The role of cross-border taxation in equity home bias in international equity flows has been unclear. Dividend imputation, attributing tax credits to shareholders, is one of the impediments to cross-border equity flows. Tax credits for foreign taxes paid on dividends help reduce free-float home bias and traditional international portfolio home bias.
The authors investigate the relationship that cross-border tax variables have with free-float home country bias. After they control for such factors as information asymmetries, behavioral biases, and governance issues, they find that a relatively high foreign tax rate without tax credits increases home bias. Free-float excludes locked-in shares, such as those held by promoters and governments. Higher income streams created by a dividend imputation tax system, which attributes taxes paid by the company to the shareholders through a tax credit, and cross-border taxation encourage a bias toward holding domestic financial assets.
How Is This Research Useful to Practitioners?
Cross-border taxation plays an important role in international investing. Using a regression model, the authors study the effect of cross-border taxation on differences in bilateral home bias. Their empirical model includes various potential sources of home bias, such as cross-border taxes and proxies for information asymmetries, and it also includes control variables, such as familiarity, diversification, governance, and accounting. The familiarity and diversification variables include foreign listing, distance, size, language, transaction costs, and correlation. The governance variables comprise disclosure intensity, governance disclosure, audit, anti-director rights, accounting standards, and disclosure requirements.
Data to calculate the float-adjusted portfolio for countries and also the float-adjusted world market portfolio are from Datastream’s Worldscope database. The authors calculate home country bias by using float-adjusted holdings of home country investors in a foreign country.
The results indicate that free-float home bias is reduced when foreign listings are available, the home and foreign countries share a common language, transaction costs are low, the correlation between home and foreign country returns is low, and the source country’s market share of the world market capitalization is higher.
How Did the Authors Conduct This Research?
The authors consider cross-border taxation rates, dividend imputation rates, and dividend tax rates during 2001–2009 for 49 countries—23 mature economies and 26 emerging economies. They use Arellano–Bover/Blundell–Bond (Journal of Econometrics 1995 and 1998) linear dynamic panel-data methods to control for endogenous variables and to test the robustness of their results. Because of the 2008 global financial crisis, the authors present the results in two sample periods, 2001–2007 and 2001–2009.
As previously mentioned, the empirical model includes tax, familiarity, diversification, governance, and accounting variables. The governance control variables serve as a robustness check in the regression model. The authors find that home bias has a statistically significant positive correlation with the correlation of returns of home and host country and statistically significant negative correlation with foreign listing, size, and the dividend tax credit variables. They find a reduction in foreign investment when foreign investors’ dividend income is taxed at relatively high rates.
International portfolio home bias is traditionally measured by using international capital asset pricing models. Results of regression analysis suggest that effects of dividend imputation and dividend tax credit are smaller for traditional international portfolio home bias than for free-float home bias. The effect of international taxation on free-float home bias holds with traditional international portfolio home bias as well. The model results imply that more disclosure, quality auditing, and better protection for shareholder rights in home countries result in lower home bias.
The authors build on the previous literature on home bias by recognizing and controlling for information asymmetries, behavioral issues, and corporate governance when examining the role of cross-border taxation. Tax-effective distributions to foreign shareholders and tax-free bonus shares are some of the schemes used by firms to address cross-border tax issues. The study could be expanded to include implications of cross-border taxation on a firm’s behavior in catering to different investor clientele.