Tax reform and corporate investment: Theory and evidence of a Q theoretic approach

Abstract

This research employs a Q theory of investment framework to examine the effects of U.S. tax reform on corporate investment in the 1980's. The Miller-Modigliani theorem suggests that a firm's real decisions regarding capital, labor, and investment will be independent of its financial decisions such as debt leverage, liquidity, and dividend payout under the assumption of perfect capital markets. By relaxing the assumption of perfect capital markets, it is possible to test the relationship between the firm's real and financial decisions. Specifically, this work tests for sensitivity of investment to liquidity constraints under two alternative processes for explaining firm dividend behavior.This work adds to the existing literature by examining the role of dividend policy in determining investment behavior of the firm. This is accomplished by developing and testing two Q specifications based on alternative assumptions about the dividend process of the firm. Estimations are performed on a panel of 220 COMPUSTAT firms over a 14 year time period to investigate the dynamic nature of firm investment. The significance of liquidity constraints is tested by including a measure of cash flow in the reduced form investment equation. The econometric approach takes into account the endogenous nature of both cash flow and Q by using lagged endogenous variables as instruments and employs a Generalized Method of Moments (GMM) estimation procedure to account for heteroscedasticity in the data.Findings indicate that liquidity constraints are important in determining firm investment behavior. This significance is confirmed for the All Firms category as well as for the larger firm size categories. Further, this finding appears to be robust to Q specification based on alternative dividend policy assumptions. Overall, results support the notion that investment growth did not fluctuate outside its normal range during the 1980's.