Taxation, capital allocation and exchange rates: Issues in international finance

Chapter 1. Capital allocation in a model of portfolio and foreign direct investment flows under uncertainty. We develop a model that describes the composition of capital flows in general equilibrium. In an environment with risk, trade, foreign direct investment, and equity flows interact and may be complements or substitutes depending on preferences and sources of risk. FDI plays two roles: it serves as a means of allocating of productive resources across countries and industries and second, it allows for diversification of income risk. When equity trading is permitted, equity may substitute for FDI to achieve diversification. On the other hand, the greater risksharing resulting from trade in equity decreases the risk of specialization and may increase the return to FDL We show that as capital markets deepen, countries may become more or less specialized depending on parameter values. Estimates of the gains from risksharing that hold the allocation of productive resources fixed may significantly underestimate the benefits of opening capital markets.; Chapter 2. Optimal taxation of foreign investment income in a strategic setting. Current tax rates on capital gains earned by foreigners are either positive or zero in most countries. This paper presents a model of optimal taxation on capital gains earned by foreigners that yields positive optimal tax rates under very general conditions. The optimal portfolio implied by the model mimics the home bias seen in actual portfolios. Simulations are presented which model these tax rates between two symmetric countries and between the United States and the United Kingdom.; Chapter 3. Measurement error in panel data: An application to purchasing power parity. Many studies that test the existence of purchasing power parity use aggregate price indices to proxy for the price level in the economy. Aggregate price indices suffer from measurement error when used to test for purchasing power parity due to the presence of nontraded, goods in the index. I use panel data to control for this type of measurement error by using a two-step estimator proposed by Griliches and Hausman (1986). I find that exchange rates do not adjust one for one with price level differentials and so do not find evidence of purchasing power parity.