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U.S. Tax Reform Impacted Foreign Firm’s Stock Returns Unevenly, With China Seeing the Largest Decline

Research from Wisconsin School of Business shows that U.S. tax reform changed the global competitive landscape, with China experiencing a total market value decrease of about $237 billion

By Wisconsin School of Business

April 15, 2019

The most recent U.S. tax reform included a substantial corporate tax rate cut from 35 percent to 21 percent. Proponents of the policy deemed the decrease to be necessary to increase U.S. competitiveness abroad, while opponents argued tax cuts would not improve U.S. firms’ ability to compete globally.

With much focus on U.S. firms’ reactions to the Trump election and the passage of the Tax Cuts and Job Act (TCJA), data has been lacking about the tax reform’s foreign spillover effects. With further tax cuts, foreign firms can also experience positive returns, as they enjoy lower taxes on their U.S. operations and U.S. prosperity increases demand for foreign goods.

A new study led by Fabio B. Gaertner, associate professor of accounting & information systems at the Wisconsin School of Business at the University of Wisconsin–Madison, along with Jeffrey L. Hoopes at the University of North Carolina and Braden Williams at University of Texas at Austin, found that the latest tax reform impacted foreign firms’ stock returns unevenly, shifting the competitive landscape. While U.S. markets and the rest of the world on average saw positive returns, Chinese stocks experienced a total market value decrease of about $237 billion in response to the latest U.S. tax reform.

“Our research indicates that investors believed U.S. firms would be better able to compete with Chinese firms as a result of the tax reform,” says Gaertner. “In fact, the pattern of negative Chinese returns and concurrent positive U.S. returns is consistent with the political argument that U.S. businesses were at a competitive disadvantage before tax reform, at least with Chinese firms.”

Gaertner notes that there were significant differences in the way countries, industries, and firms reacted to the tax reform:

  • Positive returns were larger for firms in Germany and in several South American countries with which the U.S. has a large trade surplus.
  • Chinese firms experienced the largest negative returns in response to the news. Only the food industry in China had positive average returns; all other industry returns in China were negative. Steel, mining and minerals, business equipment, and chemical industries all experienced returns of approximately -10 percent.
  • U.S. firms had positive returns with a 3.6 percent total cumulative return, suggesting the market responded significantly to tax reform news.
  • Foreign firms that face little competition and firms best positioned to compete against increasingly profitable U.S. firms exhibit more positive market reactions than other foreign firms. Most vulnerable foreign firms are those that will be negatively impacted by competitors being subject to a more favorable U.S. tax system.
  • Foreign-based multinationals benefited from U.S. tax reform by receiving more favorable tax treatment of their U.S. income

Outside of China, firms experienced a cumulative positive return of 2.5 percent. But firms in industries that intensively export to the U.S could be hurt by increased U.S. competition. This is particularly true in the case of increased U.S. domestic investment/production, which could lead to reduced demand for foreign goods.

“This research helps us understand how investors perceive the effect of the TCJA abroad, particularly, whether foreign stocks prices decrease because the U.S. is now much stronger from a competitive standpoint. And the answer seems to be, generally no,” Gaertner says. “Equity prices going up for most foreign firms signals that investors, in general, were not expecting a big hit to cash flows because of U.S. tax reform. The significant exception is Chinese firms, which experienced a sharp decrease in stock returns; suggesting these firms might be affected by increased U.S. competition.”

The study used empirical evidence on the effect of U.S. tax reform on the equity pricing of foreign firms. The researchers looked at market returns, which reflect how investors expect U.S. tax reform will affect foreign firms’ economic outcomes. Specifically, the research examined short-window stock returns for foreign firms on six key days of heightened attention to U.S. tax reform developments.

See the recently released paper, “Making Only America Great? Non-U.S. Market Reactions to U.S. Tax Reform.”