Debt or Demand: Which Holds Investment Back? Evidence from an Investment Tax Credit

Debt or Demand: Which Holds Investment Back? Evidence from an Investment Tax Credit

By Laura Blattner, Luísa Farinha, Francisca Rebelo
October 31,2017Working Paper No. 3689

We study how debt frictions and demand affect corporate investment using administrative data from a large temporary investment tax credit in Portugal. We obtain exogenous variation in demand for exporting firms from product-destination-level changes in foreign demand. We proxy debt frictions by an index of different debt-earnings ratios. We find that debt has a strong, non-linear effect on the likelihood that a firm invests in response to the tax credit. Firms in the lower two quartiles of our debt-earnings index have roughly equal predicted take-up probabilities. For firms in the third quartile predicted take-up drops by 50% while firms in the worst debt-earnings quartile have a predicted take-up rate close to zero. We show that the effect of demand is mediated by the size of a firm’s debt burden. While demand has a strong positive effect for the bottom debt quartiles, demand ceases to affect take-up in the highest debt quartile. These results highlight that the distribution of debt, rather than the absolute stock of debt, matters for understanding post-crisis investment dynamics.