Review: Capital Gains Taxation and the Cost of Capital - H Huizinga, J Voget, W Wagner

Here is a paper by Harry Huizinga, Johannes Voget and Wolf Wagner studying the relationship between capital gains taxation and cross-border takeover premia:

Capital Gains Taxation and the Cost of Capital:

Evidence from Unanticipated Cross-Border Transfers of Tax Bases

Whether capital gains tax has a significant effect on investment expenditure has been a matter of significant research. The logic adopted by Huizinga, Voget and Wagner is that capital gains tax would affect investment expenditure if it reduces the price of equity in the stock markets, thus reducing the money that can be raised by companies by selling equity. Since any researcher would need a range of capital gains tax rates to be able to study its effect, the only logical way to do it is to study it across countries. The authors choose to study the premiums associated with cross-border takeovers.

A differentiation is made between the long term capital gains tax rate (t) and the short term capital gains tax rate (s).The authors start out with three hypothesis for cash-financed transactions, which are as follows:

• a higher difference between acquirer and target country long term rates leads to lower premium
• a higher difference between short term and long term rate in target country leads to higher premium
• an increase in long term rate in target country leads to higher premium

The second major direction of the paper is the probability of a cash-financed versus equity-financed takeover. For this, the authors hypothesize that the propensity to use cash financing decreases with:

• difference between the acquirer and target country long term rates
• difference between short and long term rate of target country
• long term rate of target country

The testing of these hypotheses is done in two stages - in the first stage, the sample is divided into a few sets based on the values of the three listed variables, and then summary statistics are calculated for the different sets to see if they different significantly; in the second stage, the authors construct a series of regression models, adding corporate income tax rates and institutional environment in more complex models. The coefficients in these regressions then indicate if the particular factor is significant or not.

What I particularly like about this paper is the authors' willingness to take the reader through the process of coming up with a robust model. For example, the problem of multicollinearity is detected early on between the last two variables listed above, and then a way is found to circumvent this problem.

The results of this paper are fairly straightforward, and hence the first thought I had after reading the paper was what the implication would be for takeovers involving India. With that spirit, the key insights for me from this paper were:

• In all models except equity-financed takeovers, the coefficient for the cross-country long term tax difference is significant at the 5% level of significance. I read that there is no long term capital gains tax in India; which would imply that Indian companies acquiring targets abroad will be able to pay higher premia. Could it then be that that the absence of a long term capital gains tax in India acts as a spur to cash-financed takeovers abroad? From the second set of hypotheses, this would imply that most takeovers by Indian companies should be cash-financed.

• In most models, the difference between the short and long term capital gains tax rate in the target country is statistically significant. For India, this would mean that foreign companies aiming to take over target companies in India would have to pay high premia. This would act as a potential deterrent to cash-financed deals. From the second set of hypotheses, this would imply that most takeovers of Indian companies should be debt-financed.

Review: The Renminbi Bloc is Here - A Subramanian, M Kessler

Here is a paper by Subramanian and Kessler on the question of transformation of the Chinese Renminbi into an international currency:

http://piie.com/publications/wp/wp12-19.pdf

The authors have defined three factors that go into the making of an international currency - store of value, medium of exchange and unit of account. While they have focused the paper on the last factor, I would like to talk about the first two briefly.

As a store of value, a currency's value must be stable, or at the very least should not decrease. This has been the primary argument against the Dollar's continuation as a global currency. In fact, the very breakdown of the Bretton Woods system was due to expansionary monetary policy in the US. The inability of the US to rein in the fiscal deficit is also expected to cause a flight from dollars sometime in the future. On this front, judging the Renminbi is difficult, since the Renminbi has been pegged to the Dollar for most of recent history. How the Renminbi would perform on this front when the pressure of internationalisation would force China to liberalise the capital account, is not known.

The usefulness of a currency as a medium of trade, while linked to the first, is also a function of the home country's trade volumes. This has been the primary force behind the internationalisation of the Renminbi. The fact that Malaysia now follows an active policy of keeping Renminbi reserves is testament to China's growing external trade. The paper also talks about this aspect when dealing with the unit of account nature of currencies, and I will reserve more discussion for that.

The paper is fairly easy to understand, using a number of regressions to test the hypotheses. What I particularly like about the structure is that the authors introduce various reasons that could affect the robustness of their results, and either disprove or acknowledge it. The theme - the rise of the Renminbi - is fairly common. Being one of the first research papers on this theme that I have read, it has been an enlightening first read.

Here are a few themes in the paper that I found very interesting:

• The least controversial result in the paper is the assertion of the existence of a 'Renminbi bloc' - a group of East Asian economics whose currencies show higher movement with the Renminbi (as reflected by high co-movement coefficients, or CMCs, in the regression) as compared to the Dollar or the Euro. Also hardly surprising is the finding that the influence of the Renminbi outside of East Asia is still less than the Dollar or the Euro. The interesting observation, however, is that while the influence of the Dollar and the Euro is decreasing, that of the Renminbi is increasing.

• The emergence of the East Asian 'Renminbi bloc' is talked about, with the introduction of an East Asian dummy in the regression. The reason for the formation of the Renminbi bloc could be two fold - (1) that East Asian countries trade most with China (2) geographical proximity to China. Separation of the two effects is hampered due to high correlation between the two - geographical proximity usually implies a higher trade share. Despite this, the introduction of an East Asian dummy keeps the significance of the CMC intact. The implication of this fact would be that as China's trade share with countries outside of East Asia increases, the Renminbi as a reference currency will only grow stronger. As an illustration, the authors cite India as one of the countries for which the Renminbi has the highest CMC.

• The last section compares today's Renminbi to the 1990s' Yen. While the CMCs with a sample of East Asian countries is much higher for the Renminbi, the international character of the currency (as reflected by the percentage of trade settled in the currency) is significantly higher for the Yen. The authors provide only indicative answers, and not definitive ones, to this apparent paradox. Their hypothesis is that East Asian countries are more competitive with today's China than the 1990s' Yen (explaining the high CMC); and that the 1990s' Japan had a more liberal capital account and more multinational firms (explaining the international character). These hypotheses, especially the one about capital account, seem fairly reasonable. Even though East Asian countries have a greater incentive to mirror the Renminbi (to avoid losing their competitiveness), they would be unable to settle their trade in the currency because of restrictions on the capital account. Hence, for the Renminbi to become more international, liberalisation of the capital account becomes more important, given that the need already exists.

• The last paragraph deals with the most controversial question - will the Renminbi replace the dollar as a global currency? The surprising answer advocated by the authors is that on the basis of growth in trade alone, the Renminbi will be the most dominant currency by 2037. They argue that with liberalisation, this date could come sooner. To me, this is a very strong assertion to make. What the authors are saying is that given the capital controls that exist in China, the Renminbi could overcome these restrictions to become the global reference currency. Agree or not, that is what the data (and a few assumptions about trade growth) implies.