Policy Uncertainty and Corporate Investment

Abstract:     
Using the policy uncertainty index of Baker, Bloom, and Davis (2012), we investigate how corporate capital investment at the firm and industry level is affected by the uncertainty related to future policy and regulatory outcomes. Policy-related uncertainty is negatively related to firm and industry level investment, and the economic magnitude of the effect is substantial. Our estimates indicate that approximately two thirds of the 32% drop in corporate investments observed during the 2007-2009 crisis period can be attributed to policy related uncertainty. More importantly, we document that the relation between policy uncertainty and capital investment is not uniform in the cross-section of U.S. firms. It is significantly stronger for firms with a higher degree of investment irreversibility, for firms which are more financially constrained, and for firms operating in less competitive industries. Policy uncertainty is also associated with higher cash holdings and lower net debt issuance. Overall, these results lend empirical support to the notion that policy-related uncertainty can depress economic growth through a decrease in corporate investment. This decrease is related to precautionary delays induced by investment irreversibility and to increases in the cost of external borrowing.

Number of Pages in PDF File: 56

Keywords: Political Uncertainty, Policy Uncertainty, Corporate Investment, Investment Irreversibility, Financial Constraints

JEL Classification: D80, E22, E66, G18, G31, G38

working papers series