29 Jun 2012  Working Papers

Trade Credit and Taxes

Executive Summary — Economists have extensively analyzed the effects of taxation on many aspects of corporate financial policy, including borrowing and dividend distributions. But the effects of corporate income taxes on trade credit practices have been much less understood. Research by Mihir A. Desai, C. Fritz Foley, and James R. Hines, Jr. develops the idea that trade credit allows firms to reallocate capital in response to tax differences. Using detailed data on the foreign affiliates of US multinational firms, the authors are able to observe affiliates of the same firm operating in different countries and therefore facing different corporate income tax rates. Taken together, the findings illustrate that firms use trade credit to reallocate capital from low-tax jurisdictions to high tax jurisdictions to capitalize on tax-induced differences in pretax marginal products of capital. Their actions imply that tax rate differences across countries significantly affect capital allocation within firms, depressing investment levels in high tax jurisdictions and introducing differences between the productivity of capital deployed in different locations. Key concepts include:

  • This paper examines the extent to which taxation influences trade credit practices by affecting returns to investment.
  • Analysis of detailed foreign-affiliate-level data suggests that tax effects are large and statistically significant in explaining trade credit choices.
  • Affiliates in low tax jurisdictions have higher net working capital positions than do other affiliates.
  • Managers have incentives to set accounts receivable and accounts payable in a manner that reallocates capital from lightly taxed operations where investment opportunities have dissipated to highly taxed operations where profitable opportunities remain.
  • This mechanism implies that net working capital positions, or the difference between accounts receivable and accounts payable, should be higher for firms facing lower tax rates.

 

Author Abstract

This paper analyzes the extent to which firms use trade credit to reallocate capital in response to tax incentives. Tax-induced differences in pretax returns encourage the use of trade credit to reallocate capital from firms facing low tax rates to those facing high tax rates. Evidence from the worldwide operations of US multinational firms indicates that affiliates in low-tax jurisdictions use trade credit to lend, whereas those in high-tax jurisdictions use trade credit to borrow: 10 percent lower local tax rates are associated with net trade credit positions that are 1.4 percent higher as a fraction of sales. The use of trade credit to get capital out of low-tax, low-return environments is also illustrated by reactions of US firms to the temporary repatriation tax holiday in 2005, when affiliates with positive net trade credit positions were significantly more likely than others to repatriate dividends to parent companies in the United States.

Paper Information