International Stock Returns and Real Exchange Rates
VICTOR A. CANTO
Theory and common experience postulate that differences in domestic economic policies across countries will have a differential impact on national economies. It would seem only natural that differences in domestic economic policies would also elicit corresponding responses on domestic equity values. When a country's tax rates fall relative to the tax rates of other countries, it is likely to experience an acceleration of its economic growth. (Tax rates are broadly defined here to include any distortions generated by national economic policies.) Due to the connection between domestic economic policies (e.g., tax rates) and economic performance, the values of assets located in countries that are altering their policies will fluctuate in a predictable direction. Assets will tend to become more valuable in countries that are cutting tax rates while tax-rate increases will tend to depress asset values.
Consider two identical steel mills, one located in northern Minnesota and the other located just across the border in Canada. If both steel mills sell identical products in the U.S. market, competition will force the mills to sell their products at approximately the same price. Given this situation, consider what would happen if Canada does what it did several years ago: increased tax rates while the United States lowered tax rates. Because the steel market is highly competitive, the Canadian company would not be able pass the tax hike on in the form of higher prices.
Initially at least, the Canadian steel mill would have to absorb all or part of the tax hike through lower after-tax profits. This drop in profits would be reflected