Fiscal Consolidation Policy, Corporate Investment and Financial Market Reaction Open Access
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The financial crisis of 2007-09 sparked renewed interest in fiscal adjustment and its effect on economic growth. Although fiscal consolidation is a classic policy issue, there is no consensus on its effect on overall economic performance or private sector behavior. In my dissertation, I study the impact of fiscal consolidation on corporate investment as well as on the financial market. Chapter 1 “Fiscal Consolidation and Corporate Investment” examines the effect of fiscal consolidation on corporate investment using a panel of 16 advanced economies’ firm-level data and action-based fiscal consolidation measures. I find that firms reduce both capital expenditure and working capital as a response to fiscal consolidation, and the cut in working capital is about twice as large as the one observed for capital expenditure. However, firms do not scale back their R&D; expenses during fiscal consolidation. These findings are in line with the investment-smoothing argument that firms tend to smooth longer-term investment with higher adjustment costs by adjusting more on short-term and liquid investment. Furthermore, the decrease in corporate investment is mainly observed in small firms, firms with limited access to external financing, and firms operating in the nontradables sector. The reduction in investment is driven by both tax hikes and spending cuts. The results also suggest that the adverse impact of fiscal tightening on corporate investment can be mitigated if the consolidation is large enough to signal credibility, or when it is accompanied by accommodative macroeconomic policies. In Chapter 2 “Stock Market Reaction to the Fiscal Consolidation Announcement”, I empirically examine the stock market reaction to the announcement of fiscal consolidation by 10 advanced economies for the time period 1980-2012. Using an event study methodology with daily data, I find that there are significant positive abnormal as well as cumulative abnormal stock market returns as a response to the announcement of fiscal consolidation. The positive abnormal returns are led by the gains in the financial, industrial, energy, and telecom sectors; and they are stronger for large consolidations. The results also show that market reactions vary across countries due to different macroeconomic and political conditions.Overall, the first essay demonstrates that fiscal consolidation has an adverse impact on corporate investment, while the second essay shows that the stock market greets the announcement of fiscal consolidation with a positive reaction in stock prices. This seeming paradox can have two potential explanations. First, the adverse effect is mainly observed by small firms, whereas a positive price response is mainly seen in large firms. Thus, for firms where external financial friction is less severe, reducing government debt and the resulting long-term debt sustainability are considered positive developments. Second, the stock market is forward looking, and stock prices reflect future earnings potential. As fiscal consolidation could be beneficial for economic growth in the long run, the increase in stock prices is based on expectations of strong corporate profits. This argument also supports the finding that corporations mainly cut short-term and liquid investment more than capital expenditure and R&D;.