs in the United States and abroad. The recent presidential election campaign included proposals to alter significantly U.S. taxation of income earned by American companies abroad. Sensible tax policy responses require an understanding of the connection between the domestic and foreign operations of multinational companies. This conference presents new research on how investment abroad affects the U.S. economy and includes both historical perspectives and a bipartisan panel discussion of current policy options.

Agenda

8:30 a.m.

Registration

8:50

Opening Remarks: John Samuels, General Electric

Kevin A. Hassett, AEI

9:00

Globalization of Business Operations: Historic Perspectives

Moderator:

James Hines, University of Michigan

Presenter:

Douglas Irwin, Dartmouth College

9:45

Foreign Direct Investment and Factor Markets

Moderator:

James Hines, University of Michigan

Presenter:

Catherine Mann, Institute for International Economics

Commentator:

Robert Lipsey, CUNY and National Bureau of Economic Research

10:45

Coffee Break

11:00

Expansion Abroad and the Domestic Operations of U.S. Multinational Firms

Moderator:

James Hines, University of Michigan

Presenter:

Matthew Slaughter, Dartmouth College

Commentator:

William Randolph, U.S. Treasury Department

Noon

Luncheon

Introduction:

R. Glenn Hubbard, AEI and Columbia University

Keynote Speaker:

N. Gregory Mankiw, chairman, Council of Economic Advisers

1:15 p.m.

Effects of Outbound FDI on Domestic Economic Activity

Moderator:

R. Glenn Hubbard, AEI and Columbia University

Presenter:

Mihir A. Desai, Harvard University

Commentator:

Kevin A. Hassett, AEI

2:15

Does the Tax System Create Excessive Incentives to Move Economic Activity Abroad?

Moderator:

Sebastian Mallaby, Washington Post

Panelists:

Alan Auerbach, University of California-Berkeley

R. Glenn Hubbard, AEI and Columbia University

Matt Slaughter, Dartmouth College

Lael Brainard, Brookings Institution

3:30

Adjournment

Event Summary

December 2004

Domestic Effects of Foreign Direct Investment

Rising foreign direct investment, U.S. manufacturing job losses, and cross-border outsourcing arrangements have focused attention on how U.S. tax rules influence decisions by multinational companies to create jobs in the United States and abroad. The recent presidential election campaign included proposals to significantly alter U.S. taxation of income earned by American companies abroad. Sensible tax policy responses require an understanding of the connection between the domestic and foreign operations of multinational companies. This December 2 AEI conference presented new research on how investment abroad affects the U.S. economy and included both historical perspectives and a bipartisan panel discussion of current policy options.

Globalization of Business Operations: Historic Perspectives

Douglas Irwin
Dartmouth College

Irwin's presentation focused on U.S. direct investment abroad (USDIA). He examined how the amount and nature of USDIA has changed and what these trends tell us. Since 1914, USDIA has transformed from a peripheral component of the economy to now accounting for 25 percent of America's GDP. USDIA initially grew because foreign countries offered new sources of supply and new markets for sales. More recently, USDIA in the manufacturing sector grew because of trade barriers and the advantages of producing near local markets. Increasing international legal protection for foreign investments has also fueled USDIA.

The most recent developments have been very high USDIA growth in the last decade, heavy investment in Europe, and a shift from manufacturing to service investment. Irwin cautioned that solely looking at USDIA understates America's business involvement in the world.

Foreign Direct Investment and Factor Markets

Catherine Mann
Institute for International Economics

Focusing on the information technology (IT) sector is like looking at globalization in a Petri dish. The IT sector is already a globalized marketplace: it changes quickly, and there are strong synergies between global sourcing and technological change. The exponential declines in IT hardware prices have resulted in macroeconomic gains. While technological innovation has accounted for the majority of the price declines, 10 to 30 percent of the declines were caused by savings from global sourcing. The result was that IT accounted for half of the productivity gains in the 1990s.

Industrial sectors that invest heavily in IT also invest heavily in IT workers and are usually net exporters of services. IT has not diffused evenly throughout the economy, and some sectors, such as health care, lag behind. Currently it is not cost-efficient to provide these sectors with software and services because they are highly regulated, there are complex relationships, and the firms need tailored applications. However, the fragmentation and globalization of software and service production will soon yield lower prices that will allow these lagging industries to catch up.

Mann ended by warning that many Americans are at risk of losing their jobs and having their skills become outmoded. Domestically we need a strong transition program for displaced workers, and the government should create a human capital investment tax credit to encourage firms to train their employees. The government's foreign policy should focus on increasing international demand and the liberalization of trade.

Robert Lipsey
City University of New York and National Bureau of Economic Research

Lipsey found it difficult to imagine a price-induced substitution for IT and doubted the efficacy of a human capital investment tax credit. He also noted that total factor productivity is connected to IT growth, but this mechanism has not been explained.

Many Americans have fears about U.S. sectors losing their monopoly rents to foreign competition, but it is important to recognize the harm that blocking imports of services and technologies causes users and consumers. The import of services should be treated the same as the import of goods. America's high per-capita income is the result of our innovative abilities and our high level of education and technical skills. Many of the brightest people in the world come here to study and then remain in the country to work. Now government policies are keeping out many brilliant immigrants because of short-term security concerns.

Expansion Abroad and the Domestic Operations of U.S. Multinational Firms

Matthew Slaughter
Dartmouth College

The conventional wisdom is that outsourcing constitutes the export of American jobs to other countries. This phenomenon is perceived to have dire consequences and has resulted in political responses like the American Jobs Creation Act of 2004 and H1-B Visa caps. However, there may be a complimentary relationship between countries. CNN's Lou Dobbs examined this possibility by conducting an econometric analysis using BEA statistics on all U.S. multinational firms.

The findings were that a 10-percent increase in foreign affiliate sales increases a U.S. parent company's demand for labor by 0.3 percent. A 10-percent drop in more-skilled wages paid by an affiliate raises the parent's total labor demand by 3 percent. However, a 10-percent decline in less-skilled wages paid by an affiliate lowers parent total labor demand by about 3 percent. So the interplay between parent and affiliate more-skilled labor is complementary, while less-skilled labor acts as a substitute. Slaughter also found that when the countries that host affiliates lower their taxes, parent companies increase total labor demand. These findings contradict the view that U.S. multinationals export jobs.

William Randolph
U.S. Treasury Department

There are several problems with measurement and estimation concerning multinationals. First, looking at research and development is not a good proxy for skilled labor demand. Second, there is no good data on the skill levels that individual companies employ. It is also difficult to measure wages, especially in other countries. Finally, Randolph noted that by using industry fixed effects Slaughter might have inadvertently washed out important variation.

Randolph suggested that further research focus on more explicit links to international trade and the link between intra-firm trade and multinational employment decisions. An analysis of the link between multinational employment decisions and the overall effect of international trade on aggregate labor demand is also needed, as well as a better understanding of the role of taxes.

Keynote Address

N. Gregory Mankiw
Chairman, Council of Economic Advisers

The standard economic indicators of GDP growth, inflation, and unemployment are all doing well. Rising oil prices have strained family budgets, but this does not seriously threaten the economy. There is good reason to expect the positive economic trends to continue.

The current tax code is a drag on the economy, and the growing reach of the alternative minimum tax (AMT) will make the code increasingly difficult. Simplifying the code would lead to annual savings of $100 billion in compliance costs. Mankiw also recommended switching from income to consumption tax in order to lower the tax bias against saving and investment. To help with this process, President Bush is going to create a commission to make recommendations to the Treasury.

Crowding out by the budget deficit offsets the benefits of tax cuts and reforms. While the budget deficit as a share of GDP is expected to decline by half in the next four years, it is still important that Congress make all tax changes budget-neutral and try to restrain government spending. The retiring baby boom generation represents the real fiscal danger. The Social Security trust fund will be empty in 2042 unless there are significant reforms. Mankiw recommended the creation of optional personal social security accounts.

There is no evidence that our tax code encourages outsourcing. It is better to look at outsourcing as complimentary rather than as a zero-sum game. Free markets are the best way to guarantee growth and raise living standards.

Effects of Outbound FDI on Domestic Economic Activity

Mihir A. Desai
Harvard University

The popular intuition is that foreign direct investment (FDI) by U.S. multinationals represents the export of jobs to other countries. This is a difficult topic because other factors could be driving both types of growth and there is little microdata on firms. The alternative view is that firm value is a function of worldwide resources, so FDI can decrease or increase domestic investment. Desai and his colleagues have developed an econometric instrument that untangles the causal story and offers support for the positive alternative view.

The econometric analysis found that a $10 growth in foreign sales causes a $7 growth in domestic sales. A $10 growth in foreign assets causes a $7 growth in domestic assets. And adding one foreign worker adds two domestic workers. These findings suggest a policy change towards new welfare metrics and reduced tax burdens on the international income of U.S. firms.

Kevin A. Hassett
AEI

Hassett personally agreed with Desai's findings but doubted the paper would convince skeptics for two reasons: First, the paper deals with technology but does not contain any real treatment of technology. Second, it is not obvious that the solution to the "intangibles" problem would work.

More attention needs to be paid to the different types of multinationals. For instance, Heinz Ketchup locates abroad to sell to those local markets, whereas a semiconductor company locates abroad to sell globally. Additionally, the instrument argument fallaciously asserts that a country can grow rapidly without experiencing rising input costs. Finally, the instrument accidentally increases the positive bias in the results. Future research should separate different types of multinationals and more closely examine technology.

Does the Tax System Create Excessive Incentives to Move Economic Activity Abroad?

Alan Auerbach
University of California-Berkeley

Capital should be taxed at the same rate regardless of whether it is domestic or foreign. There may be complementarity, but taxes should be equal for all firms. Corporate taxes of any kind tend to discourage corporate investment, but no good theory exists as to how business activities and taxes interact. There is a strong inclination for businesses to remain in their home countries. This is partially because of who owns the companies. U.S. citizens primarily own U.S. companies, Japanese companies are owned mostly by Japanese, and so on.

Lael Brainard
Brookings Institution

America's tax system does create a bias to move abroad on the margin, but there are compensating benefits such as the skilled workforce. The tax system is also undesirable because it provides an incentive for financial engineering. However, taxes are not as important to multinationals as expenses like health care, regulations, and the future decline of America's skilled labor force. For instance, India may be competitive with America, but not from a tax perspective.

The fiscal and current account deficits are problems. Right now America is essentially borrowing from China to conduct FDI in China. This is not sustainable. The lesson learned from Foreign Sales Corporation and Extraterritorial Income Exclusion (FSC ETI) is that tax reform is a horrible use of the WTO's conflict resolution abilities. The process only proved that the EU is a better negotiator than the United States.

Matthew Slaughter
Dartmouth College

Profit-maximizing firms do respond to tax incentives. But other factors are more important. The ongoing change in America's labor pool is a more pressing incentive. American firms have evolved with the backdrop of an exploding labor pool. Now the labor pool is growing more slowly and becoming older and more diverse. Soon all net growth in the U.S. labor pool will be from immigrants.

U.S. affiliates of foreign-headquartered multinationals are often more footloose than domestic firms, so examining their actions is a good way to look for evidence of tax effects. Insourcing has been declining since the year 2000. This is partially due to the burst of the stock bubble, but the tax system and other variables are also contributing factors.

If the U.S. tax system is encouraging capital to move abroad, then it is also causing other factors of production to move in. It is necessary to determine which forms of production are moving in before the full economic effects of the tax system can be understood. One increasing factor is rising levels of immigrants to America.

R. Glenn Hubbard
AEI and Columbia University

When discussing multinationals and taxes, it is important to distinguish between allocators of capital and savers of capital. Multinationals have 75 percent of their FDI in OECD countries, clearly not an example of tax avoidance. It is also significant that intangibles like brand power cause imperfect competition between multinationals.

A repatriation tax delays the payment of dividends and reduces economic efficiency. America should adopt a territorial tax system similar to those of OECD countries. This would remove the incentive to delay paying dividends and eliminate an implicit tax on multinational firms.

An international tax bill did just recently pass, but U.S. corporate taxes remain relatively high. In order to continue funding social spending in a world of mobile capital, the government may have to adopt a greater dependence on consumption taxes. The fact that multinationals are important for the economy will influence the tax reform debate in potentially radical ways.

AEI intern James Moore prepared this summary.

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