Exchange Rates and Tax-Based Export Promotion

Abstract

This paper examines the impact of tax-based export promotion on exchange rates and patterns of trade. The threatened removal of Foreign Sales Corporations (FSCs) due to the 1997 European Union complaint before the World Trade Organization (WTO) is used to identify the adjustment of exchange rates to reduced after-tax margins for American exporters. The evidence indicates that days associated with significant developments in the European complaint are characterized by predicted changes in the value of the U.S. dollar. Additionally, foreign trading relationships with the United States appear to influence currency responses to the possibility of FSC repeal. Exchange rate movements on the date of the initial European complaint indicate that 10 percent greater net trade deficits with the United States are associated with currency appreciations of 0.2 percent against the U.S. dollar. This evidence is consistent with a combination of trade-based exchange rate determination and important effects of U.S. export promotion policies.