Fiscal Consolidation Policies and Corporate Investment Composition

Transcription

1 Fiscal Consolidation Policies and Corporate Investment Composition Şenay Ağca George Washington University Xiangming Fang International Monetary Fund Deniz Igan International Monetary Fund September 2015 Abstract We examine the effect of fiscal consolidation carried out to reduce government debt on corporate investment by looking at working capital, fixed capital and R&D investments in 16 advanced economies. Corporations reduce both working capital and capital expenditure but do not alter their R&D investments in response to fiscal consolidations. The reduction in working capital is twice as much as that is in fixed capital investment. The cuts in fixed capital investment are observed primarily for firms that are more financially constrained. Overall, the evidence indicates that corporations respond to fiscal consolidations by adjusting short-term and liquid corporate investments substantially more than fixed capital and do not change R&D investment. The costs of fiscal consolidation are born primarily by firms that are financially constrained or that are more reliant on domestic economy as these firms scale back fixed capital investments, which have higher adjustment costs. JEL Classification Numbers: E62, G28, G32, H32, H60 Keywords: Corporate investment, fiscal consolidation, capital expenditure, working capital, sovereign debt

2 1. INTRODUCTION Government deficits and sovereign debt soared as a result of the fiscal response to the financial crisis , raising serious concerns about fiscal sustainability. Against this backdrop, many governments have been undertaking measures to reduce government debt levels through a combination of spending cuts and tax hikes. These fiscal consolidations constitute an important policy issue for major economies and yet the debate on the short term effects of these policies is not settled. In the long run, fiscal consolidation helps government reduce debt levels, boost investor confidence and improves economic growth. 1 In the short run, however, some studies find that fiscal consolidation has contractionary effects on economic activity (for example, Guajardo et al., 2011; Blanchard and Leigh, 2013), whereas others indicate that fiscal consolidation can stimulate economy even in the short run because reduced deficit could improve household and business confidence (for example, Giavazzi and Pagano, 1990, 1996, Alesina and Perotti, 1997). A key element of economic growth is private investment. How does private sector adjust their investments in response to fiscal consolidations? In this paper, we focus on this question by looking at the composition of investment in the corporate sector. Corporations can respond to fiscal policies by changing their short term and liquid investments, fixed investments or R&D investments. Investments on R&D are the main channel of innovation within a firm that can bring in long term growth prospects. Fixed capital investment is also more closely linked to long- 1 See among others, Giavazzi and Pagano (1990, 1996), Alesina and Perotti, (1995, 1997), Alesina and Ardagna (1998, 2010). 2

3 term economic growth. Further, both R&D investments and fixed investments have higher adjustment costs than working capital and therefore it is more costly for a firm to modify investment in these investments than in working capital. Thus, in response to fiscal shocks, investments should be directed to projects with long term growth aspects. Indeed, Fazzari and Petersen (1993) indicate that corporations adjust their working capital to maintain a relatively stable fixed-investment path. Aghion et.al. (2014) discuss that fiscal shocks affect short-run output and that there is no agreement on the size of the effect. Also, Aghion et.al. (2010) and Aghion et.al. (2014) point out to the importance of credit constraints channel in examining the effects of fiscal policies on investment composition. Credit constrained firms may not be able to adjust due to financing frictions and may need to cut short term investment more substantially to accommodate longer term investment prospects. These firms also resort to cuts in long-term investments with higher adjustment costs. Using firm level panel data for 16 advanced economies over the period and detailed fiscal consolidation measures, we find that fiscal consolidation has a negative effect on both capital expenditure and working capital, whereas there is no significant effect on R&D investment. The effect on working capital is more substantial than on fixed capital - the cuts in working capital are twice as much as that is observed for fixed capital. These findings are in line with the arguments that firms adapt to fiscal shocks by considerably adjusting their short term and liquid investments whereas they alter their projects with higher adjustment costs on a relatively smaller scale. We next examine how financial constraints and industry characteristics affect the dynamics between fiscal consolidation and investment composition. Aghion et.al. (2014) show that investments of external finance dependent firms are more directly affected from fiscal 3

4 policies. Indeed Ağca and Igan (2014) show that cost of corporate credit increases during fiscal consolidations, with a more pronounced effect on firms with limited alternative financing. In addition to financing constraints, fiscal policies affect growth opportunities of corporations. Firms that operate in sectors that are more dependent on domestic economy would not be able to hedge the changes in domestic economy with operations in other countries. Thus, their investment should be more sensitive to domestic policy developments. In this regard, we look at the relation between fiscal consolidation and corporate investment by considering access to finance and reliance on domestic economy. We find that fixed capital investment is adversely affected from fiscal consolidations mainly for firms with limited access to external finance (small firms, firms with no credit rating, and firms without access to ADRs). Working capital cuts, on the other hand, are observed in both small and large firms as well as those without credit ratings and ADRs. Access to finance does not seem to affect R&D investments in response to fiscal consolidations. These findings are in line with Aghion et.al. (2014) that credit conditions of firms are an important determinant on how they adjust their investment patterns during fiscal policy implementations. Also, the costs of fiscal consolidations are primarily born to small firms with limited access to alternative funding. We do not find When we look at industry composition, our results indicate that fiscal consolidation has an adverse effect on fixed capital investment and on R&D investment mainly for firms that operate in non-manufacturing sectors. Firms that operate in non-manufacturing sector are not able to respond to fiscal shocks by shifting sales and operations to other countries. Thus, fiscal consolidation policies have a substantial effect on their investments with higher adjustment costs and with long-term growth prospects. Working capital investment cuts, on the other hand, are 4

5 observed in both manufacturing and non-manufacturing sectors although the magnitude is substantially larger in the non-manufacturing sector. These findings are consistent with the arguments that firms adjust through short term and liquid investments in order to maintain a more stable long term investment path. The adjustments are more severe in industries that are more reliant on domestic economy such that these firms not only cut their working capital but also reduce their fixed capital and R&D investments. Next, we look at the details of fiscal consolidation packages. We find that both government spending cuts and tax hikes adversely affect working capital and fixed capital investments. Increases in taxes or cuts in government spending can have a more direct effect in certain sectors. We explore this issue by looking at specific tax hikes and spending cuts. In regards to tax hikes, we find that the increase in VAT taxes is associated with lower fixed capital investment in the retail sector. In regards to government spending cuts, agriculture spending cuts are adversely related to investment overall, and this adverse effect is further pronounced for firms in the agriculture sector. For defense cuts, while the overall effect of fiscal consolidation on fixed capital investment is negative, the effect is less pronounced for firms in defense sector suggesting some crowding out effect of government spending in this sector. When we consider macroeconomic conditions in examining the effect of fiscal consolidation on investment, we find that reductions in investments are predominantly observed in counties that do not follow accommodative macroeconomic policies, such as those with tight monetary policy or no currency depreciation. Overall, the paper adds to the literature on several important aspects. We examine the dynamics between fiscal consolidation and investment using firm level data and by focusing on both short term and long term investments of corporations. Hence, our paper reveals how 5

6 corporations change their investment patterns in response to fiscal consolidation. Further, using firm level data, we uncover how financing conditions and sector characteristics affect these corporate investment patters. Another important contribution is the examination of the details of fiscal consolidation, which reveals a more direct test of the effects of fiscal consolidation on investment in certain sectors, which alleviates concerns about causality. We use fiscal consolidation measures implemented based on discretionary decisions to reduce government debt, which should not be systematically related to prospective economic development. In robustness tests, we also show that our results continue to hold using alternative definitions of fiscal consolidations. The remainder of the paper is organized as follows. Section 2 describes the data and empirical methodology. Section 3 presents the results on the relation between fiscal consolidation and corporate investment. Section 4 concludes. 2. DATA AND METHODOLOGY 2.1. Data We calculate fiscal consolidation measure as in Devries et al. (2011), and extend the dataset for the period Devries et al. (2011) builds on the approach developed in Ramey and Shapiro (1998), Romer and Romer (2010) and Ramey (2011), where they consult contemporaneous official documents to identify the size, timing and motivation for the fiscal actions taken by each country. In particular, only the discretionary changes in fiscal policy with an aim to reduce the government deficit are recorded as fiscal consolidation. Consequently, such fiscal consolidations should not be systematically related to current economic developments (Romer and Romer, 2010). In the end, 116 fiscal consolidation episodes in total are considered in 6

7 the paper. All 16 countries have implemented fiscal consolidations in the sample period, although some countries are more active than the others. Fiscal consolidations for each country and year are in Appendix 1. We also consider an alternative definition of fiscal consolidations that are based on cyclically adjusted primary balances as in Alesina and Perotti (1997) and Alesina and Ardagna (1998, 2010). Also in alternative specifications, following the literature, for both fiscal consolidation measures, we consider large consolidation as those exceeding 1.5 percent of GDP. We look at a panel of 16 advanced countries for a time period from The countries included in the sample are Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Portugal, Spain, Sweden and United Kingdom. The data used in the paper is on annual basis and from several sources. Firm-level financial and accounting data are from WorldScope. Most fiscal and macroeconomic data are from the OECD, IMF and the World Bank database. GDP forecast data is from Consensus Forecast database. Sovereign ratings data is provided by Moody s. Indices on government stability, law and order and investment profile come from the PRS Group s International Country Risk Guide (ICRG) Methodology The empirical specification is a firm level panel regression with firm and year fixed effects, where standard errors are clustered at the firm level. We estimate the relation between investment and fiscal consolidation measures, while controlling for an extensive list of firm and country level variables. The general form of regression equation is as follows: 7

8 The dependent variable is measured as working capital, capital expenditure, or R&D investment, all of which are scaled by the beginning of period total assets. In all the specifications, i, j and t represent firm, country and time, respectively. Fiscal is a measure of fiscal consolidation. In the baseline, we consider total fiscal consolidation in percent of GDP and later, we consider variations of this fiscal consolidation measure such as tax hikes, government spending cuts or indicators related to fiscal consolidation packages. CF is the cash flow of a firm and TobinQ represents firm s growth opportunities. We also differentiate between negative and positive cash flow as firms in distress may behave differently than those that are not (Allayannis and Mozumdar, 2004). In this regard, we include an interaction of an indicator that takes the value of one when cash flow is negative with the cash flow variable. Ctry is a set of countrylevel control variables. Definition of variables is provided in Appendix 2. We consider beginning of period fiscal consolidation in examining the relation between fiscal consolidations and investment since investment decisions should be carried out given the information available at the start of the period. Firm level control variables are cash flow (CF) and growth opportunities (TobinQ), which are the main determinants of corporate investment at the firm level. Firm level variables are winsorized at 1 and 99 percentile to remove outliers. For country level control variables, consistent with related literature, we use sovereign ratings of countries, sovereign debt in percent of GDP, inflation, level of interest rate, change in interest rate and exchange rate, natural logarithm of real GDP, nominal GDP growth, stock market capitalization, imports and exports in percent of GDP, government stability, law and order, and country investment profile. 8

9 Sovereign rating and sovereign debt are used to control for debt sustainability and credit risk of a country, which directly affects fiscal policies and sovereign risk premium. Inflation, interest rate and exchange rate are controlled as they are related financial and monetary environment in a country. GDP growth reflects overall economic condition, while exports and imports entails country s trade position. Political risk of a country is measured by averaging tree sub-indices of ICRG country risk law and order, government stability and investor profile. Government stability sub-index of ICRG is also considered separately to assess the effects of fiscal policy in relation to the stability of the political system. 3. EMPIRICAL RESULTS Table 1 presents descriptive statistics. We have 122,947 observations from 16 advanced economies over the period The average fiscal consolidation accounts for 0.2 percent of GDP. The largest fiscal consolidation 4.7 percent of GDP is observed for Ireland in Average spending cuts are larger than tax hikes (0.12 percent versus 0.09 percent). For sovereign bond ratings, the letter rating from Moody s is converted to a numeric one as following: the highest rating, Aaa, is equal to 21 and the value decreases by 1 for each downward notch in rating. The average sovereign rating is somewhere between Aa2 and Aa1, with the lowest rating, Baa1, observed for Ireland in Sovereign debt is 92 percent of GDP on average, and the maximum is above 200 percent of GDP for Japan after Short-term interest rate exhibits a high degree of variation. The interest rate is lower than 1 percent in Japan in the middle 1990s, while it is above 15 percent in Italy, Spain, Portugal and Australia from middle 1980s to early 1990s. The changes of exchange rate also vary widely, while the average inflation is low, around 1 percent. As the sample contains advanced economies only, the average 9

10 nominal GDP growth and political stability index is high, and their trade are open to the rest of world. Working capital, capital expenditure, and R&D expenses account for 19 percent, 7 percent, and 4 percent of total assets for an average firm, respectively. 2 Cash flow is 1 percent of total assets and the mean growth opportunity (i.e. Tobin s Q) is The leverage ratio and size of assets are fairly varied in the sample. There is variation in firm level variables within the sample as shown in 25 th and 75 th percentiles Corporate Investment Horizon Table 2 presents the baseline results using equation on fiscal consolidation and corporate investment as in equation (1). Table reports results for working capital, capital expenditure, and R&D expenses. Firm and year effects are controlled and standard errors are clustered at the firm level. Results in Table 2, Panel A suggest an adverse relation between fiscal consolidation and working capital investment. Working capital is shorter term and more liquid than fixed investment, whereas fixed capital investments have higher adjustment costs. In this regard, most of the adjustment is likely to occur through working capital where firms prefer not to alter their fixed capital investments due to irreversibility and also long term growth prospects. In the table, we also report results where we include an indicator variable for fiscal consolidation, which is equal to 1 whenever country has a consolidation. The results show a similar relationship between fiscal consolidation and capital expenditure. 2 As all firms in the sample do not have investment in R&D, a subsample containing only firms with at least one positive R&D observation is used to test the effect of fiscal consolidation on R&D expenses. This sample consists of 61,152 observations. 10

11 Corporate capital expenditure is also adversely affected from fiscal consolidation measures that aim to reduce government debt. This finding is in line with the view that fiscal consolidations can be contractionary in the short run due to the break in the aggregate demand. This finding also supports that the uncertainty about the effects of fiscal policy on aggregate demand and corporate profitability leads to lower investment. When we look at the economic significance of these findings, we observe that the response of working capital to fiscal consolidation is more substantial than that of fixed capital. Specifically, increasing fiscal consolidation by one standard deviation (0.44 percent of GDP) corresponds to a decrease in working capital that is twice as much as that is observed for fixed capital investment. The magnitude of decrease is 0.73 and 0.14 for working capital and fixed capital investment, respectively. Evaluated at the mean level, this finding indicates that working capital reduces by around 4 percent, whereas fixed capital investment decreases around 2 percent. This evidence gives support to the view that firms use the changes in working capital to buffer against economic shocks and also to maintain a stable fixed-investment path as in Fazzari and Petersen (1993). In Fazzari and Petersen (1993), working capital and fixed investment compete for a limited pool of finance in a firm. It is usually costly for firms the change the level of fixed investment. As a result, firms smooth fixed investment in the short run by adjusting working capital substantially more than capital expenditure. Nevertheless, fiscal consolidations have an adverse relation for fixed capital investment as well, suggesting that corporations cut longer term more productive investments as well. Among country-level variables, capital expenditure declines with inflation and the increase in interest rate, as higher interest rate pushes up the cost of capital. In line with literature, the increase in exchange rate is associated with lower investment, because currency appreciation 11

12 could hurt net exports and corporate profitability. In addition, as expected, corporate investment increases with higher GDP growth and sovereign rating. With regards to firm-level variables, both growth opportunity and cash flow are positively correlated with firm s investment except when firms are in distress (indicated by negative cash flows as in Allayannis and Mozumdar, 2004). Consistent with the findings in corporate finance literature, these results show that internal funds and the growth prospects of corporations are major determinants of corporate investments. In Table 2, Panel B, we look at firms that have at least one positive R&D expense over the sample period. We present the results for working capital, fixed capital and R&D for this subsample in Panel B. When we examine R&D investment, we observe that firms do not cut their R&D expenditures during fiscal consolidation. The coefficient on working capital is similar to the one that is in the full sample. The results show a reduction in capital expenditure using fiscal consolidation indicator but is not significant when we use fiscal consolidation as percent of GDP, indicating a more mitigated response of fixed capital to fiscal consolidation for the R&D intensive firms. The findings on R&D expenses support the argument that firms smooth R&D investment over time because of its high adjustment costs (Brown and Petersen, 2011; Brown et al., 2012). Brown et al. (2012) suggest that firms seek to maintain a smooth path of R&D spending due to its high adjustment costs. Moreover, the finding is consistent with the long-term gain argument (Clinton et al., 2010). It has been emphasized for long that technological innovation based on R&D investment is indispensable to increase productivity and output. Empirical studies also support the role of 12

13 R&D as an important determinant of economic performance. 3 R&D investment may not generate profits in the short-term, but the successful R&D could be used in the production of final goods and creates a large amount of wealth for the firm in the future. R&D investment is a forwardlooking decision and closely related to growth prospects. Given that, firms may have more incentives to maintain R&D investment if they believe fiscal consolidation will benefit economic growth over the long run, even though they acknowledge the adverse impact of tightening in the short run Firm Characteristics In Table 3, we examine how firm characteristics affect the relation between fiscal consolidation and investment by focusing on firms access to external finance and their dependence on domestic economy. Although reduction in sovereign default risk through consolidation would affect all firms by reducing the credit risk arising from potential sovereign risk, the recessionary effects fiscal consolidations may be more severe for small firms (see Fazzari et al., 1988, and Hadlock and Pierce, 2010) or firms with limited alternative sources of financing. Moreover, the effects of fiscal consolidation would be more pronounced for firms operating in nonmanufacturing sectors, as they can t smooth out the fluctuations in domestic demand through the business activities in foreign markets Access to External Finance Aghion et.al. (2014) show that financial frictions are an important channel in examining the relation between fiscal policies and economic growth. To explore this issue further, we look at 3 See Guellec and van Pottelsberghe de la Potterie (2001) for an extensive empirical analysis. 13

14 firms access to external capital markets by considering size, bond rating and ADRs as alternative proxies for constraints in accessing finance. Small firms have more information asymmetry and lower collateral levels. Thus cost of external funding is higher for these firms. Firms that have bond ratings can reach to bond markets, whereas those without any ratings are mainly limited to bank loans. Lastly, firms that have American depository Receipts (ADRs) can reach global markets and therefore domestic financial frictions should not be as relevant for them. We examine the relation between fiscal consolidation and corporate investment in relation to access to external finance in Table 3. Panel A, Panel B, and Panel C give results for working capital, capital expenditure and R&D, respectively. 4 Firms that are above the median firm size in a given country are categorized as large firms, and firms below the median size as small firms. When we look at working capital in Panel A, both small and large firms cut their working capital in response to fiscal consolidation, but the magnitude is much larger on small firms. This finding suggests that smaller firms need to modify their working capital more substantially than larger firms as a buffer for fiscal adjustments. Firms without bond-rating or ADRs reduce working capital as well, whereas those with access to bond and ADR markets do not carry out any significant changes in their working capital as well. When we look at Panel B, the relation between capital expenditure and fiscal tightening is negative for small firms but not in large firms. The magnitude of coefficient for fiscal consolidation in the subsample of small firms is also larger than the one in baseline results, indicating that small firms bear the costs of fiscal consolidations. Also, firms without bond ratings and without ADRs reduce their fixed capital investments, whereas there are no adverse 4 Results on R&D expenses are based on the subsample that has at least one R&D expense over the sample period. 14

15 effects for firms with bond ratings and those with ADRs. These findings give support to Aghion et. al. (2014) by showing that firms with limited access to alternative external financing are the ones that are hurt by fiscal consolidation policies as they cut fixed capital investment and therefore forego future growth prospects. When we look at access to external finance for R&D intensive firms in Table 3, Panel C, the results do not indicate any differential response based on financial constraints. R&D intensive firms do not cut R&D investment during fiscal consolidations. This finding could be explained by R&D investment characteristics that make it different from ordinary investment (Hall, 2002). First, R&D spending is predominantly a wage payment of highly educated scientists and engineers, and their efforts make up intangible assets to the firm. On one hand, these intangible assets are difficult to evaluate and can t be used as collaterals, creating serious information asymmetry problem. As a result, firms prefer to finance R&D spending with internal funds rather than external funds. On the other hand, as R&D investment loses part of its value when the scientists are fired, firms tend to avoid laying off knowledge specialists. Second, R&D investment usually has high degree of uncertainty, especially at the beginning of a research program or project. It then requires large financial support and long-term commitment. All these characteristics suggest that firms have high incentives to smooth R&D investment as it can t alter R&D projects without incurring large costs. Overall, the findings suggest that financial constraints of firms are important determinants of corporate investment response to fiscal consolidations. Firms with limited alternative financing resources not only adjust to fiscal shocks through more liquid and short term investments in working capital but also cut their fixed capital investment, which is longer 15

16 term, more costly to adjust and with relatively higher growth prospects. Thus, fiscal consolidations have an asymmetric effect on firms depending on their access to finance Dependence on Domestic Economy Firms that are more reliant on domestic economy will not be able to hedge by shifting operations and sales to international markets when there are changes in domestic policies. As most tradable goods are manufactured products, we look at manufacturing sector and other sectors in relation to fiscal consolidations. The results are reported in Table 4. The results show asymmetric effects of fiscal consolidation in regards to manufacturing and other sectors. While firms that are in all sectors cut working capital, the cuts in working capital are substantially higher for the firms operating in other sectors. This finding suggests that firms that are more reliant on domestic economy adjust more substantially to fiscal consolidation by changing their short term and liquid investments. When we examine fixed capital, firms that are in the other sectors not only cut working capital but also their fixed capital investment. Thus, growth opportunities of firms in other sector are limited to domestic economy and fiscal consolidations have a direct effect by decreasing aggregate demand for their goods. As a result, these firms scale back their fixed capital investment, which is longer term and with higher adjustment costs. Thus, other sectors are vulnerable to fiscal consolidation policies due to their higher reliance on domestic economic conditions. Firms operating in manufacturing sectors, on the other hand, cut only their working capital investments and do not scale back their fixed capital investment. On the contrary, these firms increase their investments. This increase can be due to these firms not being affected from short term pain in the domestic economy due to hedging across other countries and also due to 16

17 positive expectations that the economy will improve in the long run due to reduced sovereign debt. When we look at results on R&D investment for the R&D intensive firms, we find that firms in other sectors cut R&D investment during fiscal consolidations whereas there are no adverse effects of fiscal adjustments on R&D expenses for the manufacturing sector. This result suggests that firms that are not able to hedge through overseas operations and thus are more sensitive to domestic policy bear significant costs as they reduce their investments with long term growth prospects and with high adjustment costs. Overall, the findings indicate that firms that depend on domestic economy are more severely and adversely affected from fiscal consolidations as they adjust both through short term and liquid as well as longer term investments with potentially better growth prospects Fiscal Consolidation Measures Tax Hikes and Spending Cuts Fiscal consolidation packages include a combination of spending cuts and tax hikes. Although the literature on the effects of composition of fiscal consolidation on economic activity is rich and varied, the evidence is mixed on the effects of spending cuts versus tax hikes. Supporters of expansionary consolidation argue that spending cut based fiscal adjustments are more effective and less likely to create recession. 5 Another strand of literature finds that tax increases have a large negative effect on investment regardless of the composition. 6 5 See Alesina and Perotti (1997), Ardagna (2009) and Alesina and Ardagna (2010) 6 See Romer and Romer (2010) and Guajardo et al. (2011) 17

18 We explore the effects of spending cuts and tax hikes on corporate investment in Table 5. The results indicate that both tax hikes and spending cuts have adverse effects on both working capital and fixed capital investment, suggesting that baseline results are driven by both tax hikes and spending cuts. For R&D investment, on the other hand, mainly spending cuts reduce R&D investment that may be driven by reduced government support for R&D activities When we look at capital expenditure, the effect of tax hikes and spending cuts are similar, indicating that both of these measures lead to reductions in fixed capital investment on a similar magnitude. In regards to working capital, on the other hand, we observe that firms scale back their working capital more in response to tax hikes than spending cuts. This finding indicates that tax hikes may be leading to lower aggregate demand or lower internal funding, as a result of which firms adjust more substantially. Regarding spending cuts, if the government was crowding out a sector, cuts in government spending can be less devastating. Although we see more substantial cuts in working capital in response to tax hikes than government spending cuts, for fixed capital investment, the coefficients on tax hikes and government spending cuts are comparable. Thus, crowding out of government is not a major driver of the findings Fiscal Consolidation Package We look at the details of fiscal consolidation packages to further explore the relation between fiscal consolidation measures and corporate investment. In addition to including tax hikes and spending cuts as percentages of GDP, we look whether specific measures are in the consolidation package. If a specific spending cut or tax hike is in the fiscal consolidation package, we include an indicator that take a value of one. For tax hikes, we consider increases in VAT, corporate and personal income taxes. For spending cuts, we look at reductions in public investment, 18

19 government expenditure, social benefits, personnel, unemployment benefits, pension benefits and healthcare benefits. Table 6 presents the results. The results indicate that government expenditure cuts and personnel cuts lead to lower investments both in working capital and fixed capital investments. VAT tax, on the other hand, has a positive effect on both types of investments, suggesting that corporations consider VAT tax increases as a credible signal for government to reduce public debt levels and hence improved expectations about future economic growth. Corporate and personal income tax hikes mainly affect working capital, but not fixed capital investment. This finding suggests that firms use working capital to buffer themselves from adverse effects of fiscal consolidation policies on fixed capital investment. The evidence is also consistent with the notion that corporations do not consider the adverse effects of these fiscal consolidation measures to be long-lasting and do not adjust their fixed capital investment as a result. Some of the specific fiscal consolidation measures included in the package can have a more direct effect on some sectors than on an average firm. We examine the effects of such fiscal consolidation measures in Table 7. Panel A, Panel B, and Panel C give results on working capital, capital expenditure, and R&D expenses, respectively. When we look at the findings on capital expenditure, VAT tax increases have an adverse effect on retail sector, and cuts in agriculture has a negative effect on an average firm and a more pronounced adverse effect on agriculture sector. For defense cuts, we find that even though overall effect is negative, for the defense sector, the coefficient is less substantial, suggesting crowding out by government in defense sector, which is mitigated with spending cuts. 19

20 The evidence on working capital and on R&D investmentent do not suggest a differential effect of fiscal consolidation measures on sectors that are more directly affected from these measures. The findings on the relation between fiscal measures and fixed capital investment in different sectors alleviate concerns about causality between fiscal consolidations and corporate investment. If the results were driven by a latent factor, we should not be seeing a differential effect for the sectors more directly related to the fiscal consolidation measures implemented. Yet, the results on capital expenditure indicate that firms operating in sectors that are more directly affected from fiscal consolidation measures respond more to the implementation of these measures than an average firm Country Conditions We examine whether country conditions, such as currency value, monetary stance, trade openness and government stability affect the relation between fiscal consolidation and corporate investment. The results are in Table 8. Panel A, Panel B, and Panel C give results on working capital, capital expenditure, and R&D investment, respectively. Fiscal policy and monetary policy are two major drivers of a country s economic performance. In this regard, we look at how the effects of fiscal policy relates to the monetary stance of a country. The results indicate that the adverse relation between fiscal consolidation and corporate investment is observed mainly in countries with tight monetary policy. Loose monetary conditions alleviate financial frictions in a country that is implementing fiscal adjustments. Thus firms do not resort to cutting short term and long term investments as a result. Exchange rate is another important policy instrument. Currency depreciation could increase external competitiveness and thus boost exports. Consequently, increasing external 20

21 demand could partly offset the contractionary effects on domestic demand caused by consolidation. This argument is supported in our findings, which show that corporations scale back fixed and working capital investments mainly in countries that do not depreciate their currencies. In countries with currency depreciations, corporations do not scale back their investment consistent with the notion that increased external competitiveness offsets for the reduction in aggregate demand due to fiscal tightening. Political stability is another important factor in examining the effects of fiscal consolidation. Fiscal policies implemented with unstable governments may not be considered credible in reducing government debt levels. As a result, policies implemented by unstable governments can increase uncertainty in the economy and dampen aggregate demand. Indeed, we find that adverse effects of fiscal consolidation on working capital and fixed capital investment are observed particularly in countries with unstable governments. Fiscal policies implemented by stable governments are considered to be credible and corporations do not change their investment patters in response to fiscal consolidation measures. The last relation we explore is trade openness of the economies. Countries that are more open to trade can tap into external markets when domestic economic conditions change due to fiscal consolidation policies. Our results indicate that firms reduce their working capital irrespective of trade openness, but scale back their fixed capital investment only in countries that are not very open to trade. Indeed in these countries, the brake on aggregate demand can dampen growth prospects of corporations. As a result, corporations resort to adjust not only by cutting only the short term and liquid investment but also fixed capital investment. 21

22 Overall, the findings indicate that more accommodating macroeconomic policies and stable governments help mitigate the adverse effects of fiscal consolidations on corporate investment Alternative Specifications We consider several alternative specifications. We differentiate between small and large fiscal consolidations, include further lags of fiscal consolidation, spending cuts, and tax hikes, replace the Moody s sovereign rating with that from the Institutional Investor, and use CAPBbased fiscal consolidation measure. The results are in Table 9. Panel A, Panel B and Panel C give the results for working capital, capital expenditure, and R&D investment, respectively. One of the major arguments of the expansionary austerity view is that large fiscal adjustments are less contractionary as they are more credible and boost investor confidence about future growth prospects. 7 In this regard, we include an interaction of an indicator variable for large fiscal consolidation with lagged fiscal consolidation. Following the literature (Alesina and Ardagna, 2010; Leigh et.al., 2010), we consider fiscal consolidations above 1.5 percent of GDP as large consolidations. The results indicate that indeed large consolidations reduce the adverse effects of fiscal consolidation on corporate investment. Yet, the relation between fiscal tightening and fixed capital and working capital continues to be negative, while firms even cut R&D expenses in this case. This finding is in line with several arguments. Large fiscal consolidation can create positive expectations as they are more credible. Also, large fiscal consolidation is less likely to be reversed in the future and deemed to have more permanent component. As a consequence, 7 See Giavazzi and Pagano(1990) and Alesina and Perotti (1997). 22

23 agents expect less disruptive adjustments in the future, and hence have a greater incentive to consume and invest. This is consistent with the finding in Alesina et al.(2012) that fiscal adjustments may be associated with low output lost when they are permanent rather than transitory. Next, we include second lags of fiscal consolidation, tax hikes and spending cuts, all measure as percentage of GDP. Both working capital and fixed capital investment do not significantly relate to these further lags and the coefficient on fiscal consolidation measures are comparable to the baseline. Lastly, we consider CAPB-based fiscal consolidation measure instead of the narrative record based consolidations used in estimations. We check whether our results continue to hold when we use this alternative method for determining fiscal consolidations. The findings show that adverse relation between fiscal consolidation and corporate investment is observed for capital expenditure and working capital with this alternative fiscal consolidation measure as well. The coefficient on the fiscal consolidation variable is relatively smaller than that is obtained in the baseline regressions but they indicate the same direction and hence are comparable. R&D expenses remain unchanged with CAPB-based fiscal consolidation measure. Since short and long term investment decisions are joint decisions, we also look at working capital and fixed investment capital together for the full sample and working capital, fixed capital, and R&D investment for the subsample with R&D expenses. We consider simultaneous equations model with two stage or three stage least squares estimation methods. As instruments, we use the average sector level corporate investment for each country in a given year. The results are provided in Table 10. Panel A presents the results for working capital and fixed capital, and in Panel B we consider R&D expenses also. The results in Panel A are in line 23

24 with those reported earlier: working capital and fixed capital investment decrease in response to fiscal consolidations, and the decrease in working capital is more substantial than fixed capital investment cuts. The results for working capital and fixed capital investment in Panel B are also consistent with the baseline results, whereas the coefficient of R&D expenses is close to the baseline but marginally significant. 4. CONCLUSION Using a panel of 16 advanced countries firm-level data and detailed fiscal consolidation measures aimed at reducing government debt, we examine how fiscal consolidation affects corporate investment by differentiating between working capital and fixed capital investments. We find that fiscal consolidation has an adverse effect on working capital as well as fixed capital investment but the effect is around three times larger on working capital than on fixed capital investment. The findings also indicate that access to finance is an important channel affecting investment behavior during fiscal consolidations. In particular, small firms, firms without credit ratings and firms with limited access to global market are more vulnerable to fiscal tightening as they cut fixed capital investment in addition to working capital, pointing out to longer term adverse effects of fiscal consolidations on these firms. We also find that both tax hikes and spending cuts lead to lower investments. Thus, fiscal consolidation weighted towards one type of measure does not alter how corporations respond to fiscal adjustments. Adverse effects of fiscal consolidations on corporate investment can be mitigated if the consolidation is large enough to signal creditability, and also when accompanied with accommodative monetary policy, currency depreciation, or carried out by a stable government. 24

25 Overall, fiscal consolidation affects both short and long term corporate investment. While corporations use working capital as a buffer while adjusting to fiscal consolidations, firms that have limited access to finance are not able to adjust solely through working capital and scale back their fixed capital investment as well. Thus, fiscal consolidation policies carry assymetric effects on corporations, where the costs are born primarily to those with limited access to finance and those that are more reliant on domestic economy. References Aghion, Philippe, Angeletos, George-Marios, Banerjee, Abhijit, and Kalina Manova, 2010, Volatility and Growth: Credit Constraints and the Composition of Investment, Journal of Monetary Economics, 57, Aghion, Philippe, Hemous, David and Enisse Kharroubi, 2014, Cyclical Fiscal Policy, Credit Constraints, and Industry Growth, Journal of Monetary Economics, 62, Agca, Şenay and Deniz Igan, 2014, Fiscal Consolidations and the Cost of Credit, Working Paper, George Washington University. Alesina, Alberto and Roberto Perotti, 1995, Fiscal Expansions and Fiscal Adjustments in OECD Countries, Economic Policy, 21, pp Alesina, Alberto and Roberto Perotti, 1997, Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects, IMF Staff Papers, Vol. 44, Alesina, Alberto and Silvia Ardagna, 1998, Tales of Fiscal Adjustment, Economic Policy, Vol. 13, No. 27, pp Alesina, Alberto and Silvia Ardagna, 2010, Large Changes in Fiscal Policy: Taxes versus Spending, Tax Policy and the Economy, Vol. 24, pp Alesina, Alberto, Carlo Favero and Francesco Giavazzi, 2012, The Output Effect of Fiscal 25

26 Consolidations, NBER Working Paper No Allayannis, G., Mozumdar, A., The impact of negative cash flow and influential observations on investment cash flow sensitivity estimates, Journal of Banking and Finance 28, Blanchard, Olivier and Daniel Leigh, 2013, Growth Forecast Errors and Fiscal Multipliers, IMF Working Paper, WP/13/1, Washington, DC Devries, Pete, Jaime Guajardo, Daniel Leigh, and Andrea Pescatori, 2011, A New Action-based Dataset of Fiscal Consolidation, IMF Working Paper 11/128, Washington, DC Fazzari, Steven, R. Glenn Hubbard, and Bruce Petersen, 1988, Financing constraints and corporate investment, Brookings Papers on Economic Activity 19, Fazzari, Steven, and Bruce Petersen, 1993, Working Capital and Fixed Investment: New Evidence on Financing Constraints, The RAND Journal of Economics, Vol. 24, No. 3 pp Giavazzi, Francesco and Marco Pagano, 1990, Can Severe Fiscal Contractions Be Expansionary? Tales of Two Small European Countries, NBER Macroeconomics Annual, Vol. 5, pp Giavazzi, Francesco and Marco Pagano, 1996, Non-Keynesian Effects of Fiscal Policy Changes: International Evidence and the Swedish Experience, Swedish Economic Policy Review, Vol. 3, pp Guajardo, Jaime, Daniel Leigh, and Andrea Pescatori, 2011, Expansionary Austerity: New International Evidence, IMF Working Paper 11/158, Washington, DC. Guellec, D. and B. van Pottelsberghe de la Potterie, 2001, R&D and productivity growth: Panel data analysis of 16 OECD countries. Working Paper 2001/3, OECD, Paris Hadlock, C., and J. Pierce. 2010, New Evidence on Measuring Financial Constraints: Moving Beyond the KZ Index, Review of Financial Studies 23, Leigh, Daniel, Pete Devries, Charles Freedman, Jaime Guajardo, Douglas Laxton, and Andrea Pescatori, 2010, Will It Hurt? Macroeconomic Effects of Fiscal Consolidation, Chapter 3 in World Economic Outlook, October, Washington, DC. Ramey, Valerie A. and Matthew D. Shapiro, 1998, Costly Capital Reallocation and the Effects of Government Spending, Carnegie-Rochester Conference Series on Public Policy, Vol. 48, pp

27 Ramey, Valerie A., 2011, Identifying Government Spending Shocks: It s All in the Timing, Quarterly Journal of Economics, Vol. 126, No. 1, pp Romer, Christina D. and David H. Romer, 2010, The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks, American Economic Review, 100(3), pp

28 Table 1. Descriptive Statistis Mean Std. Dev. 25th percentile Median 75th percentile Main Variables of Interest Capital Expenditure Working Capital R&D Expenses 1/ Fiscal Consolidation Large Fiscal Consolidation > 1.5% GDP Tax Hike Spending Cut Country Variables Sovereign Rating Interest Rate Interest Rate, Change Exchange Rate, Change Log Real GDP Nominal GDP Growth Stock Market Capitalization Exports Imports Inflation Sovereign Debt Sovereign Debt, Change Political Stability 2/ Firm Variables Size Growth Opportunities Cash Flow Negative Cash Flow Observations 122,947 Sources: WorldScope, PRS Group's ICRG, IMF, World Bank, OECD, national sources, and author's calculations. Note: All firm level variables are winsorized at 1 and 99 percentiles to reduce the influence of possible outliers. 1/ It is based on the subsample consisting of 61,152 firms that have at least one positive R&D observation. 2/ It is the average score of 3 ICRG indicies: investment profile, government stability and law&order. 28