February 6, 2019

Politically risky business

How much do close elections affect business investment?

Nataliya Hora/trongnguyen

American companies are holding an unprecedented amount of cash. Their reluctance to put that money to use could mean missing the next big idea or game-changing innovation.

And yet, they continue to avoid funding new business ventures.

Any number of unknowns could give companies pause before pursuing a risky investment, but research published in the American Economic Journal: Economic Policy shows that political uncertainty can drive investment away permanently.

The authors Nathan Falk and Cameron Shelton look specifically at how close gubernatorial races affect the amount manufacturers’ invest within a state.

Governors and their appointees influence a state’s business environment in a number of ways. They can be involved in setting minimum wage laws and determining corporate taxes.

To the extent that you can, you want to be clear about policy intentions and try to make clear what's going to be the case for many years going forward.

Cameron Shelton

Corporations often form relationships with governors and their administrations that shape expectations and become important for the long-run profitability of business ventures. A company may rely on building permits or work permits that a new administration is less willing to give out.

But it’s difficult to isolate the effect of policy uncertainty from a state’s economy.

“We needed elections that we knew were going to be closer for reasons totally unrelated to investment,” Shelton said in an interview with the AEA.

A bad economy can deter business investment. But it can also cause voters to oust the incumbent, which might then create policy uncertainty. In that case, it would be impossible in retrospect to figure out if it’s the economy or political turmoil that’s causing a slowdown in investment.

Falk and Shelton point out that most states have term limits for governors or governors that leave office for other reasons unrelated to the business climate, like death. These special cases offered the best environment to estimate the effect of policy uncertain on investment.

But just because there’s electoral uncertainty doesn’t mean there’s policy uncertainty; governors from opposing parties may not be offering very different policies. In the 2018 gubernatorial races, candidates from both parties could be found supporting the legalization of marijuana, for example.

To make the step from electoral uncertainty to policy uncertainty, the authors use a measure of the polarization between the Democratic party and Republican party in each state. The measure uses the voting records of each states’ congressional delegates to DC as a proxy for candidate governors’ policy preferences.

By combining measures of electoral uncertainty and policy differences between the parties, Falk and Shelton were able to estimate the impact of policy uncertainty on manufacturing investment. They find that a doubling in policy uncertainty around elections reduces manufacturing investment by roughly 2.5 percent for a typical state.

What’s more, the investment activity doesn’t appear to rebound after elections. Some argue that companies will sit on the sidelines until new governments have come to power and sorted out their policies. Once the outcome is clear, businesses will invest again.


Flight to the neighbors
The chart below shows that businesses responded to uncertainty during gubernatorial election years by decreasing investment in their own state and increasing investment in neighboring states. Investments do not significantly recover in their own state. The dots represent point estimates of elasticities (the percentage increase in investment), and the bars 95 percent confidence intervals.
Source: Falk, et. al. (2018)


However, Falk and Shelton’s research suggests that companies who can relocate to more stable political climates won’t hesitate to leave.

As an example, the authors say that Louisiana was able to attract big-budget movies in the 2000s by offering studios tax credits. But in 2015, in response to tight state budgets, film tax credits became a point of difference between the 2015 candidates for governor. Eventually Disney/ABC executives decided to film elsewhere, rather than take their chances.

There is an important caveat to making any generalizations.

Companies deciding between states may permanently relocate their long-run projects, but this argument may not translate to the national level. Companies may be forced to wait and see what happens after a national election because the costs of moving investments between countries is much higher than moving between states.

So investment slowdowns during national elections could be only temporary, whereas they could be permanent at the state level.

Most voters and politicians are keenly aware of the direct impact that governments have on businesses. The authors’ research shows that even before policies are made the government exerts significant influence on the economy.

Unfortunately, Shelton doesn’t think there’s a lot that policymakers can do about this. Political uncertainty is just a part of democracy.

“To the extent that you can, you want to be clear about policy intentions and try to make clear what's going to be the case for many years going forward,” Shelton said.

"Fleeing a Lame Duck: Policy Uncertainty and Manufacturing Investment in US States" appears in the November issue of the American Economic Journal: Economic Policy.