Skip to main content
Log in

Trade liberalization, profitability, and financial leverage

  • Article
  • Published:
Journal of International Business Studies Aims and scope Submit manuscript


We investigate the effects of trade liberalization on profitability and financial leverage using Canadian data arising from implementation of the Canada–US Free Trade Agreement. We find that falling domestic tariffs are associated with declining profits, especially for import-competing firms, while falling foreign tariffs are associated with increasing profits, especially for export-oriented firms. Also, import tariff reductions tend to increase leverage while export tariff reductions tend to decrease leverage.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Subscribe and save

Springer+ Basic
EUR 32.99 /Month
  • Get 10 units per month
  • Download Article/Chapter or Ebook
  • 1 Unit = 1 Article or 1 Chapter
  • Cancel anytime
Subscribe now

Buy Now

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Similar content being viewed by others


  1. Statistics Canada information on national income accounts, available at the Statistics Canada website at, indicates that between 2000 and 2004 exports averaged more than 40% of GDP and imports were close to 40% of GDP. See CANSIM Table 228–0003. Putting these numbers together and adjusting for government output (most of which is not traded) implies that well over two thirds of the private sector economy is either export-oriented or import-competing.

  2. The share of exports and imports going to and coming from the United States is readily available from the Statistics Canada website at See CANSIM Table 379–0017.

  3. An ‘establishment’ is not necessarily equivalent to a ‘firm’, as some large firms have more than one establishment, but the overwhelming majority of firms are single establishments and, correspondingly, the vast majority of establishments correspond to independent firms. We shall use the term ‘firm’ to represent the units in the data set from now on.

  4. We use the log of (profits+1) so as to bound the argument of the log function strictly away from 0. This is desirable given that the log of 0 is not defined. Using the log of profits (i.e., without adding 1) has no significant effect on the results but, in our view, is conceptually flawed.

  5. In view of the time-series variation in the data it is possible in principle to include three-digit fixed effects. However, the only source of variation in tariff changes for a given firm is that some tariffs went to zero over 5 years and thereafter remained unchanged. Computationally, three-digit fixed effects absorb the variation due to cross-sectional variation in tariff changes. Also, we expect industry effects to operate at a higher level of aggregation than the three-digit level in any case. We therefore report results based on two-digit SIC fixed effects. There are 22 two-digit industries in the data and 121 three-digit industries. For example, the two-digit industry ‘Transportation Equipment’ is subdivided into eight three-digit industries, including aircraft, motor vehicles, motor vehicle parts, truck and bus body parts, and railroad rolling stock. We have run regressions using three-digit industry fixed effects and find that the effects of tariffs on profit remain significant and qualitatively similar to the results in the paper. However, the significance of the effect on leverage is largely eliminated.

  6. This is consistent with the empirical work of Brander (1991) and Thompson (1993) showing that expected and actual ratification of the FTA had a significant effect on stock market valuations of Canadian firms.

  7. These results and all other regression results referred to in the text but not reported in tables are available from the authors on request.

  8. Strictly speaking, this event cannot be called a true ‘experiment’ as the tariffs and subsequent tariff reductions arose from an endogenous process, not from the exogenous determinations of an experimenter. However, we might describe it as a ‘quasi-experiment’ in which the ‘treatment group’ consists of firms subject to large tariff changes. At the very least, we would follow Trefler (2004) in saying that the Canada-US FTA was a relatively clean policy exercise in that the changes in trade policy consisted almost entirely of tariff changes.


  • Allen, F. (2000) ‘Capital structure and imperfect competition in product markets’, in P.J. Hammond and G.D. Myles (eds.) Incentives, Organization, and Public Economics: Papers in Honour of Sir James Mirlees, Oxford University Press: Oxford, UK, pp: 281–301.

    Google Scholar 

  • Baggs, J. (2005) ‘Firm survival and exit in response to trade liberalization’, Canadian Journal of Economics 38 (4): 1364–1383.

    Article  Google Scholar 

  • Baker, M.P. and Wurgler, J. (2002) ‘Market timing and capital structure’, Journal of Finance 57 (3): 1–32.

    Article  Google Scholar 

  • Beaulieu, E. (2000) ‘The Canada–US Free Trade Agreement and labour market adjustment in Canada’, Canadian Journal of Economics 33 (2): 540–563.

    Article  Google Scholar 

  • Brander, J.A. (1991) ‘Election polls, free trade, and the stock market: evidence from the canadian general election’, Canadian Journal of Economics 24 (4): 827–843.

    Article  Google Scholar 

  • Brander, J.A. and Lewis, T.R. (1986) ‘Oligopoly and financial structure: the limited liability effect’, American Economic Review 76 (5): 956–970.

    Google Scholar 

  • Brander, J.A. and Spencer, B.J. (1984) ‘Tariff Protection and Imperfect Competition’, in H. Kierzkowski (ed.) Monopolistic Competition and International Trade, Oxford University Press: Oxford, UK, pp: 194–206.

    Google Scholar 

  • Bris, A., Koskinen, Y. and Nilsson, M. (2003) ‘The Euro is good after all: evidence from corporate valuations’, Working Paper, Yale School of Management.

  • Buffie, E.F. and Spiller, P.T. (1986) ‘Trade liberalization in oligopolistic industries: the quota case’, Journal of International Economics 20 (1): 65–82.

    Article  Google Scholar 

  • Donaldson, G. (1961) ‘Corporate Debt Capacity: A Study of Corporate Debt Policy and the Determination of Corporate Debt Capacity’, Graduate School of Business Administration, Harvard University.

  • Feinberg, S.E. and Keane, M.P. (2001) ‘US–Canada trade liberalization and MNC production location’, Review of Economics and Statistics 83 (1): 118–132.

    Article  Google Scholar 

  • Feinberg, S.E. and Keane, M.P. (2005) ‘Accounting for the growth of MNC-based trade using a structure model of the US MNCs’, Discussion Paper, University of Maryland.

  • Frank, M.Z. and Goyal, V.K. (2005) ‘Capital structure decisions: which factors are reliably important?’, Discussion Paper, University of British Columbia.

  • Gaston, N. and Trefler, D. (1997) ‘The labour market consequences of the Canada–US free trade agreement’, Canadian Journal of Economics 30 (1): 18–41.

    Article  Google Scholar 

  • Gu, W., Sawchuk, G. and Rennison, L.W. (2003) ‘The effects of tariff reductions on firm size and firm turnover in Canadian manufacturing’, Review of World Economics 139 (3): 440–459.

    Article  Google Scholar 

  • Hay, D.A. (2001) ‘The post-1990 Brazilian trade liberalisation and the performance of large manufacturing firms: productivity, market share and profits’, Economic Journal 111 (473): 620–641.

    Article  Google Scholar 

  • Head, C.K. and Ries, J.C. (1999) ‘Rationalization effects of tariff reductions’, Journal of International Economics 47 (2): 295–320.

    Article  Google Scholar 

  • Lester, J. and Morehen, T. (1987) ‘New estimates of Canadian tariff rates by industry and commodity’, Canadian Department of Finance. Working Paper, No. 88-2.

  • Lewis-Bynoe, D., Griffith, J. and Moore, W. (2002) ‘Trade liberalization and the manufacturing sector: the case of the small developing country’, Contemporary Economic Policy 20 (2): 272–287.

    Article  Google Scholar 

  • Maksimovic, V. and Zechner, J. (1991) ‘Debt, agency costs and industry equilibrium’, Journal of Finance 46 (5): 1619–1643.

    Article  Google Scholar 

  • Modigliani, F. and Miller, M.H. (1958) ‘The cost of capital, corporation finance and the theory of investment’, American Economic Review 48 (3): 261–297.

    Google Scholar 

  • Myers, S.C. (1984) ‘The capital structure puzzle’, Journal of Finance 39 (3): 574–592.

    Article  Google Scholar 

  • Pavcnik, N. (2002) ‘Trade liberalization, exit, and productivity improvements: evidence from Chilean plants’, Review of Economic Studies 69 (1): 245–276.

    Article  Google Scholar 

  • Thompson, A.J. (1993) ‘The anticipated sectoral adjustment to the Canada–United States free trade agreement: an event study analysis’, Canadian Journal of Economics 26 (2): 253–271.

    Article  Google Scholar 

  • Titman, S. (1984) ‘The effect of capital structure on a firm's liquidation decision’, Journal of Financial Economics 13 (1): 137–152.

    Article  Google Scholar 

  • Trefler, D. (2004) ‘The long and short of the Canada–US free trade agreement’, American Economic Review 94 (4): 870–895.

    Article  Google Scholar 

  • Wooldridge, J.M. (2002) Introductory Econometrics, (2nd ed.), South-Western: Mason, Ohio.

    Google Scholar 

Download references


This paper is related to Chapter 3 of Jen Baggs' unpublished PhD thesis, written at the University of British Columbia. We thank Lorraine Eden, in her role as departmental editor, and four anonymous reviewers for very helpful comments. In addition, we thank Avi Goldfarb, colleagues at Queen's University, and colleagues at the University of British Columbia, particularly Werner Antweiler, Sandra Chamberlain, Murray Frank, Keith Head, Kai Li, and John Ries. We also owe a significant debt to the Business and Labor Market Analysis Division of Statistics Canada, particularly Garnett Picot. The authors are associated with the Entrepreneurship Research Alliance, and gratefully acknowledge financial support from Social Sciences and Humanities Research Council (SSHRC) MCRI Grant 412-98-0025.

Author information

Authors and Affiliations


Corresponding author

Correspondence to James A Brander.

Additional information

Accepted by Lorraine Eden, Departmental Editor, 6 July 2005. This paper has been with the author for two revisions.

Data appendix

Data appendix

The T2-LEAP data set is created by linking the Longitudinal Employment Analysis Project (LEAP) with the Corporate Tax Statistical Universe File (T2SUF). Firms enter the LEAP database when they first hire employees, and exit the database when they cease to have employees. Annual employment for each firm is measured in average labor units (ALU). The reported ALU is interpreted as the number of ‘standardized employees’ working for a firm during a year. A standardized employee corresponds to the industry-specific average (based on payroll data) across full-time and part-time workers.

The T2SUF tracks every incorporated firm in Canada filing a T2 form with the Canada Revenue Agency (CRA). Thus, the T2-LEAP data set contains every firm in Canada that is both incorporated and legally hires employees. We limit our data to firms with more than one employee. This removes the very smallest firms and a lot of ‘noise’ from the data. The eliminated firms are significant in number but negligible in economic importance.

A second filter relates to leverage as measured by debt to asset ratio. Firms report assets, debt, and equity. CRA reporting imposes the constraint that the sum of debt plus equity equals assets. Firms normally determine a book value of assets and a book value of debt according to tax law and generally accepted accounting principles (GAAP). Equity is then determined as the difference between assets and debt. Assets almost always (i.e., in about 97% of cases) exceed debt, leading to a leverage ratio between 0 and 1. However, firms can have debts exceeding the book value of assets, implying a leverage ratio exceeding 1. Most such cases reflect a measurement problem. A firm might borrow money on the basis of a business idea that is, conceptually, an economic asset, but that is not reported as an asset. Debt could then exceed reported assets, and the leverage ratio could exceed 1, even though the ‘true’ debt to asset ratio would be less than 1. In fact, a few firms report positive debt and no assets, leading to infinite leverage ratios. There are also some finite but absurdly large ratios that would be misleading outliers in any regressions. We eliminate all observations for which the debt to asset ratio exceeds 2. This filter eliminates observations whose values consist primarily of measurement error.

T2-LEAP contains firm information for 15 years, from 1984 to 1998. However, the first and last years are subject to partial reporting, leaving the usable portion as 1985 to 1997. We use observations from 1989 forward, and use earlier data when necessary in constructing lags. For each firm, we discard the first and last year of its life in T2-LEAP, as the first and last years will typically be partial years. As we use first differences for some variables, we need two full calendar years of data for a given observation. For example, the firms appearing in our sample for 1989 are those that became incorporated and hired one or more employees on or before 31 December 1987, and did not exit the market before 1990.

The data set includes Canadian subsidiaries of foreign corporations. A large majority of firms either have purely Canadian or widely dispersed ownership. The share of Canadian manufacturing assets controlled by wholly owned or partially owned subsidiaries of American firms is fairly large (approximately 26%), but this ownership is concentrated in large firms (GM Canada, Ford Canada, etc.). We believe that subsidiaries will, in any case, normally be subject to the same incentives as other firms in making capital structure decisions, and that any deviations would have no systematic effect that would bias our analysis.

For firms involved in mergers, acquisitions or spinoffs during the sample period, the T2LEAP record is defined by retrospective reconstruction. If, for example, firm A merged with firm B in year t, then a new firm, C, is created and given a synthetic history aggregated from the histories of firms A and B. The individual histories of A and B disappear from the database, and firm C represents their joint operations.

Using three-digit SIC codes, we are able to match both Canadian and US tariff rates to each firm by year and industry as in Head and Ries (1999). The matching of tariffs to three-digit SIC codes is from Lester and Morehen (1987). The starting point is statutory commodity-level tariffs. These tariffs are aggregated to the three-digit level by taking a weighted average of the underlying commodities in each three-digit category. The weights are production weights where possible, augmented by trade weights. US tariffs are compiled using the 93 industry classification provided in Table A2.1 of the Canada–US Free Trade Agreement: An Economic Assessment (Government of Canada, Department of Finance, 1988).

The annual prime rate and exchange rate are used as control variables. The prime rate was 13.3% in 1989, peaked at 14.1% in 1990, and reached its lowest point in 1997 at 5.0%. The exchange rate was 0.845 US dollars per $C in 1989, rose as high as 0.873 (in 1991), and fell to 0.722 as of 1997.

Rights and permissions

Reprints and permissions

About this article

Cite this article

Baggs, J., Brander, J. Trade liberalization, profitability, and financial leverage. J Int Bus Stud 37, 196–211 (2006).

Download citation

  • Received:

  • Revised:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: