Domestic Tax Policy and Foreign Investment

Investment abroad has come to play a major role in the total investment undertaken by U.S. firms. Despite this development, very little attention has been paid to the impacts of domestic tax policy on foreign investment. One reason has been the presumption that, since changes in domestic tax rules ordinarily also apply to foreign-source income, policy changes should affect foreign and domestic investment similarly. However, the fact that the tax on foreign-source income is deferred until the income is repatriated represents a crucial difference in the treatment of foreign and domestic income. So long as the U.S. tax is deferred, the effective U.S. tax rate on foreign-source income can be shown to be irrelevant to a firm's optimal foreign reinvestment decision. Foreign investment is now largely accomplished by firms reinvesting earnings abroad, so the reinvestment decision is of primary importance. Thus, a decrease in the effective U.S. tax rate which applies to both domestic and foreign investment income can be thought of as a cut in the tax on domestic investment income, which is encouraging to domestic investment (perhaps at the expense of foreign investment), combined with a cut