Fiscal Consolidation and Firm Dynamics: Theory and Evidence (with Gulcin Ozkan, and Paulo Santos Monteiro)

Full paper (here); Slides (here)

The effects of fiscal consolidation on output and unemployment have been extensively investigated in the literature. They find that expenditure-based austerity plans are much less costly in terms of output losses than tax-based austerity plans and that adjustments that rely primarily on tax hikes do not lead to a permanent consolidation of government finances. However, existing empirical studies have focused on aggregate level data and have failed to consider the heterogeneous effects that fiscal consolidation might have on the economic performance of the business sector. This omission, due in large part to the scarcity of firm-level data capturing how firm’s assets and liabilities are affected by fiscal consolidation, restricts our knowledge about how fiscal adjustments impact economic performance. Moreover, the endogeneity of tax policy makes it very hard to obtain robust estimates of the causal effect of fiscal consolidation without using disaggregated data.

This paper provides novel empirical evidence on the transmission of fiscal shocks to the firm's employment, investment, and balance sheet. We identify tax multipliers by including unanticipated narrative tax shocks in a panel VAR model. We provide evidence of heterogeneous responses across credit-constrained and unconstrained firms. Finally, we provide a simple theory to explain these findings.

We find that tax-based fiscal consolidations lower firm-level employment and investment but raise labor productivity. In addition, we show that fiscal consolidations lead to higher firm leverage and also raise cash holdings (liquid assets). However, financially constrained firms deleverage. In addition, we find that fiscal consolidations lower investment by small and financially constrained firms mostly.

We propose a simple model with the following ingredients to explain the possible mechanisms that drive differential responses by small and large firms to fiscal adjustments: heterogeneous firms (with endogenous exit dynamics); debt financed working capital requirements); borrowing constraints a la Kiyotaki and Moore (1997). Therefore, fiscal consolidation leads to: lower labor demand and employment; higher labor productivity (reallocation across firms); higher leverage for unconstrained firms and finally cleansing effects (endogenous exit of least productive firms).

Financial Constraints and the Effect of the Corporation Income Tax: Average vs. Marginal?

Full paper (here); Slides (here)

How do firms respond to changes in average versus marginal tax rates? In this paper, we find evidence that unconstrained firms are more sensitive to changes in marginal rates and, conversely, constrained firms are more sensitive to changes in average rather than marginal rates. Our findings are consistent with the view that firms' response to average versus marginal tax rates depends on their access to credit markets. This result is robust to alternative choices of the dependent variable and across alternative approaches for sorting firms into financially constrained and unconstrained.

Most empirical studies in macroeconomics and corporate finance rely on the assumption that firms respond to prices set in centralized securities markets, such as the market for interest rates (through the "cost of capital" or "q"). The implication of this view for tax policy is clear: the marginal tax rate (MTR) on returns from a new project matter for investment, not the firm's average tax burden on returns from its investments in place. In this paper, we use variations in average and marginal tax rates to examine the link between taxation and financial frictions, and correspondingly, the role played by average as opposed to marginal rates in determining corporate activities.

Our paper is the first to provide empirical evidence that constrained firms are significantly more responsive to ATRs than unconstrained firms that are relatively more sensitive to MTRs. Although this view has been mentioned previously, however, there are no empirical studies addressing this notion. For our empirical purpose, we report estimates from a set of regressions using a sample of public companies in the US with financial data. In particular, we examine the response to average and marginal tax changes of investment, cash holdings, debt, and inventories of constrained and unconstrained firms.

The results support our hypothesis. We find a significant effect of the ATR on firms' activities for constrained but not unconstrained firms. The results are robust to alternative methodologies for measuring dependent variables and to alternative methods of identifying financially constrained and unconstrained firms. In particular, our results are robust to four alternative approaches for sorting firms into financially constrained and unconstrained using annual payout ratio, debt ratings, paper ratings, and Kaplan-Zingales index.

Conference and Seminar Presentations:

Fiscal Policy Workshop (University of York), 12-13 September 2019

EcoMod conference (Ca Foscari University of Venice), June 6, 2019

Annual Conference (Heriot-Watt University - Royal Bank of Scotland, Edinburgh), 5-7 September 2018