Policymakers should note that good economic policy, defined as restrained spending and an improving tax burden relative to the national economy, creates jobs and income at a rate faster than the national average. Investors should also note that small-cap stocks located within states with an improving economic environment tend to outperform the market.

Our argument is as follows: in a frictionless world, Purchasing Power Parity (PPP) would hold. To see this, consider a perfectly mobile factor located in region A. If rates of return are higher in location B, the factor in A will move to arbitrage the difference.

Generalizing this mechanism, we conclude that, for mobile factors, after-tax returns will be equalized across countries. That’s what we mean when we say that the factor is priced in the national economy–local returns for a factor will be the world’s after-tax return grossed up by local taxes. Changes in factor returns/prices send a common signal to the state’s economies, which, all else the same, induce a common economic response across states. This is an important insight for predicting regional economic performance. So, in the absence of any PPP violation, to forecast a state’s economic performance, all we need to do is forecast the national economy. As part of our economic analysis, we forecast the US real GDP growth on a regular basis; thus we already have the forecast for the impact of PPP on a state’s economic performance. All we lack is a forecast for the impact of the dispersion in state and local fiscal policy actions on the states’ relative performance.

The calculus for immobile factors of production is a little different. By definition, the factor cannot move across state boundaries; therefore that factor cannot escape local taxes. The point here is that for the immobile factor, the after-tax return or valuation need not be the same across states. Thus, if mobility is not perfect across countries or factors of production, the level and type of government expenditure and the manner in which revenues are raised across states produces systematic deviations from PPP. The burden of taxation will fall disproportionately among the least mobile factors across states and this will result in systematic differences in the pattern of returns across states. Differences in fiscal policies across states go a long way in explaining the dispersion among the state’s economic performances.

Our methodology attempts to correct some of these deficiencies. We then estimate historical relationships between state economic performance in terms of US economic performance and the dispersion of fiscal policy changes across states. The estimates of state actions for the coming fiscal year are generated by the NCSL and the equations estimated using historical relationships are then used to calculate each state’s forecast as well as the likelihood that the state will grow faster than the United States. The evidence produced by our research shows that a state’s competitive environment is directly related to its tax actions [2].

There are other reasons that lead us to focus on the smaller capitalization stocks. We believe that increases in the regulatory burden due to the changing tax laws have tilted the economic environment in favor of smaller-cap stocks. The smaller caps are more nimble and thus can react much more quickly to a changing economic environment. Since the smaller caps can move more quickly to take advantage of the changing regulations, it is easy to see why the changing environment favors the smaller caps in the short run. Nevertheless, as time goes on, many of the scheduled changes do take effect and the need to be nimble to take advantage of the changing regulatory burden disappears.

In addition, one can argue that during the last 35 years we have never gone more than one presidential term without changing the tax code in a significant way. Reagan lowered tax rates twice. Bush senior raised them once and Clinton raised the personal income tax rate and lowered the capital gains tax rate. George W. Bush lowered the top tax rates and the dividend and capital gains tax rates. President Obama raised the top personal income tax rates. Viewed this way, the uncertainty associated with the temporary nature of the tax code may be overstated. There is no reason to expect the rates to remain unchanged. Therefore we believe that a changing tax rate environment favors the smaller more nimble stocks.

However, if the tax code and regulatory environments were to become more predictable, our analysis would point to a market where the larger caps dominate the economic landscape. Again the rationale for this conclusion is straightforward. As uncertainty regarding the tax code is reduced, its impact on the regulatory burden becomes smaller and more predictable. The larger caps have the resources to hire the best lawyers and accountants, and thus they have the ability to chip away at the regulatory burden.

To the extent that one views the regulatory burden as a fixed cost, the larger corporations have an advantage over the smaller ones. The regulatory fixed costs amount to a lower increase in the per unit cost for the larger corporations. One example that immediately comes to mind is the effect of the regulatory burden and the mandated use of catalytic converters in automobiles a couple of decades ago. Because of antitrust provisions (i.e., another regulatory burden), the big three domestic automakers were forced to develop their own catalytic converters. In the absence of the antitrust provision, the three automakers could have joined forces and developed a single converter that they could have shared. Needless to say, the antitrust provision forced the development of two catalytic converters too many. The higher costs reduced the attractiveness of domestic cars relative to foreign cars not subject to the antitrust provision.

The extra costs associated with the development of the catalytic converters were borne in part by the shareholders in the form of lower profits and by the domestic workers in the form of lower employment. But that is not all. The regulation had a disproportionate impact on domestic producers. If the costs of developing the converter were roughly the same for the three automakers, the amortization of the development costs increased the unit costs of the smallest company the most. This means that the regulation put the smallest company at a competitive disadvantage over the larger ones.

The catalytic converter example provides us with a powerful insight that has clear investment implications. Once the environment becomes predictable, the regulatory burden becomes a “fixed” cost and it tends to favor the larger-cap stocks because they can amortize the costs over a larger base. One simple way to reduce the effect of the regulatory burden is to get bigger. Thus, companies have an incentive to get larger. Whether or not it is through direct investments or acquisitions is irrelevant to our argument. As long as they get larger, they will minimize the impact of the regulatory burden. By the way, one can make a similar argument regarding technology. If the gains related to productivity are large, then the larger is the ensuing volume of output. The cost amortization argument points toward a consolidation of business where a few large companies will dominate their industries.

The international trends are also inadvertently pushing the world toward consolidation. The removal of trade barriers is making the world markets approach a single market. To see this, consider the extreme case of two identical countries with trade restrictions so high that they do not trade at all with each other. In this case two identical economies will develop. The world will have two of everything. However, what if the two economies decide to merge in a union and eliminate any barriers among them? The answer depends on whether there are economies of scale or not. If they are, it will behoove the companies to grow. The one who grows first will have a cost advantage and thus will eventually dominate the market. In real life, we do not start with countries or companies being of equal size. Freer trade will give an advantage to those that are more efficient and could dominate the combined markets.

The move toward freer trade may in fact cause some consolidation to take advantage of economies of scale in the production process. Yet, the consolidation argument that we are advancing goes beyond the traditional economies of scale. The economies of scale we are focusing on are a direct result of the regulatory burden and how to amortize its costs. The quest for consolidation is that the larger the volume, the lower the per unit regulatory cost/burden. As, in general, regulations tend to be national in scope, it follows that a prudent company will tend to have a well-diversified portfolio of production facilities. The advantages of diversification to a local shock are significant. One example that comes to mind is the California energy crisis. It had a disproportionate impact on the companies located in California. This is understandable as energy costs surged mostly in California; only those who produced in California would be affected. Our research found that even within California companies, the smallest cap suffered the most. Again this is understandable; the larger-cap stocks tend to have multiplant facilities, with some outside the state. As energy costs soared in California, the multiplant companies shifted their production to facilities outside the state thereby minimizing the impact of the energy prices. In contrast, the smallest-cap companies, many of which were single plant or had the bulk of their production facilities in California, were not able to shift as much of their production outside the state. The higher energy costs had a direct and disproportionate impact on their cost, profits, and production levels. We made a similar argument during the California crisis. To test our theory we looked at the companies in the S&P 1500 headquartered in California. We also excluded the tech companies to exclude the tech debacle. The results of the remaining companies were enlightening. The large-cap companies headquartered in California lagged the non-Californian large-cap by 20 basis points. In the mid-cap universe, the Californian companies lagged the non-Californian companies by 300 basis points. For the small-cap comparison, the gap grew to 700 basis points. The results are fairly conclusive; the larger caps are able to insure against localized shocks. The corollary of that is that the larger caps will not be able to fully capture the impact of beneficial shocks. The only way to do so will be to shift all their production to the locality. If they cannot do that, then the smaller caps located in the region will outperform. The small-cap effect is the way to take advantage of location/country effects. In the world we foresee the larger caps are trying to become location-independent concerns.

We have made a compelling case for the larger-cap stocks in the long run. Does this mean that the small caps have no future? Nothing could be further from the truth; the case for the small caps is a bit different. The fact that a few global companies will dominate the markets does not rule out a role for the little guy. Although the concept of an integrated economy with a single global market is a great theoretical construct in real life, it is a chimera. The local or country effects are here to stay. There will always be the special interest groups that will create artificial barriers that will partially segment some markets (i.e., trade barriers etc.). In other cases, the local effect may be due to immobile natural resources (i.e., tourism) or due to explicit economic policy (i.e., the California energy crisis). The regional/country effects may create market segmentation that represents too small a market share for the larger global companies. Given the size of the market in relation to that of the company, it may not be worth it for the larger companies to alter their overall plans to capture such a small market. The larger companies may very well decide to bypass or ignore that market altogether. The larger companies will cede that market to other players.

One example that comes to mind is in my own native Dominican Republic (D.R.). With the opening of trade, it has become clear that many of the Dominican agricultural operations will not be able to compete with the United States. The D.R. is much better off importing rice and many other staples. The question is what would the Dominican farmers produce? Some smart producers have recognized that and instead of going toe to toe with the US producers in the regular staples, they would be better off specializing in niche markets. They have discovered that the developed countries are quite interested in organically grown products. More importantly, the organically grown products sell at a premium. The organic market is a great opportunity; it allows the local grower to use less of a very expensive product (i.e., fertilizers and other chemicals), which is too expensive for them to use. Converting to the organic reduces the use of the expensive inputs; however the decline in production would be much less than that of the US farmers who switch to organic methods because, to begin with, the D.R. farmers employ a less intensive use of the chemicals. In other words, the D.R. farmers have a clear comparative advantage in the production of the organic products.

Natural endowments, government regulations, and many other factors combine to create pockets of market segmentation/product differentiation. It is in those markets where the smaller-cap stocks have the greatest advantage. They are nimble and can adjust faster to the changing market conditions. It is at the small-cap level where the democratic capitalism will flourish and give an opportunity to compete with the emerging nations. Local entrepreneurs will develop products for the niche markets. As they become successful overtime, they will expand their scale of operations and move into the more conventional markets. In the process, these companies may join the larger-cap universe. It is at the niche level that investors have to isolate regional differences due to government regulations and other country-specific locations. Alternatively stated, it is at the small-cap level that the country effect will be most pronounced.