Trade liberalization, profitability, and financial leverage

by Jennifer Baggs and James A. Brander
Business and Labour Market Analysis Division
Analytical Studies Branch research paper series, No. 256

Context

One of the fundamental questions of financial economics concerns the determination of financial leverage—the relative importance of debt as opposed to equity in financing the firm. This paper advances the hypothesis that changes in international trade policy might influence financial leverage. In the increasingly open and interdependent world economy any such influence is likely to be of increasing importance.

Objectives

The paper investigates whether trade liberalization affects profitability and financial leverage, using Canadian data from the period following implementation of the Canada-U.S. Free Trade Agreement.

Findings

The paper finds that falling domestic tariffs are associated with declining profits and increasing leverage for import-competing firms, while falling foreign tariffs are associated with increasing profits and decreasing leverage for firms in export-oriented industries. This pattern is consistent with the "pecking order" theory of capital structure.

Data Sources: Corporate tax information from "T2" tax forms, and the Longitudinal Employment Analysis Project

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