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Abstract
How do taxes influence the way U.S. corporations divide foreign affiliate operating
income among royalties, dividends, interest, and retained earnings? The paper goes beyond
previous work that focused largely on dividend repatriation behavior, and provides a
comprehensive analysis of the disposition of foreign subsidiary operating income. The
empirical results show that taxes have a large and statistically significant effect on the
composition of payments. Own tax prices discourage the payment of dividends, royalties
and interest. But dividend and other repatriation taxes do not increase retained earnings,
they only alter the composition of payments. The results are, therefore, consistent with a
generalized HartmanSinn model of the mature controlled foreign corporation that has
various alternative repatriation vehicles. Finally, this paper integrates the choice of
payments with income shifting among countries because the latter may be part of a low-tax
strategy for repatriations. In this general framework, conventional composite tax prices are
not appropriate because the response to a change in a composite tax price depends on which
components changed. 1998 Elsevier Science S.A.
Keywords: Dividends; Multinational corporations; Royalties; Tax prices
JEL classification: H32; H87; F23
1. Introduction
Almost all of the previous studies of multinational corporation (MNC) financial
*Tel.: 11 202 622 0465; fax: 11 202 622 2969; e-mail: harry.grubert@treas.sprint.com
0047-2727 / 98 / $19.00 1998 Elsevier Science S.A. All rights reserved.
PII S0047-2727( 97 )00077-7
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for each type of income, or basket, in order to isolate active business income
from passive and other lightly taxed income. There are also anti-abuse provisions
that currently tax CFC passive income and the income from sales to related parties
routed through low-tax countries.
The more comprehensive analysis of CFC financial behavior demonstrates that
the conventional construction of composite tax prices for particular distributions is
inadequate because it is necessary to know the separate components of the tax
price. For example, suppose two CFCs have the same high tax price on dividends.
One has a parent in excess credit so the tax price on dividends reflects only the
high host country withholding tax. With excess foreign tax credits, the parent has
no residual U.S. tax liability on any marginal repatriations. The other CFC has a
parent in excess limit, and its dividend tax price is high because the host country
effective tax rate is low compared to the U.S. tax rate, resulting in a high residual
U.S. tax on dividends. These two companies with identical tax prices for dividend
payments (and identical tax prices for interest and other repatriations) might have
widely differing repatriation behavior. When a high withholding tax is the source
of the high repatriation tax, the CFC can respond by shifting income to another
foreign affiliate with lower withholding taxes. This strategy would provide no
benefit if the parent does not have excess credits. Accordingly, these two cases
should be distinguished in the econometric work.2
The empirical results, based on the 1990 U.S. Treasury corporate tax files,
indicate that the own tax prices always have a negative and significant effect on
dividends, interest and royalties. However, the fact that a higher tax price on
dividends discourages dividend distributions does not mean that there is an
equivalent increase in retained earnings. In fact, retained earnings do not go up at
all, suggesting that the company uses alternative ways for taking money out of a
CFC. Introducing the tax prices of alternatives into each payment equation has a
significant effect on the results. For example, including the tax prices of interest
and royalty payments in the dividend repatriation equation has a very important
effect on the coefficients for the dividend tax prices. The interest and royalty
equations suggest that they are substitutable forms of repatriating income.
2. Analytic background
Another way of expressing this point is that the tax price of payments (including income shifting) to
other foreign affiliates should be included in the equation.
272
the determinants of the tax prices that enter into the model.3 Tax prices have been
discussed extensively in earlier work (Grubert and Mutti, 1991; Altshuler and
Newlon, 1993; among others). But let us summarize some of the basic considerations, with particular emphasis on royalties and their alternatives.
The tax cost of a payment depends on whether the parent is in an overall excess
foreign tax credit position in the relevant basket.4 If it is in an excess foreign tax
credit position, the tax consequences of paying an additional dollar of royalties,
rather than retaining the income, is w L 2 t S , where w L is the withholding rate on
royalties and t S is the foreign statutory tax rate. The royalty, being deductible,
reduces the foreign corporate tax by t S , but a withholding tax of w L has to be paid.
There is no additional U.S. tax liability because of excess credits. Note that the tax
price is likely to be negative because withholding rates on royalties are generally
lower than statutory tax rates. In this excess credit case, the tax cost of a dividend
compared to retention is w D , the foreign withholding tax rate on dividends. The
foreign corporate tax has already been paid and there is no residual U.S. tax.
If the parent does not have excess foreign tax credits, the credits that accompany
a distribution become relevant. The credit for the underlying foreign corporate tax
linked to a dividend depends on the foreign average effective tax rate t E , not t S .
The distinction is important in the empirical work because companies get a credit
only for foreign taxes actually paid on true equity income. It is common for t E to
be substantially less than t S because of accelerated depreciation, investment credits
and other incentives.
In this excess limit case, the tax cost of a marginal dividend instead of retention
is t US /(1 2 t E ) 2 t E /(1 2 t E ), where t US is the U.S. statutory tax rate.5 The
dividend is first grossed-up by the underlying foreign effective corporate tax rate,
then the U.S. tax is applied and the foreign tax credit on the grossed up dividend is
subtracted. The tax cost of a royalty payment instead of retention is t US 2 t S . (This
does not include the possible effect of an additional royalty on the credits for any
existing dividends, which is discussed below.) The foreign withholding tax rate on
royalties w L is not relevant because it is now fully creditable against the U.S. tax.
Note how a low foreign effective rate t E compared to t S affects the relative tax
costs of a royalty and a dividend in the excess limit case. Take a company paying
out no dividends or royalties that is deciding on how to repatriate a dollar of
pre-tax operating income. Paying it out as a deductible royalty will result in a tax
equal to t US , the U.S. statutory rate. Assuming no inframarginal dividends, the
3
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274
used in the second period. Finally, it repatriates the entire net worth of the CFC at
the end of the second period. The two decision variables are the initial equity
injection E and the amount R it retains after the first period.
The parents cash flows are 2E at the beginning of the first period, ( f(E)(1 2
t F ) 2 R)(1 2 t D ) at the end of the first period, and E 1 f(E 1 R)(1 2 t F )(1 2 t D ) 1
R(1 2 t D ) at the end of the second. The parent company has an after-corporationtax required rate of return on equity r. Taking the present value at the discount rate
and maximizing with respect to E and R leads to the following two optimizing
conditions:
f 9(E 1 R)(l 2 t F ) 5 r,
(1)
1 1 r(1 2 t D )
f 9(E)(1 2 t F )(1 2 t D ) 5 1 1 r 2 ]]]].
(1 1 r)
(2)
Condition (1), which determines the amount of capital in the second period,
reproduces the HartmanSinn result that capital in the mature state does not
depend on the repatriation tax t D . But it is necessary to note that we are implicitly
assuming that R, retentions after the first period, are non-negative, i.e. that the CFC
becomes mature after the first period. (It is as if we assumed that the first period
is long enough for first-period earnings to be sufficient to fund required new
investment for the second period.)
Condition (2), which determines the initial equity injection, indicates as
expected that the repatriation tax plays a role in this decision. The right-hand side
is also consistent with Sinns initial underinvestment effect, in which the parent
initially invests less than in a one period case (or in a non-deferral world) because
it wants to obtain the benefits of deferral until it reaches the target capital stock
in the mature state.
The HartmanSinn result that capital in the mature state is not affected by
repatriation taxes does not, of course, hold when t D is negative, as would be the
case if the parent is in excess limit for its worldwide foreign income but this
subsidiary has a foreign tax rate above the U.S. rate. If t D is negative, the CFC will
pay out all its income every period and reinject any amount of equity required to
finance an increase in K. If f(K) is unchanged over time, K will be constant in the
two periods with f 9(K)(1 2 t F )(1 2 t D ) 5 r. The equity is not trapped but
expelled.
Consider how the picture changes when royalties or license fees L are
introduced as an alternative to dividends. We first focus on royalties as a share of
total repatriations and the substitutability of different payments. It is helpful to
consider the excess credit and excess limit cases separately because the relative
advantages of a royalty and dividend will differ. Start with the parent always
having excess credits, in which case the tax price on dividends is the withholding
tax on dividends and the tax price on royalties is the foreign withholding tax on
royalties less the foreign statutory tax rate. As noted above, the tax price on
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276
the dividends-only model above depended on t D , the tax price on dividends, being
constant over time. If the marginal cost of repatriations remain constant in a world
with more than one repatriation vehicle, then these generalized repatriations can
simply be substituted for dividends in the model and condition (1) will still hold.
The capital stock of the mature CFC will not depend on repatriation taxes even
though an increase in the cost of dividends relative to royalties will reduce
dividends in the mature state.
The above discussion of the determinants of tax prices and the least cost
condition for the choice of royalties and dividends shows that the requirement that
the marginal cost of repatriations remain constant over time (in a given tax regime)
will frequently be met. In the excess credit case, the tax price on dividends is
simply the (fixed) foreign withholding tax on dividends. The equality of the
margin cost of royalties (including penalties) and dividends will, therefore, always
take place at the same level of marginal costs as long as some dividends are paid.
Any distributions beyond this point will be in the form of constant cost dividends.
If the parent is in excess limit, t D is constant if t E 5 t S , because the credit rate on
dividends is not reduced if greater royalties are paid. In any case, the mix of
royalties and dividends do not affect repatriation costs. In this situation, it might
appear that the requirement to pay royalties would alter the eventual real
equilibrium because not all earnings can be trapped. For example, what if the
CFC always had to be paid a certain share of its operating income in royalties. The
issue in the mature state is whether it should reinvest any of its income net of
royalties now and repatriate the proceeds in the next period. The return is (1 2 t D )r
if the income is repatriated now and f 9(K)(1 2 t US ) if reinvested. The total tax rate
on next periods earnings is t US irrespective of what share is in the form of
royalties. Because (1 2 t US ) 5 (1 2 t F )(1 2 t D ), i.e. the total tax paid on the
dividends including the foreign corporate tax is the U.S. rate, condition (1) will
still hold. (The transition to the mature state may be different.)
The mix of royalties and dividends also do not affect repatriation costs even if t E
is not equal to t S as long as all operating earnings are repatriated, as they would be
in a pure HartmanSinn mature state. The subsidiary would, therefore, eventually
arrive at the HartmanSinn mature state with condition (1) holding.
But the marginal cost of repatriations may not be constant in all cases in a
model that goes beyond the strict requirements of the Sinn (1993) model, in which
f(K) is fixed over time and retained earnings are always zero in the mature state
when K has reached its target level. The model becomes more relevant if we
broaden the mature state to one in which increases in K are positive but they can
be financed entirely by retentions. That is, the production function f(K) is not
stationary over time and desired K increases over time for a given cost of capital.
Less than all operating income is paid out.
The previous section showed that if t E is less than t S in this situation and the
parent is in excess limit, the tax price of dividends depends on the amount of
royalties paid out and the marginal cost of royalties depends on the amount of
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model. Even though the income on the passive assets would be taxed currently
under the anti-abuse rules in the U.S. tax code, it may pay the company to invest
operating income in passive assets, rather than repatriating, because the passive
income would be earned on a larger base. Under some scenarios, the CFC may
accumulate passive assets for an indefinite period after the real capital stock has
reached its mature level. The availability of the passive asset alternatives for the
CFC may also change any transition to the mature real capital state. Because
CFCs have an asset they can switch to that is not subject to diminishing returns,
their initial underinvestment strategy may no longer be necessary (see Weichenrieder, 1995).
279
rents and royalties paid by the CFC by the ratio of expenses to rents and royalties
reported by the parent. The second alternative used the gross royalties income
item from the first page of the Form 1120, the basic corporate tax return, where
rents are reported separately. This could include some domestic royalties, but
when the lesser of total royalties and foreign rents and royalties are computed
for each company, the total for the universe is very close to the total foreign
royalties received reported by the Commerce Department. This lesser of variable
was, therefore, substituted as a second variation. Neither alternative produced
results different from the unadjusted variable used in the tables.
The parent R&D variable, which is likely to be an important determinant of
royalties paid by CFCs, is based on the reported total qualified research for
purposes of the research credit available to U.S. companies. This has the advantage
of being restricted to R&D performed only in the United States. But sometimes it
is not reported on the tax return, presumably because no research credit is claimed.
When no qualified research is reported for the purposes of the credit and positive
R&D is reported for the company on Compustat, the Compustat data (with
adjustment), are used. (See Grubert and Slemrod, 1994, for the adjustment.) The
Compustat-based R&D observations may include some R&D performed abroad,
because the R&D reported on financial statements would be worldwide R&D, but
when they are excluded from the analysis the conclusions are not much different.
Some of the tax variables are derived from the tax return files themselves. These
include country average effective tax rates, total taxes paid as a percent of earnings
and profits. Statutory corporate tax rates as well as withholding rates on royalties,
interest, and dividends were taken from Corporate Taxes A Worldwide Summary
for 1990 published by Price Waterhouse (1990). In some cases judgment had to be
exercised, e.g. on the general availability of tax holiday rates in some countries. In
these cases, the decision on the appropriate statutory tax rate was in part based on
the country average effective rate.
280
the own tax price responsiveness effects, not changes in t S which is common to all
deductible payments. In the empirical work, it will, therefore, be convenient to use
the withholding tax rates to identify the specific effect of increasing a tax price,
holding other tax prices constant, while retaining the statutory tax rate as a
separate variable. The own royalty and interest tax price coefficients are unchanged, but the source of the tax price change and the role of the statutory tax
rate are clarified.
As noted in the Introduction, the companys response to a higher tax price for
dividends will depend on what the source of the change is. If it is a high
withholding tax (which is relevant if the parent has excess tax credits) this may
lead to income shifting to other CFCs. If another CFC has a similar high dividend
tax price but it is due to a low effective tax rate in the host country and a parent in
excess limit, shifting income to another affiliate would not reduce repatriation
taxes because all foreign taxes are creditable. Another way of stating this point is
that the separate components of the dividend tax price have a different effect on
the price of routing income to other foreign affiliates; it is as if there were an
excluded variable in the payments equations. It is, therefore, necessary to
distinguish tax prices on dividends due to high withholding taxes from those due
to low effective tax rates.
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only companies that filed a Form 1118 and reported foreign dividends, which may
be a non-random subgroup.
Another problem with observed excess credit positions is that they can vary
over time. Capitalization and payment strategies are in part based on long run
expectations because there are probably constraints on the extent to which
royalties, interest and income reported can vary from year to year. The 1990 file
indicates that for 50% of active foreign income, the effective foreign tax rate is
within four percentage points of the excess-credit threshold, i.e, between 30 and
38%. The current years position may not be a good indication of long run
expectations. Indeed, companies may not have a clear picture themselves.
This problem of excess credit position expectations is addressed by including
both the excess credit tax price and the excess limit tax price as independent
variables. This implicitly assumes that companies are uncertain about their long
run credit position and recognize that there is some positive probability of being in
either excess credit or excess limit. These long run probabilities may, of course,
vary among companies (although it was difficult to identify any set of company
characteristics that determine the probability of being in excess credit), but this
would bias the estimated coefficients toward zero. Introducing excess limit and
excess credit tax prices separately also is consistent with the possibility emphasized above that the company will respond differently to a tax price depending on
its components.6
Note that the inclusion of withholding rates on royalties and interest and the
local statutory corporate rate implicitly captures both the excess limit and excess
credit tax prices on royalties and interest. For example, the excess credit tax price
on royalties is w L 2 t S and the excess limit price is t US 2 t S . The U.S. corporate
rate, t US , is constant in all observations and the other terms are variables in the
equations.
282
the withholding tax rate on dividends, adjusted for the net benefits of a dividend to
U.S. investors under tax systems that integrate corporate and shareholder taxes.
This latter adjustment affects dividends from the United Kingdom, for example.
The withholding tax rate on royalties (and interest) was defined to include the
impact of nondeductibility that is imposed by a few host countries. For example, if
the statutory tax rate is 35% and royalties are not deductible from corporate
taxable income, the nondeductibility provision is the equivalent to a 35%
withholding rate on royalties that are deductible.
Table 1
Profitability and payment equations a (3467 CFCs)
R&D
Withholding tax on
Excess
credit
Royalties
Excess
limit
Potential undistorted
profitability
0.260
(2.93)
0.406
(6.91)
20.118
(4.25)
0.030
(1.16)
0.046
(1.18)
0.081
(2.08)
20.178
(5.26)
Sum of E&P,
royalties and interest
0.567
(4.64)
0.593
(7.29)
20.151
(3.92)
20.035
(1.00)
0.150
(2.80)
0.017
(0.32)
20.172
(3.68)
Payment equations
Dividends to U.S.
affiliates tobit
0.646
(4.16)
20.066
(0.60)
20.157
(3.08)
20.158
(3.55)
0.167
(2.42)
2034
(0.49)
20.252
(4.20)
0.443
(19.75)
0.528
(2.66)
20.036
(0.26)
20.264
(4.10)
20.009
(0.16)
0.139
(1.58)
20.074
(0.84)
20.151
(2.00)
0.796
(27.65)
Royalties tobit
0.425
(9.21)
0.093
(3.01)
20.031
(2.02)
20.061
(4.42)
20.083
(3.66)
0.039
(1.81)
20.044
(2.36)
0.086
(13.11)
Interest tobit
0.110
(3.87)
0.031
(1.67)
0.015
(1.70)
0.042
(4.95)
0.055
(4.24)
20.074
(5.32)
0.074
(6.51)
0.006
(1.43)
20.282
(3.27)
0.001
(0.02)
20.33
(1.21)
20.066
(0.26)
0.082
(2.18)
0.037
(0.98)
20.112
(3.41)
0.353
(29.62)
Retained earnings
Profitability equations
Earnings and profits
Advertising
N53467.
a
t values in parentheses.
283
284
285
The contrast between dividends to the United States and all dividends is
noteworthy. The excess limit tax price, which depends on the difference between
the U.S. tax rate and the local effective tax rate, is not significant for total
dividends. But the excess credit tax price, the withholding tax on dividends, is
highly significant. These withholding taxes may be more relevant because some of
the dividends may go to non-U.S. shareholders in a country that exempts foreign
dividends. For them, the repatriation tax is always simply the withholding tax.
In the retained earnings equation, the coefficient for the local statutory tax rate is
negative and significant. This may reflect the cases in which shifting income to
other affiliates provides a positive benefit and dominates other payment vehicles.
Equity could be reinjected by the affiliates to which the income has been shifted.
The positive coefficient for the withholding tax on royalties, which is significant at
the 5% level, seems inconsistent with the discussion above because the conditions
for the validity of the HartmanSinn model are met in the excess credit case where
the withholding taxes are relevant. The second row of Table 1 confirms that this is
an anomaly because the data seem to suggest that a higher withholding tax rate on
royalty payments increases total operating income, which is impossible on
conceptual grounds.
Turning now to interest payments, Table 1 shows that they respond in the
expected way to tax considerations. The withholding tax rate on interest has a
negative and highly significant effect. Conversely, the withholding tax rate on
royalties has the expected positive effect, indicating substitutability between
interest and royalties. The statutory tax rate also has a positive significant effect as
expected because it reduces the tax cost of deductible payments such as interest.
Finally, the tax price of dividends also indicates substitution between dividends
and interest, with the excess limit price highly significant and the excess credit
price of borderline significance.
Proceeding to consider royalties, we see in Table 1 that the withholding tax rate
on royalties has the expected significant negative effect. The withholding tax rate
on interest has a positive effect, consistent with the substitutability between
royalties and interest found in the interest equation, although the coefficient is only
of borderline statistical significance.
But the role of the tax variables associated with dividends and equity income
seems puzzling in the royalty equation. The dividend tax prices have a significant
negative effect, not positive as would be expected with substitutability between
dividends and royalties. In addition, the statutory tax rate also has a negative effect
even though it increases the tax benefits of deductible payments. This may suggest,
as mentioned above, that for some companies equity earnings and royalties are
complementary. If a low statutory tax rate encourages an inward shift of
intangible income, through commodity pricing, the company may feel compelled
to pay higher royalties as well. In other words, the income effect outweighs the
substitution effect between royalties and dividends.
This suggested complementarity between royalties and equity income is
286
confirmed when an interaction between R&D (and advertising) and the statutory
tax rate is added to both the royalty and the E&P equation. (These are not shown
in the tables.) The interaction terms are intended to capture the possibility that
greater parent R&D and advertising increase the opportunities for shifting income
to low-tax countries. Further, if intangible income is shifted to low-tax countries,
do royalties increase as well? The coefficient for the R&Dtax interaction term is
negative and significant in both equations. (The advertisingtax interaction term is
negative and significant in the earnings equation but, while the coefficient is
negative in the royalties equation, it is only slightly larger than its standard error in
absolute value.) Intangible income is shifted to low-tax countries where it is
associated with larger royalties to the parent. The size of the R&Dtax interaction
coefficients in the royalty and earnings equations suggests that a lower tax rate
increases the effect of R&D on royalties by about a third as much as it increases
E&P, which seem plausible.
Table 1 shows that tax prices have a quantitatively significant effect on
behavior. At the mean of the independent variables, a one percentage point
increase in both of the dividend tax prices reduces dividends by 2.7%. The
elasticity of dividends with respect to a change in (1 2 t D ), the portion of the
dividend left after paying the repatriation tax, is thus greater than 2.
Table 2
Alternative dividend equations a (all tobits)
Tax prices included
R&D
Advertising
Withholding tax on
Excess
credit
Excess
limit
Royalties
Dividend tax
prices only
0.638
(4.38)
0.068
(0.62)
2027
(0.67)
20.031
(0.98)
Statutory tax
rate added
0.644
(4.15)
20.071
(0.65)
20.071
(1.71)
20.152
(3.42)
0.675
(4.35)
20.062
(0.57)
20.131
(2.59)
Withholding tax on
dividends only
0.684
(4.40)
0.066
(0.60)
20.028
(0.71)
0.589
(3.60)
0.008
(0.07)
0.590
(3.62)
0.010
(0.09)
20.770
(4.95)
0.045
(0.41)
Country average
divided tax price
Potential profitability
Earnings and
profits
0.447
(19.77)
0.143
(2.09)
20.008
(0.12)
0.228
(3.88)
0.466
(19.84)
20.102
(2.40)
0.444
(19.75)
0.477
(19.79)
0.058
(0.82)
20.083
(1.61)
Interest
Statutory
tax rate
20.190
(4.29)
0.118
(1.70)
0.042
(0.57)
20.063
(0.89)
0.130
(2.06)
0.137
(2.27)
20.182
(2.34)
0.432
(18.72)
20.038
(0.71)
0.433
(18.80)
0.602
(19.40)
a
Number of observations same as in Table 1 except for rows 5 and 6, in which constructing the country average price on dividends reduced the number of
observations to 3227. t values in parentheses.
287
288
which depends on the local effective tax rate, are highly correlated, so not
including the former has a large effect on the significance of the latter.
The same pattern reoccurs when an attempt is made to use dividend tax prices
identical to ANRs instruments.7 The third and fourth rows of Table 2 simply use
the country withholding rate on dividends, one of the instruments ANR employed.
It is significant in the third row when the other tax variables are included, but not
in the fourth when they are not. Similarly, the next two rows use a country average
dividend tax price along the lines of ANRs alternative instrument.8 It is again
significant in the presence of the other tax prices, but not by itself.
The last row of Table 2 shows that using unadjusted Earnings and Profits tends
to greatly reduce the significance of the withholding tax rate on dividends. As
indicated by the E&P equation in Table 1, high withholding taxes appear to
increase deductible payments, lowering E&P and capturing some of the role of the
dividend tax price.
Table 2 does not exactly replicate the ANR procedure, because they constructed a permanent tax
price using instrumental variables rather than simply including the instruments as regressors.
8
When the country average is used, the estimation is restricted to countries with more than 10
observations. The country average is almost significant at the 5% level when countries with more than
four observations are included.
9
Under the AMT rules, foreign tax credits cannot eliminate more than 90% of its total (including
domestic) U.S. tax liability, so it is conceivable that there is a residual U.S. tax under the AMT where
there would be none under the regular tax.
289
the coefficients of the tax price variables are virtually unaffected in size and
significance.
Acknowledgements
I am grateful to Gordon Wilson and Paul Dobbins for providing me with the
linked data files in a convenient form, and to Don Rousslang, David Joulfaian,
Julie Collins, Douglas Shackleford and an anonymous referee for very helpful
comments on an earlier version of this paper. Nothing in this paper should be
construed as the views or policy of the U.S. Treasury Department.
290
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