July 2006

Corporate Cash Balances and Economic Activity

Corporations have built up an extraordinary level of cash reserves during the current expansion. Firms have only recently started to draw down their substantial cash holdings through accelerated shareholder payouts, cash-financed mergers and acquisitions, and increased investment. These developments highlight the strong interest that economists and policymakers have in the interaction between cash balances and investment spending. But what is the link between cash and investment? Has the relationship changed over time? These and other issues were examined at a July 18 conference at AEI.

Kevin M. Warsh
Federal Reserve Board of Governors

A striking feature of this economic expansion has been a dramatic expansion in cash accumulation by corporations. Profit margins have jumped dramatically to the highest levels in decades, largely as a result of efficiency and productivity gains that have strongly outpaced compensation growth. Accordingly, ratios of cash to assets have risen sharply, and ratios of cash to investment have risen from around 60 percent in the past to 150 percent at the end of 2004. This kind of increase is unusual during an expansion; usually, a highly liquid corporate sector corresponds with the beginning of an expansion rather than a mature one. Moreover, cash holdings remained elevated through 2005, and only in recent quarters has this trend abated.

Traditionally, operating cash flow and capital expenditure correlate strongly to the rise and fall in cash holdings, but the current period appears to be an outlier because those two measures only cover half of the rise in cash. One explanation for this additional gap is the growth of foreign operations of U.S. multinationals. Many of these firms leave cash dividends with foreign subsidiaries instead of repatriating the money and facing U.S. corporate taxes. If this explanation is correct, many firms’ assets are actually less accessible than a balance sheet would indicate. The evidence shows that the ratio of cash to total assets is up 20 percent for domestic-only firms, but cash intensity of balance sheets at multinationals has increased by more than 50 percent. Cash balances may continue to remain somewhat higher than historical levels as a result of the higher expense involved in repatriating cash.

Another explanation for the larger cash balances may be that investors are placing an increased emphasis on balance sheet liquidity. In the wake of the corporate governance scandals and other worrisome geopolitical factors, both investors and boards of directors seem to be more risk-averse than is warranted by current fundamentals. The historically low ratio of business fixed investment to GDP may also point to a capital overhang from the previous expansion.
 
The cash hoarding trend may have abated or reversed. Ratios of cash to assets and investment have fallen in recent quarters, while debt ratios have edged up. Levels of merger and acquisition activity, outlays for nonresidential construction and high tech equipment, and several other measures have all risen recently, perhaps indicating a return to more normal conditions. Firms are likely to continue to draw down cash balances, though it seems likely that increased cash levels will be the norm for firms going forwards due to geopolitical, regulatory, and legal factors that all encourage caution. Fortunately, U.S. firms have shown a remarkable ability to adapt to these rapidly changing business conditions over the past few years.

Kevin A. Hassett
AEI

Investment models have traditionally drawn on the idea that since firms need to borrow money to invest, the cost of that capital and the depreciation of assets should drive investment decisions. This model was once rejected as a failure, because though user cost of capital ought to be negatively correlated with investment, in a time-series graph, they move with each other. Cash flow, then, seems to play a far more important role than taxes in affecting investment. That conclusion leaves very little room for supply-side economics, which say that if you change the tax rate, you change the user cost of capital and, therefore, the level of investment.

There exists a real identification problem here concerning user cost over time. If we have an economic boom, the Fed will raise interest rates, yet firms will still be investing. Naturally, the time series of user cost and investment would not show much, because growth is driving interest rates and investment to be positively correlated. But by looking for cross-section differences in responsiveness to tax policy among different assets, Alan Auerbach and I were able to reveal the expected negative correlation and, therefore, the importance of user cost in investment decisions. In another recent paper I coauthored, we developed a measure called real Q, which is the tax-adjusted user cost that, according to the traditional model, ought to drive investment. Analysis showed that the traditional economic model has a role for fundamentals and no role for liquidity--when Q is higher, then investment is too, which confirms the relationship.

Therefore, booming cash levels do not mean that liquidity constraints are being relaxed, which would lead to an investment boom. But if policymakers change tax policy, then there ought to be a reasonably sized effect in investment. The numbers shows that President George W. Bush’s dividend tax cut translated into about a 10 to 15 percent cut in the marginal effective tax rate on firms, which in turn could yield an investment boost of 5 to 10 percent over time. Quite possibly, his tax cuts led to a 10 to 15 percent increase in business fixed investment.

However, as we have gotten to the point where we think that we understand business fixed investment, the importance of that investment has been shrinking relative to investment in intangibles. Were we in a predominantly manufacturing economy, we would have a far better understanding of consequences of our policies, but our economy is increasingly focused on intangible investments like research and development. The returns on those investments, though, have been incredibly high throughout history, which suggests that firms have not been optimally investing in intangibles.

Andrew Lyon
PricewaterhouseCoopers

Three particular flaws exist in the current investment and tax literature. First, some errors arise in empirical studies that underestimate the complexity of the tax system. In particular, the models assume all firms are paying taxes, but a wide literature makes clear that many firms are in loss status and are therefore unable to take advantage of deductions immediately--instead having to carry them forward to future years[ef4].  In that case, partial expensing allowances, which permit firms to deduct a fraction of the cost of new capital goods from their taxable income, may have no effect on a firm’s behavior.

Likewise, many studies fail to appreciate the way changes in the tax law[ef5] actually play out. For example, in March 2002, Congress enacted a temporary partial expensing provision, yet this provision has been variously modeled as a permanent provision instead, which creates problems. That assumption is problematic, for one would expect a much greater response in investment with the temporary provision.

Another problem concerns the interpretation of event studies. One example stems from event studies performed on tax cuts. There are two competing theories: one argues that tax reduction will stimulate investment by lowering the cost of capital; the other claims tax cut legislation will simply be capitalized into existing stock prices, benefiting current shareholders. However, finding support in stock prices for a theory does not mean the theory is correct, but rather only implies that the market acted in a manner consistent with the theory. We need to be cautious in interpreting what the event studies really tell us.

Alan Viard
Federal Reserve Bank of Dallas

Intangible investment is already a major part of our economy and constitutes a critical area of future research. Unfortunately, the bulk of intangible investments continue to be considered as part of inputs into current production rather than being treated separately as it ought to be. Though the task of separating intangible investment from inputs is difficult, it is a critically important one. Knowing the size of intangible investment and its relationship to user costs has significant implications for tax policy.

Hassett mentioned that some tests involve user costs and some involve Q. We need to remember that the Q-based tests can be problematic, particularly if we used a Q measure based directly on a firm’s market value. On one hand, if you put both Q and cash flow into the regression to explain investment, it is not clear how to think about cash flow coming back with a significant coefficient. Q includes the market value of a firm’s assets, which have to be discounted at an interest rate that may reflect the financial frictions the firm faces. So when a firm responds to market value, it may be responding to cash flow or liquidity issues in part as reflected in Q, which precludes us from discounting the importance of all financial frictions as they relate to investment.

The best measure here is real Q, which looks directly at projections of future cash flows and thereby isolates fundamentals. Analysis with real Q shows a definite role for fundamentals and also seems to show a limited role for cash flow in making investment decisions. Interestingly, though, the strong preference of firms for cash in hand when it comes to tax policies does suggest a significant role for cash in the investment decision process, so I would hesitate to rule out financial frictions completely.

AEI intern Trent Magruder prepared this summary.