Download Investment in Innovation and Fixed Assets: the effect of US tax

Investment in Innovation and Fixed Assets: the effect of US tax
reforms that reduced the relative price of equity to debt
Gareth Macartney
University College London, Institute for Fiscal Studies and AIM
April 2007
[preliminary- please do not quote without the author’s permission]
Abstract
Tax reforms in the US in the mid-1980s reduced the relative tax cost of equity and internal
finance to debt by 30%, from a large reduction in the statutory rate. This paper finds evidence
that for innovative firms this lead to a decrease in ordinary investment and an increase in
innovative investment, while controlling for other variation in the prices of ordinary and R&D
investment. This suggests that equity and internal finance are cheaper for innovation than debt
finance, to the extent that exogenous decreases in their relative prices can cause innovation. The
ability to substitute from ordinary investment to R&D investment was larger for firms with
plentiful internal financial resources, consistent with a large external financing premium for
R&D.
JEL codes: L2, G32.
Keywords: Innovation, capital structure, debt, equity, investment.
Acknowledgements: The author would like to thank Sami Berlinski, Nick Bloom, Wendy Carlin, Rachel
Griffith and Bronwyn Hall for useful suggestions.
Correspondence: [email protected]; IFS, 7 Ridgmount Street, London WC1E 7AE, UK.
1
1
Introduction
Innovation as investment is long term and risky, involves high information asymmetry between
investors and firms due to its specialist nature, and offers little collateral.1 Such attributes imply
that innovation requires equity finance (or internal funds if available), rather than debt finance.
Equity instruments involve a residual claim on returns and therefore, whatever the personal risk
preferences of investors, such instruments are better suited to risky investments than debt
instruments.2 Secondary markets in shares enable equity holders to crystallise gains or loses as
more information becomes available. Equity markets involve diverse ownership which promotes
hard budget constraints in that re-financing of projects requires attracting new investors.3 Equity
holders have some residual control of the firm in the form of voting rights, although it is fair to
say that debt holders can exercise control in the form of debt covenants at the time of loan
renewal. Such considerations would imply that firms face a lower (unobserved) cost of capital
for the R&D project if financed by equity rather than debt.
Empirical evidence to date supports the assertion that internal funds and equity are associated
with R&D, see Hall (2002) for a survey. Aghion et al. (2004) shows that for publicly traded
firms those that report R&D expenditure are more like to issue new equity and more so with
greater R&D intensity. Bond et al. (2003) find that the availability of internal funds predicts
R&D participation, although not the R&D intensity thereafter, in UK firms. Although highly
informative these results could be driven by omitted variables such as demand shocks that affect
both the incentive to innovate and the availability of internal funds or the ability to raise equity.
The current paper implements a new identification strategy to test if, as debt finance becomes
more expensive relative to equity and internal funds, firms engage in more R&D. The paper uses
changes in the tax treatment of debt relative to equity as an exogenous source of variation in the
relative price.
The specific tax reform used is the 1986 corporate tax cut in the US from 49.6 percent to 34.0
percent. As the interest on debt is tax deductible the tax advantage of debt over equity decreases
with corporate tax cuts and this tax reform, therefore led to a reduction in the relative price of
equity to debt. As part of the same reform the tax base was broadened, leaving the direct effect of
taxation on the price of investment largely unchanged, at least on average. This paper controls
for variation in the price of investment, and, also controls for the impact of the R&D tax credit of
1981. The results suggest that US manufacturing firms substituted from fixed capital to
‘knowledge’ capital in that the ordinary investment rate decreased and the R&D investment rate
increased. Furthermore the substitution to R&D investment is larger for firms with internal
funds, as identified by their dividend behaviour, possibly because these firms faced a lower cost
of finance for R&D than those firms dependent on external finance.
1
About 50% of R&D costs are spent on the specialised labour of scientists and engineers, Hall (2002).
2
The payoff schedule for equity is convex for a firm with debt, whereas for the debt holder it is concave. Equity
holders like the possibility of high returns.
3
See Dewatripont and Maskin (1995).
2
Throughout the paper assumes a hierarchy of finance model of firm investment.4 Under strong
assumptions the cost of capital should be independent of the type of capital used: the financial
structure of the firm should be irrelevant to the value of the firm.5 These assumptions are: one,
there is perfect information between firms and investors; two, there is no difference in the tax
treatment of different types of finance and; three, there is no loss in the event of bankruptcy.
Where informational asymmetries do exist all firms must pay investors a ‘lemon’ premium to
insure investors against the possibility that they have invested in a bad firm6. This premium
increases the cost of external finance above that of internal finance. In all developed economies
debt has a tax advantage in that interest payments on debt finance are exempt tax at the corporate
tax rate. Bankruptcy risk increases with the indebtedness of the firm as the firm has greater and
greater interest payments that it is obliged to meet and, if we assume that there is some intangible
loss of firm value in the event of bankruptcy the cost of debt capital increases with indebtedness.
These considerations lead to a hierarchy of finance for ordinary investment where for the
marginal investment internal finance is cheaper than external finance, and, due to its tax
advantage, debt is cheaper than equity. The aim of this paper is to find empirical evidence that
the ordering is different for R&D projects, in that as equity becomes cheaper relative to debt
there is greater R&D investment relative to ordinary investment.
As well as clear implications for the nature of the tax treatment of debt this paper has
implications for the finance and growth literature. Overall financial development appears to
matter for growth in developing countries, but whether this finance is bank based or market
based seems to be unimportant in the aggregate, see Levine (2005) for a survey. However, in
developed countries Carlin and Mayer (2003) find cross-sectional evidence that inherently equity
dependent, skill-intensive industries grow faster, through increased R&D, in countries with good
accounting standards, suggesting that informational concerns are the reason behind some
industries dependence on certain financial structures.7 The current paper provides direct evidence
that institutional structures (in this case tax) that affect firm financial structure are important for
an outcome that we have strong evidence to suggest drives productivity growth.
This paper proceeds as follows: section 1 models the effect on ordinary and R&D investment of
a reduction in the tax advantage of debt; section 2 describes the empirical strategies and data
used; section 3 provides results and a final section concludes.
4
See Bond and Meghir (1994), Bond and Soderbom (2006).
5
See Miller and Modiaglini (1958).
6
As described by Akerloff (1970) for the used car market.
7
Or conversely, as is the point of Carlin and Mayer (2003), why some countries with specific financial structures
engage in certain activities.
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2
Modelling a Shock to the Tax Advantage of Debt
For a firm investing in ordinary and knowledge capital, where the former can be financed with a
mixture of debt, internal funds and equity, and the latter can be financed only with internal funds
and equity, a decrease in the tax advantage of debt will have two effects. Firstly, it will change
the steady state mix of factor inputs shifting from ordinary capital to “knowledge” capital. If we
assume that the firm has an optimal output level (i.e. the firm has market power), this will lead to
lower ordinary capital and higher knowledge capital in the steady state. Secondly, if the firm
faces strictly convex adjustment costs a decrease in the tax advantage of debt will affect the
optimal investment rate.
Considering the first effect, financing costs are important in the steady state as capital stocks
have to be maintained in the face of depreciation and this requires funding. The first effect also
assumes that firms have market power so that there is an optimal output level for given variable
(labour) costs. If this were not the case any increase in the price of one factor would lead to less
output- the factor mix would change only in the sense that ordinary capital would decrease, with
knowledge capital likely decreasing also if factors are complementary. So, for some optimal
output level Y ∗ = F ( K ∗ , G ∗ ) and linearly homogeneous production we can write:
dYt = rt K dK t + rtG dGt = 0 ,
(1)
where Yt , K t and Gt denote output, ordinary capital and knowledge capital respectively. The
prices rt K , rtG denote the user costs of capital for K t and Gt respectively. This leads to the
familiar condition for the marginal rate of technical substitution:
dGt
rK
r Debt
= − t G = − Equity /tInternalfunds ,
dK t
rt
rt
(2)
and we assume that production is such that the left hand side is more negative for higher Gt
relative to K t . From the previous discussion it is assumed that the cost of finance for ordinary
investment is increased by a loss in the tax advantage of debt and, so, the steady state value of
ordinary capital, K t∗ , will decrease, and the steady state value of knowledge capital, Gt∗ will
increase. Output will remain at the optimal level, as long as the new factor mix is within the
feasible production set (i.e. the change in relative prices is not too large). It is assumed that this
will happen in some average sense for all firms and a decrease in the tax advantage of debt is
considered an increase in the ratio of the cost of capital for debt finance to the cost of capital for
equity and internal finance, expressed as rt Debt rt Equity / Internalfunds and referred to hereafter as the
‘cost ratio’.
4
The optimal investment rate of a firm facing convex adjustment costs is given by8:
⎡ ∂Vt +1 ⎤
⎥
⎣ ∂K t +1 ⎦
βE ⎢
Π It =
α tK
=
λtK
,
α tK
(3)
where Π It = ∂Π t ∂I t is strictly positive in the ordinary investment rate, I t K t , and decreases
linearly with the price of investment goods. λtK is the shadow value of ordinary capital and α tK
is the shadow cost of finance for ordinary capital investments. Assuming convex adjustment
costs for investment in knowledge capital a similar condition holds for R&D investment:
⎡ ∂Vt +1 ⎤
⎥
⎣ ∂Gt +1 ⎦
βE ⎢
Π Rt =
α tG
λGt
= G ,
αt
(4)
where Π Rt = ∂Π t ∂Rt is strictly positive in the R&D investment rate, Rt Gt , and decreases
linearly with the price of investment goods. λGt is the shadow value of knowledge capital and
α tG is the shadow cost of finance for knowledge capital investment. λtK and λGt will follow an
inter-temporal condition dependent on discounted expected future marginal productivity shocks.
The change in the tax advantage of debt will leave α tG unchanged if debt is not used for R&D
investment, as we believe.
Assuming that ordinary investment can be finance by a mixture of debt, cash and new equity, but
that R&D investment can only be financed by cash or new equity, a reduction in the tax
advantage of debt will have the following effects. Firstly, it will change the desired steady state
production mix in favour of knowledge capital. Secondly, where it increases the shadow cost of
finance, it will reduce the ordinary investment rate. Thirdly, it will increase the R&D investment
rate as the firm tries to adjust to the new steady state and to make up for the decrease in the
ordinary investment rate, and the effect will be dampened where the shadow cost of financing
R&D investment is high. This latter effect comes from both the new steady state and the
adjustment of investment, simply in both cases it is more costly to substitute from ordinary
investment to R&D investment when the cost of R&D investment is high.
At this stage we can summarise these results as follows:
8
See Hayashi (1982), Bond and Meghir (1994), Bond and Soderbom (2007). Also, Hall (1995) and Hall and
Hayashi (1989) for models of dynamic investment with tangibles and intangibles. Investment is productive next
period.
5
Prediction 1: A decrease in the tax advantage of debt will lead to a lower fixed investment rate
and a higher R&D investment rate.
Prediction 2: The increase in the R&D investment rate will be lower for firms facing higher
financing costs.
We can consider a change in the desired steady state mix of factors from K t∗ to Gt∗ as a
reduction in the shadow value of ordinary capital, λtK , and an increase in the shadow value of
knowledge capital, λGt . Intuitively, ordinary capital becomes less valuable as the financial cost of
maintaining it increases, and as a result, to maintain optimal output, knowledge capital becomes
more valuable. This implies that:
Π It = λtK + f (CostRatio t ) + S t * f (CostRatio t )
(5)
Π Rt = λGt + g (CostRatio t ) + S t * g (CostRatio t )
(6)
where S t is a measure increasing with the shadow cost of finance, and the CostRatiot increases
as debt becomes more expensive relative to other forms of finance, i.e. as its tax advantage
decreases. Predictions 1 and 2 suggest that an increase in the cost ratio should be decreasing in
(4) and increasing in (5), and that in (5) its increasing should be less for high S t . How changes in
the cost ratio will be differential across firms with different measured financing costs warrants
further discussion about the hierarchy theory of finance. This and a discussion of what is
observable concerning the shadow cost of finance faced by the firm is covered in the next
section.
2.1 Financial Regimes and Variation in the Shadow Cost of Finance
In the hierarchy theory of finance the source of financing is relevant to the firm’s investment
decision.9 This assumes that there is a bankruptcy risk and a deadweight loss in the event of
bankruptcy.10 In addition there is a tax advantage for debt in that interest payments are taxdeductible at the statutory rate. If bankruptcy risk increases with indebtedness then debt is the
preferred source of finance for low leverage firms. If the tax system is such that dividend income
faces higher tax than capital gains (as is the case in most countries) then internal funds are a
cheaper source of finance than new equity. Even more so if new equity incurs placement costs,
which may increase with the level of equity raised.
In the model presented above the cost of the marginal source of finance affects investment
decisions through the shadow cost of finance α t , which may be differential across tangible and
9
See Bond and Meghir (1994), which models financial regimes in a dynamic investment framework and finds
empirical evidence of financial regimes in UK manufacturing firms.
10
Otherwise the Miller-Modiaglini (1958) conditions hold and debt policy is irrelevant.
6
intangible investment. For tangible investment the hierarchy of finance model suggests that
α tK = ε (Bt K t ) , for low leveraged firms, where ε (⋅) is the cost of the marginal unit of debt
finance and is increasing in the level of indebtedness due to increased bankruptcy risk. Firms will
borrow up to the point where the marginal cost of debt finance equals the marginal cost of
internal finance and therefore, for firms with higher debt levels and internal funds available
α tK = γ t , where γ t determines the relative tax advantage of dividend income against capital
gains.11 For firms exhausted of internal funds, but with investment opportunities that require
further funding α tK = φ (N t K t ) , where φ (⋅) is the cost of the marginal unit of equity finance and
is increasing in the level of shares issued.
Figure 1 describes optimal fixed investment for three firms each with different adjustment cost
schedules and each with the same shadow value of capital. This is a form of the graphs in Bond
and Soderbom (2006), with the addition of the debt region. Equivalently this could be described
in a converse fashion with three firms with the same adjustment cost schedule and with the
shadow value of capital shifting up the y-axis. Firm 1’s marginal source of finance is debt, firm
2’s marginal source of finance is cash and firm 3’s marginal source of finance is equity. More
fully there could be a second debt region where debt is more expensive than cash, but cheaper
than equity. For simplicity this possibility is ignored with the expectation that it should, if
anything, strengthen the model’s predictions. We can write the shadow cost of finance thus,
where the indicator function 1(⋅) equals one if its argument is true and zero otherwise:
⎛ I B∗ ⎞
⎛ B∗ I B∗ + C ⎞
⎛ B∗ + C I ⎞
⎟⎟γ + 1⎜⎜
〈 ⎟⎟ ,
α (⋅) = 1⎜⎜ 〈 ⎟⎟ε (⋅) + 1⎜⎜ 〈 〈
K ⎠
K⎠
⎝K K ⎠
⎝K K
⎝ K
(7)
where in Figure 1 the constant γ has been normalised to one. As described before the shadow
cost of debt finance increases the finance adjusted shadow value of capital due to its tax
advantage, but decreasingly so due to bankruptcy risk, hence the decreasing λ K α schedule in
the first region. At B ∗ K the gains from debt’s tax advantage are outweighed by bankruptcy risk
the firm’s optimal source of finance is cash, if available. At B ∗ + C K cash is exhausted and
the firm resorts to equity finance which, due to placement costs, decreases the finance adjusted
shadow value of capital.
(
)
We are concerned here with variation in the price of debt relative to other forms of finance with
the expectation that increases in its cost relative to internal finance and equity will results in a
decrease in ordinary investment and an increase in R&D investment. Let us consider the form of
the shadow value of debt finance ε (⋅) . For optimal debt policy the following inter-temporal
condition must hold:
γ t = (1 − m ) (1 − c ) where m is the tax rate on dividend income and c is the tax rate on capital gains. Most tax
systems are such that γ t < 1 , that is capital gains are taxed less than dividend income.
11
7
ε t (⋅) =
∂Vt ∂Π t
∂Dt
=
+γ
+ βE [ε t +1 ]
∂Bt
∂Bt
∂Bt
(8)
That is the value of one extra unit of debt in period t equals the change it causes in profits in
period t plus its discounted expected value in period t+1. The first term reflects the interest cost
of debt and the second term merely its value in the sources and uses of funds constraint. If we
assume that the cost of debt in profits is given by the function:
⎛
⎛ B ⎞⎞
C (⋅) = (1 − τ t )⎜⎜ it + c0 + c1 ⎜⎜ t ⎟⎟ ⎟⎟ Bt
⎝ Kt ⎠⎠
⎝
(9)
where it is the risk free interest rate, c 0 a firm specific risk adjustment and the third term reflects
the increase of interest costs due to increased bankruptcy risk with indebtedness. The factor
(1 − τ t ) reflects the tax advantage of debt in that interest payments are exempt tax at the statutory
rate τ t . In (7) (∂Dt ∂Bt ) = 1 , and from (8):
⎛
⎛B
∂Π t
= −(1 − τ t )⎜⎜ it + c0 + 2c1 ⎜⎜ t
∂Bt
⎝ Kt
⎝
⎞⎞
⎟⎟ ⎟
⎟
⎠⎠
(10)
Therefore the shadow cost of debt increase with indebtedness and the rate it does so is
determined by the statutory tax rate due the tax exemption of interest payments. That is, the slope
of the λ K α schedule in the debt region of Figure 1 is determined by the statutory tax rate, the
lower it is the more negative the slope, i.e. the quicker tax advantages are outweighed by
bankruptcy risk and the lower the value of B ∗ K (the level of debt at which ε = γ ). For firm 1
in Figure 1 a decrease in τ will, ceteris paribus, decrease the optimal investment rate, for firm 2
a decrease in τ will leave the optimal investment rate unchanged and for firm 3 a decrease in
τ will decrease the optimal investment rate. This is shown in Figure 2. Simply a reduction in the
tax advantage of debt directly increases the marginal cost of finance for firms using debt a their
marginal source and indirectly increases the marginal cost of finance for firms using equity as
they are required to issue more equity than before.
It is not possible to observe all of the regions in Figures 1 and 2 directly, but what can be
observed is the dividend and equity behaviour of firms. This behaviour has been used in the
investment literature as an indicator of the financial constraints of firms, notably in Bond and
Meghir (1994) and Hall (1995). Four financial regimes exist for firms: regime 1 firms pay
dividends and issue no equity, they can cover all investment with internal funds and debt with
sufficient funds remaining to distribute to shareholders; regime 2 firms neither pay dividends nor
issue shares, investment just absorbs all internal funds; and regime 3 firms pay no dividends and
issue new shares, investment has exhausted all internal financing and requires equity to be raised.
In addition there is a fourth regime where firms both pay dividends and raise new shares.
Although this fourth regime should not exist by the predictions of the hierarchy of finance model
it is quite common, and is likely due to signaling or transaction cost considerations, see Bond and
Meghir (1994) for a discussion. For our purposes here I consider that the marginal source of
8
finance for regime 4 firms is new equity. These observed financial regimes correspond to the
regions in Figures 1 and 2 as described in Table 1. From the discussion in the previous paragraph
we would expect a reduction in the tax advantage of debt to decrease ordinary investment for all
firms in regime 2, 3 and 4, and for some of the firms in regime 1, namely those whose marginal
source of finance is debt.
To the extent that it is possible to control for the direct incentive effect of changes in corporate
taxation, i.e. by conditioning on λ K , this leads to the following proposition:
Prediction 3: A decrease in the tax advantage of debt will lead to a decrease in the investment
rate more so for firms raising equity, if the cost of equity increases quickly with the level raised.
2.2 Adjustment Costs and Identification Issues
Following Devereux and Keen (1994) we can write the marginal cost of investment as follows:
− Π It = (1 − τ t ) pty G I (I t , K t ) + ptI
(11)
Assuming adjustment costs to be of the form:
2
⎫
b⎧I
G (I t , K t ) = ⎨ t − a ⎬ K t
2 ⎩ Kt
⎭
(12)
⎛I
⎞
− Π It = (1 − τ t ) pty b⎜⎜ t − a ⎟⎟ + p tI
⎝ Kt
⎠
(13)
gives us:
Substitute (6) into (3) gives:
It
λtK
p tI
=a+ K
+
Kt
α t (1 − τ t ) pty b (1 − τ t ) pty b
(14)
λGt
ptR
Rt
=a+ G
+
Gt
α t (1 − τ t ) pty b (1 − τ t ) pty b
(15)
Equivalently for R&D:
The price of ordinary capital goods, ptI , should be adjusted to take into account allowances and
the price of R&D, should be adjusted to take into account R&D tax credits and the fact that R&D
expenditure is expensed as it is incurred. These features are discussed in the empirical section.
9
3
Empirical implementation
This together with (4) and (5) implies the following regressions for estimation:
⎛ I it
⎜⎜
⎝ K it
⎛
⎞
ptI
⎟⎟ = β 1QitK + β 2 (CostRatio )it + β 3 S it * (CostRatio )it + β 4 S it + β 5 ⎜⎜
y
⎠
⎝ (1 − τ t ) pt
⎛ Rit
⎜⎜
⎝ Git
⎛
⎞
ptR
⎟⎟ = γ 1QitG + γ 2 (CostRatio )it + γ 3 S it * (CostRatio )it + γ 4 S it + γ 5 ⎜⎜
y
⎠
⎝ (1 − τ t ) pt
⎞
⎟ + η i + u it , (9)
⎟
⎠ it
⎞
⎟ + η i + vit ,
⎟
⎠ it
(10)
where η i is a firm fixed effect, u it , vit are random disturbance terms and QitK and QitG are
measures of average Q normalized by one minus the statutory tax rate and the output price level.
An implicit assumption so far has been one of imperfect competition, in that there exists an
optimal output level that the firms wants to achieve and therefore shifts from K t to Gt in the
face of changes in their relative financing prices. This means that average Q will be less than
marginal Q, as additional units of capital at the margin will decrease the price of output if the
firm is a price maker, see Hayashi (1982). Of course this is a common problem in most of the Q
literature, but as I rely on the assumption of imperfect competition, this warrants highlighting
here. Were changes in this measurement error to be correlated with changes in the cost ratio of
debt to other finance there would be cause for concern, but there is no reason to believe that they
are.
Predictions 1 to 3 suggest that β 1 < 0 , β 2 < 0 and γ 1 > 0 , γ 2 < 0 . In order to identify these
coefficients it is essential that the disturbance terms in (9) and (10) are uncorrelated with changes
in the cost ratio. For this to be the case it is imperative that changes in the relative prices of
capital and R&D goods to output goods are controlled for, including changes in allowances and
the effects of the way R&D expenditure if expensed. This will be discussed in Section 3.1. Qvalues and financial regimes are likely to be endogenous in investment equations and as such
will be instrumented using past values, in keeping with the investment literature.
The cost ratio is calculated using cost of capital data from Devereux and Griffith (2002). It is the
ratio of the required rate of return for the marginal investment financed with debt to that financed
with equity/retained earnings in the face of depreciation allowances, a statutory tax rate and, in
the case of debt, fully tax-deductible interest payments.12 It is always less than one, due to the tax
advantage of debt, and is strictly increasing as the tax advantage of debt is reduced by decreases
in the statutory tax rate. Its value is different for different asset classes as plant and machinery
12 A real discount rate of 10%, inflation rate of 3.5% and a depreciation rate of 12.25% for all assets (plant and
machinery and buildings) is assumed.
10
receive different depreciation allowances to buildings. Therefore I calculate its value for each
firm-year observation as follows:
CostRatioit =
CR _ Build t * AssetsBuilding it + CR _ Plant t * AssetsPlant it
,
AssetsBuilding it + AssetsPlant it
(11)
where instrumenting with past values will address any endogeneity concerns.
The dummy variable S it is equal to zero when the firm is paying dividends but not issuing new
equity in that year, and is equal to one in all other cases. Therefore one indicates that the firm is
facing an external financing premium that may be increasing in the level of financing. Again,
instrumenting with past values should mitigate against problems of endogeneity.
3.1
US Tax Reforms in the 1980s
The key tax reform of interest is the cut in the statutory tax rate from 49.6 percent to 34.0 percent
which came into effect in 1987.13 This led to an increase in the relative price of debt finance to
equity finance from 41 percent to 53 percent for plant and machinery and from 52 percent to 62
percent for buildings, see Table 2. At the same time the tax base was broadened in that the
depreciation allowances for both plant and machinery, and buildings were made less generous.
For the marginal investment this almost exactly offset the cut in the statutory tax rate as we can
from the lack of variation in the tax price of fixed investment in column (2) in Table 3. This
makes this tax reform ideal for our purposes on average, although it is likely the direct incentive
effect is differential across firms and, therefore, I attempt to control for this, again using data
from Devereux and Griffith (2002).
As we shall see the result I find for R&D investment works very much like a common shock,
although it is differential across financial regimes as expected a priori. The reader will note the
lack of year dummies in (9) and (10), although the results for (9) are robust to their inclusion,
only the interaction in (10) is, not the linear effect. For this before and after identification to be
convincing it is essential to control for other changes to the price of R&D investment over the
same period. Two tax effects are important during this time. The first is the introduction of R&D
tax credits in 1981. My strategy here is to measure the effect of the tax credit on the price of
R&D and include it as a control. The tax credit actually became less generous in 1986, however
empirical research estimating its effect suggests that firms did not start to react to it until the
latter part of the decade, when it was thought more permanent (see Hall and Van Reenen (2000)
for a survey of studies of R&D tax credits and Hall (1993) for a detailed study of the 1981 US
R&D Tax Credit). To control for this I ensure my results are robust to letting the coefficient on
the tax price of R&D vary over time. The second tax change of relevance is the reduction in the
statutory rate itself. R&D expenditure is fully tax-deductible and is expensed as it is incurred, a
benefit which decreases as the statutory rate decreases, and therefore which decreased in 1987.
Although this effect, if uncontrolled for, would lead to less R&D, not more R&D as I observe, I
13
For a full description and figures see Chennells and Griffith (1997).
11
include it in the price of R&D investment. I calculate the real tax R&D price, as a much
simplified version of the calculation used in Hall (1993):
~R
⎛ pR ⎞
⎟ = p (1 − Titτ t − ERCit ) ,
⎜
~y
⎜ py ⎟
⎠ it p
⎝
(11)
where the effective credit rate is given by ERCit = ρ t Z it . The statutory credit rate, ρ t , is zero
before 1981, 0.25 from 1981 to 1985 and 0.20 from 1986 onwards and Z it is zero if declared
R&D expenditure in the current year is less than the base, equals one if it is greater than the base
and equals two if it is more than twice the base. The base is defined here as the average R&D
p R is an R&D price deflator used in Hall (1993) and ~
p y an
expenditure in the last three years. ~
output price deflator from the OECD, see data appendix. Tit is one if the firm has taxable income
and zero otherwise, as the firm only benefits from the full tax-deductibility of R&D when it has
income to be taxed.14 In sum, as shown in table 3 and observed in Hall (1993), the tax price of
R&D increases from 1986 onwards. However, there remains the concern that firms did not
respond to its lowering due to the introduction of tax credits in 1981 until much later, and to
mitigate against this I will let its effect vary over time.
3.2
Firm and Patent Data
The source for firm accounts data is Compustat and the source for matched patent data is Hall et
al. (2001). The sample period is 1979 to 1994 and the 690 US manufacturing firms in the sample
each have at least eight observations between these years. One concern with using such data is
that the rate of matching success varies over time. As described in Hall et al. (2001) the firm data
is centered on 1988, but the total number of patents start to decrease well before that time due to
the shift of patenting to new firms which have not yet been listed. Therefore, the aggregate level
of patenting is decreasing over this time period. Concerns about attrition will be mitigated by the
use of firm fixed effects.
The data items used in estimation are described in full in the appendix. It is important to point
out here that both the fixed capital stock and the knowledge capital stock were estimated using
the permanent inventory method. Thus they are measured with error that decreases with time
and, therefore, the first four observations for each firm are dropped from the sample. Their
average values are shown in Table 4.
14 Currently this is a simplification of the formula in Hall (1993) in that it ignores: (i) the change in the base
definition in 1990; (ii) carry forwards and carry backs; and (iii) the share of qualified expenditure. Ignoring (i) and
(ii) will over estimate the price of R&D, ignoring (iii) will (greatly) underestimate the price.
12
4
Results
Table 5 shows the ordinary least squares results (OLS) for the fixed investment rate and for the
R&D investment rate. In column (1) we see that the coefficient on the cost ratio is negative
indicating that as the tax advantage of debt decreases the ordinary investment rate decreases, as
expected. The coefficient on average Q is positive as expected, indicating that the investment
rate increases as investment opportunities increase. The coefficient on the price of investment
goods is positive, which is counterintuitive but as it varies so very little over the time period this
correlation may be a little spurious or due to endogeneity of estimating its differential impact
across firms using current period asset mixes (as we shall see it becomes negative, though
insignificant when we instrument). Column (2) shows that the R&D investment rate increases as
the tax advantage of debt decreases. This is the key result of the paper: that firms appear to
substitute from fixed investment to R&D investment as equity and retained earnings become
relatively cheaper forms of finance than debt. Column (3) and (4) show the interaction of the cost
ratio with the financial regime of the firm. As discussed financial regime 2,3 or 4 indicates that
the firm has exhausted all internal funds for investment and that its marginal funding source is
external. For fixed investment the negative effect of the decrease in the tax advantage of debt is
increased for firms in such regimes, suggesting that they suffer more as their marginal source of
finance increases with the extent to which it is used, as suggested by Prediction 3. The positive
effect on the R&D investment rate is lower for firms dependent on external finance, suggesting
that even though these firms may be forced to reduce ordinary investment the likely high
external financing premium for R&D makes substitution to R&D too costly. The coefficient on
average Q is insignificant for R&D investment, although will become positive when
instrumented.15
The previous results controlled for other changes in the price of R&D investment over the same
period by calculating a real R&D price based on the R&D tax credit and the tax-deductibility of
R&D expenditure and adding it as a control. However, despite the fact that the tax price of R&D
was increasing over the time period research in the form of Hall (1993) amongst others,
suggested that firms may not have reacted to the tax credit of 1981 until sometime later. Hall
(1993) shows that the coefficient on this price is greater after 1985. In Table 6 column (1) and
column (2) I let the R&D price vary before and after 1985 and see that my results are robust to
this and that the coefficient is more negative after 1985 as expected. The choice of 1985, of
course, is somewhat arbitrary here and so in column (3) and column (4) I let the effect of the
price of R&D vary over time by interacting it with year dummies. We can see that the coefficient
on the tax price does get more negative in later years in the 1980s as expected. My results are
still robust to this in that the decrease in the tax advantage of debt increases the R&D investment
rate, although the interaction with financial regimes loses some significance in column (4). This
loss of significance is less when I use instrumental variables as we shall see below. To the extent
that the reader is dissatisfied with the extent to which I have controlled for the R&D tax credit of
1981 I appeal to the fact that the effect of the cost ratio of debt to equity on R&D investment is
differential across firms in that it is higher for firms with internal funds, whereas we might
15 Average Q for innovation is measured with severe error in that the denominator is the patent stock. Naturally it is
difficult to estimate a replacement value for the patent stock and this will have to be improved in later versions.
13
expect that the effect of R&D tax credits would be higher for firms that are cash constrained, as
described in Hall (1993).16
Table 7 shows instrumented variables using the generalized method of moments (GMM).
Columns (1) and (2) show the basic linear result. The coefficient on average Q is now positive in
both cases. The coefficients on the cost ratio lose significance although it likely due to the lack of
validity of the instruments. In columns (3) and (4) the results are significant once more when
firm heterogeneity in financial regimes is exploited and the instruments are valid for the R&D
investment equation. In columns (5) and (6) the results are robust to the inclusion of year
dummies. Column (7) and (8) show that the R&D investment result is robust to the inclusion of
the time varying R&D price as included in column (4) of Table 6.
What is the economic magnitude of these effects? Using the estimated coefficients from Table 7
columns (3) and (4) and the observation that the mean value of the financial regime 2, 3 or 4
variable is 0.36 (i.e. just over one third of firms are in these regimes, as we might expect from a
sample of listed firms), we can calculate that the mean effect of an increase in the relative cost of
debt of 12 percentage points on the fixed investment rate is a decrease by 1.5 percent
[100*0.12*(-0.009-0.326*0.36)]. The mean effect on the R&D investment rate of the same
change is an increase of 0.3 percentage points [100*0.12*(0.074-0.135*0.36)]. This mean effect
is rather small, but for firms with internal financial resource, regime 1 firms, the effect is 0.9
percent [100*0.12*0.074].
16 This might not be the case were firms in regime 1 much more likely to have table income than other firms, but in
this sample of listed firms 90% of firm-year observations are those where taxable income exists.
14
5
Conclusion
This paper has found results that suggest that increases in the relative price of debt to equity and
retained earnings lead manufacturing firms to substitute from fixed investment to R&D
investment. This both strengthens the evidence that equity and retained earnings are preferred
forms of finance than debt for R&D and suggests that firms’ investment decisions respond to the
differential tax treatment of financial assets in a way that may influence firm productivity.
The strength of these conclusions relies on the extent to which I have successfully controlled for
contemporaneous changes in the price of R&D over the sample period. Although , I would argue,
a reasonable first attempt has been made at this there remains much to be done. Firstly, the
calculation of the R&D tax price remains very crude and can be greatly improved on to take into
account qualified expenditure and the change in the definition of the R&D base in 1990.
Secondly, R&D and fixed capital price deflators used thus far have varied solely across time,
whereas these may be differential across industries.
In addition, much work can be done to further investigate if firms really are substituting R&D
investment for fixed investment. Properties of patent data such as technology class can be used to
ascertain if innovation that increase are the sort that may make fixed capital more productive.
Also, throughout there has been an implicit assumption that firms are trying to maintain an
optimal output level and (assuming constant returns to scale) that firms have market power.
Therefore we may expect to see the cost ratio effect to be more pronounced in sectors where
product market competition is low.
15
Figure 1 Optimal investment with financial regimes
Π I1
ΠI2
Π I3
λK
λK
α
B∗
K
B∗ + C
K
16
I
K
Figure 2 A Reduction in the Tax Advantage of Debt
Π I1
ΠI2
Π I3
λK
λK
α
B ∗∗
K
B∗
K
B ∗∗ + C B ∗ + C
K
K
17
I
K
Table 1: Tax and the Cost of Capital
Marginal source of
I/K
Regime
finance
1 (D>0, N=0)
Debt
I B∗
〈
K K
1 (D>0, N=0)
Internal funds
B∗ I B∗ + C
〈 〈
K K
K
∗
2 (D=0, N=0)
New equity
I
B +C
=
K
K
∗
3 (D=0, N>0)
New equity
B +C I
〈
K
K
∗
4 (D>0, N>0)
New equity
B +C I
〈
K
K
18
Table 2: Variation in the cost ratio of debt to equity and internal finance
Year
Statutory
Cost Ratio
Cost Ratio
Av. Firm
Sd. Firm
Rate
Plant &
Buildings specific Cost specific Cost
Machinery
Ratio
Ratio
1979
0.50
0.42
0.57
0.48
0.03
1980
0.50
0.42
0.57
0.48
0.03
1981
0.50
0.41
0.52
0.44
0.03
1982
0.50
0.41
0.52
0.44
0.03
1983
0.50
0.41
0.52
0.44
0.03
1984
0.50
0.41
0.52
0.44
0.03
1985
0.50
0.41
0.52
0.44
0.03
1986
0.50
0.41
0.52
0.44
0.03
1987
0.38
0.53
0.62
0.56
0.02
1988
0.38
0.53
0.62
0.56
0.02
1989
0.38
0.53
0.62
0.56
0.02
1990
0.38
0.53
0.62
0.56
0.02
1991
0.38
0.53
0.62
0.56
0.02
1992
0.38
0.53
0.63
0.56
0.02
1993
0.39
0.53
0.63
0.56
0.03
1994
0.39
0.53
0.63
0.53
0.02
Table 3: Variation in the price of R&D and fixed investment
Year
Av. Tax Price of Av. Tax Price of Av. Real Tax Price Av. Real Tax Price
R&D
Fixed Investment
of R&D
of Fixed Investment
1979
-0.40
0.65
-0.62
0.82
1980
-0.38
0.65
-0.58
0.82
1981
-0.78
0.61
-1.18
0.78
1982
-0.74
0.61
-1.09
0.77
1983
-0.70
0.61
-1.03
0.74
1984
-0.73
0.61
-1.09
0.71
1985
-0.70
0.61
-1.05
0.70
1986
-0.61
0.61
-0.91
0.69
1987
-0.19
0.62
-0.27
0.70
1988
-0.19
0.62
-0.28
0.69
1989
-0.19
0.62
-0.28
0.68
1990
-0.19
0.62
-0.28
0.67
1991
-0.19
0.62
-0.27
0.66
1992
-0.19
0.62
-0.28
0.64
1993
-0.21
0.63
-0.31
0.64
1994
-0.22
0.60
-0.34
0.61
19
Table 4: The dependent variables
Year
Av. I/K
Av. R/G
1979
0.23
0.08
1980
0.23
0.08
1981
0.22
0.08
1982
0.18
0.07
1983
0.16
0.07
1984
0.19
0.07
1985
0.17
0.08
1986
0.16
0.08
1987
0.15
0.09
1988
0.15
0.09
1989
0.15
0.09
1990
0.14
0.08
1991
0.13
0.08
1992
0.12
0.08
1993
0.12
0.08
1994
0.13
0.08
20
Table 5: OLS Results
Dependent variable:
Average Q
Cost Ratio (Debt to Equity)
(1)
I/K
0.00108
[0.00054]**
-0.3256
[0.02203]***
(2)
R/G
-0.00002
[0.00001]
0.04275
[0.01455]***
Cost Ratio * Financial
Regime 2,3 or 4
Financial Regime 2,3 or 4
Price of Ordinary Investment
1.72509
[0.08312]***
Price of R&D Investment
Output Gap
Constant
Firm fixed effects
Observations
R-squared
0.00505
[0.00044]***
0.0353
[0.02687]
Yes
9461
0.39
-0.0095
[0.00176]***
0.00148
[0.00035]***
0.05917
[0.02413]**
Yes
9461
0.36
(3)
I/K
0.00093
[0.00050]*
-0.16085
[0.01925]***
-0.43424
[0.04150]***
0.21558
[0.02146]***
1.77
[0.08353]***
0.00491
[0.00043]***
-0.02527
[0.03208]
Yes
9461
0.4
(4)
R/G
-0.00002
[0.00001]
0.0662
[0.01731]***
-0.05108
[0.02787]*
0.01315
[0.01417]
-0.00926
[0.00175]***
0.00142
[0.00035]***
0.06977
[0.02723]**
Yes
9461
0.36
Notes: The regressions include an unbalanced panel of 690 US manufacturing firm over the period 1979-1994.
Robust standard errors are in parentheses. Three, two, one stars denote statistical significance at 1%, 5% and 10%
respectively.
21
Table 6: OLS Results – controlling for the time-varying impact of R&D Tax Credits
(1)
(2)
(3)
(4)
Dependent variable:
R/G
R/G
R/G
R/G
Average Q
-0.00002
-0.00002
-0.00002
-0.00002
[0.00001]
[0.00001]
[0.00002]
[0.00001]
Cost Ratio (Debt to Equity)
0.06422
0.08198
0.13997
0.14993
[0.01904]*** [0.02085]*** [0.03340]*** [0.03343]***
Cost Ratio * Financial Regime 2,3
-0.05049
-0.0431
or 4
[0.02789]*
[0.02822]
Financial Regime 2,3 or 4
0.0131
0.00986
[0.01417]
[0.01433]
Price of R&D Investment
-0.00885
-0.00877
[0.00179]*** [0.00179]***
Price of R&D Investment after
-0.00273
-0.00204
1985
[0.00156]* [0.00157]
Price of R&D Investment*1979
-0.0137
-0.01363
[0.00340]*** [0.00340]***
-0.00749
-0.00748
[0.00239]*** [0.00239]***
-0.0104
-0.01026
[0.00299]*** [0.00299]***
-0.00094
-0.00109
[0.00348]
[0.00348]
-0.00903
-0.00891
[0.00296]*** [0.00295]***
-0.01433
-0.01418
[0.00288]*** [0.00288]***
-0.00755
-0.00743
[0.00310]** [0.00310]**
-0.00687
-0.00651
[0.00276]** [0.00277]**
-0.01605
-0.01477
[0.00356]*** [0.00358]***
-0.02096
-0.02002
[0.00386]*** [0.00387]***
-0.02152
-0.02034
[0.00417]*** [0.00418]***
-0.02472
-0.02372
[0.00363]*** [0.00364]***
-0.01619
-0.01516
[0.00370]*** [0.00370]***
-0.02167
-0.02029
Price of R&D Investment*1980
Price of R&D Investment*1981
Price of R&D Investment*1982
Price of R&D Investment*1983
Price of R&D Investment*1984
Price of R&D Investment*1985
Price of R&D Investment*1986
Price of R&D Investment*1987
Price of R&D Investment*1988
Price of R&D Investment*1989
Price of R&D Investment*1990
Price of R&D Investment*1991
Price of R&D Investment*1992
22
Price of R&D Investment*1993
Price of R&D Investment*1994
Output Gap
Constant
Firm fixed effects
Observations
R-squared
[0.00355]*** [0.00357]***
-0.01951
-0.01825
[0.00386]*** [0.00387]***
-0.01882
-0.01769
[0.00327]*** [0.00328]***
0.00153
0.00145
0.00247
0.00241
[0.00035]*** [0.00035]*** [0.00082]*** [0.00082]***
0.0482
0.06335
0.01286
0.03731
[0.02480]* [0.02767]** [0.02957]
[0.03020]
Yes
Yes
Yes
Yes
9461
9461
9461
9461
0.36
0.36
0.36
0.36
Notes: The regressions include an unbalanced panel of 690 US manufacturing firm over the period 19791994. Robust standard errors are in parentheses. Three, two, one stars denote statistical significance at 1%,
5% and 10% respectively.
23
Table 7: GMM Results
(1)
(2)
I/K
R/G
0.0153
0.00008
[0.00283]*** [0.00004]**
Cost Ratio (Debt to
-0.05813
0.01956
Equity)
[0.06185]
[0.02293]
Cost Ratio *
Financial Regime
2,3 or 4
Financial Regime
2,3 or 4
Price of Ordinary
0.83848
Investment
[0.31439]***
Price of R&D
-0.00789
Investment
[0.00515]
Price of R&D
Investment*Year
Output Gap
0.00612
0.00245
[0.00077]*** [0.00053]***
Constant
-0.04934
0.1145
[0.08207] [0.03158]***
Firm fixed effects
Yes
Yes
Year dummies
Instruments
t-3, t-4
t-1…t-4
Observations
6821
6818
HansenJtest
0
0.01
PartialR2
0.1
0.65
Dependent variable:
Average Q
(3)
(4)
(5)
(6)
(7)
(8)
I/K
R/G
I/K
R/G
R/G
R/G
0.01495
0.00007
0.01388
0.00006
0.00008
0.00006
[0.00266]*** [0.00004]* [0.00276]*** [0.00004]* [0.00004]** [0.00004]*
0.00904
0.07405
2.37333
0.28024
0.26121
0.28054
[0.06963] [0.02872]*** [1.44668] [0.12365]** [0.05170]*** [0.05199]***
-0.32611
-0.13493
-0.35452
-0.12846
-0.11491
[0.12043]*** [0.05808]** [0.12486]*** [0.05819]**
[0.05842]**
0.2254
[0.08096]***
0.8496
[0.31468]***
0.03643
[0.03243]
0.21377
[0.08065]***
-5.47344
[4.29753]
-0.00543
[0.00507]
0.00667
0.00221
[0.00082]*** [0.00053]***
-0.12075
0.08375
[0.09772] [0.03222]***
Yes
Yes
t-3, t-4
6821
0
0.1
t-1…t-4
6818
0.22
0.65
0.03185
[0.03227]
0.0299
[0.03238]
-0.00915
[0.00510]*
-0.04489
[0.03172]
-0.28863
[0.26322]
Yes
Yes
t-3, t-4
6821
0
0.06
-0.00121
[0.00217]
-0.09389
[0.06621]
Yes
Yes
t-1…t-4
6818
0.17
0.65
Yes
Yes
0.00215
[0.00142]
0.11462
[0.07423]
Yes
0.00161
[0.00142]
0.13576
[0.07459]*
Yes
t-1…t-4
6818
0.03
0.65
t-1…t-4
6818
0.16
0.65
Notes: The regressions include an unbalanced panel of 690 US manufacturing firm over the period 1979-1994. Robust standard errors are in parentheses. Three,
two, one stars denote statistical significance at 1%, 5% and 10% respectively. In columns (7) and (8) the time-varying price of R&D is not instrumented.
24
6
Data Appendix
25
7
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