financial constraints and strongcompanystrong investment - ifs.pdfVIP

Fiscal Studies (1994) vol. 15, no. 2, pp. 1− 18 Financial Constraints and Company Investment STEPHEN BOND and COSTAS MEGHIR1 I. INTRODUCTION The question we address in this paper is whether the investment spending of at least some firms is affected by the availability of internally generated finance (retained earnings), reflecting some constraint on the ability of these firms to raise external finance (debt or new equity) for investment. The opposing view is that the cost at which investment funds can be obtained, taken to be independent of the amount invested, is the only financial consideration that matters in the determination of investment. This is an old question in economics, which has been the subject of several official inquiries2 as well as a large body of academic research. The answer to this question has a number of important implications. Profits are highly cyclical, so if investment depends directly on the availability of profits then investment spending will be more sensitive to fluctuations in economic activity than would otherwise be the case. This could be an important factor in the propagation of business cycles. If post-tax profits help to determine investment spending then 1 Stephen Bond is Programme Director of the Corporate Sector at the Institute for Fiscal Studies, and Gwilym Gibbon Research Fellow in Public Economics at Nuffield College, Oxford. Costas Meghir is Deputy Director of the ESRC Centre for the Microeconomic Analysis of Fiscal Policy at the Institute for Fiscal Studies, and Professor of Economics at University College London. This paper forms part of the work of the ESRC Centre for the Microeconomic Analysis of Fiscal Policy at IFS. The authors are grateful to the Economic and Social Research Council for funding, and to Michael Devereux and Paul Johnson for helpful comments. 2 In the UK these inc