December 2, 2004
Juann H. Hung and Angelo Mascaro
Despite the large size of U.S. net financial obligations to foreigners, U. S. residents have continued to earn more income on their assets abroad than foreigners have on their assets in the United States. In other words, the rate of return on U.S.-owned assets abroad is still higher than the rate of return on foreign-owned assets in the United States. The advantageous return gap for U.S. investment has reflected the much greater return on U.S. direct investments abroad than that on foreign direct investments in the United States.
We investigate the validity of three major hypothesis advanced to explain the persistent return gap that has been so advantageous to U.S. direct investments: (1) the risk-compensating hypothesis, which claims that U.S. direct investments abroad are riskier than foreign direct investments in the United States and therefore command a higher return to compensate for their higher risks; (2) the age-effect hypothesis, which claims that foreign-owned companies in the United States are temporarily less profitable than U.S.-owned companies abroad because they are relativelynew and it takes time for new investment to turn a profit; and (3) the profit-shifting hypothesis, which maintains that the return gap is the net result of multinational companies’ shifting profits through transfer pricing schemes to minimize their overall tax cost.
We find that evidence in support of the age-effect hypothesis is the strongest, followed by that for the risk-compensating hypothesis. There is no clear evidence that, on balance, profit-shifting activities bymultinational companies contributed significantly to the return gap in favor of outward direct investment. Our findings suggest that the extent to which the (reported) return gap will remain favorable to the United States in the future largely depends on the net result of two opposing developments. First, the age effect suggests that foreign-controlled companies’ profitability should improve over time, unless the positive age effect is dominated by the negative effect arising from new flows of inward direct investment. Second, as foreign subsidiaries become more profitable over time, they also are likely to become more active in profit-shifting practices, thereby depressing the reported profits of those companies.