Abstract
Integrating tax methodology and foreign exchange rates dynamics, and utilizing Miller and Scholes [1] framework, we are able to derive a testable algorithm that identifies financial flow of funds across countries, which in turn leads to short term changes in exchange rates. In this model we are going to identify changes in the flow of funds, directed toward financial investments, lending or borrowing, between two countries, and thereby the short term changes in the foreign exchange rate that solely stems from expected changes in the tax codes. Thus, expected change in the foreign exchange rate becomes an endogenous variable, while the common view in the literature is that expected change in foreign exchange rates that differs from the market consensus is the trigger for flows of funds across countries. Alternatively, by using the above-mentioned algorithm, one can imply the market beliefs regarding expected changes in the tax code.
Highlights
Integrating two different fields; taxation and foreign exchange dynamics, may lead to a resolution of the Fama’s [2] “parity puzzle”
We review the literature in the following order: first, the framework that is used in this study, foreign exchange theories, and the tax code that is related to the framework
In this paper, pointing out to a neglected area in the literature, we argue that very important factors that affect the flow of investment funds across countries are tax related: the difference in expected tax codes among various countries, the Tax Treaty that may exist between each two countries, the level of enforcement, thereby affecting both, the modeling of the Interest Rate Parity Theorem (IRP) (See Appendix), the flow of funds across countries and the exchange rates
Summary
Integrating two different fields; taxation and foreign exchange dynamics, may lead to a resolution of the Fama’s [2] “parity puzzle”. We review the literature in the following order: first, the framework that is used in this study, foreign exchange theories, and the tax code that is related to the framework . Miller and Scholes [1] developed a basic model that imbeds investment decisions and the domestic tax code.
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