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The Use of Tax Havens As A Real Option

This paper develops a real options model which shows the theoretical effect of business uncertainty and of having (or not having) a tax haven (TH) affiliate on the timing of foreign direct investment (FDI). It assumes that a multinational firm has a monopoly over the FDI decision, which is seen as a real option and, if it is optimally exercised, leads to an enhancement of the firm’s pre-tax profits. In line with the real options literature, we conclude that business uncertainty delays the FDI decision irrespective of whether the multinational firm has a TH affiliate or not, but multinational firms with a TH affiliate invest earlier. This runs counter to the existing literature which indicates that the use of tax havens deters investment. We test this theoretical finding using a firm-level dataset that covers the time period 2009 to 2017 and includes information on 22,703 multinational firms. Using a range of empirical models, we find robust evidence to corroborate our theoretical predictions.