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E-MailSyed Walid Reza is Assistant Professor of Finance at SUNY at Binghamton. This post is based on an article authored by Professor Reza; Alexei Ovtchinnikov, Associate Professor of Finance at HEC Paris; and Yanhui Wu, Lecturer at Queensland University of Technology. Related research from the Program on Corporate Governance includes Shining Light on Corporate Political Spending and Corporate Political Speech: Who Decides?, both by Lucian Bebchuk and Robert Jackson (discussed on the Forum here and here).
Although the relation between political activism and firm value appears well established, our understanding of the exact mechanisms through which political activism creates value and affects real economic outcomes is far from complete. In the paper, Political Activism and Firm Innovation, publicly available on SSRN, we contribute to this literature by analyzing the effect of political activism on firm investment decisions, specifically investment in innovation.
We focus on three distinct hypotheses. Under all three, firms operate in a market for political benefits and invest in strategies that maximize the expected payoffs from political activism. Under the first hypothesis, which we call the “information acquisition” hypothesis, we argue that firms that engage in political activism do so in part to acquire information about the lawmakers’ political cost, which reduces political uncertainty. Note that this argument departs significantly from the existing literature on the effects of policy uncertainty on firm investment (see, e.g., Julio and Yook (2012), Bhattacharya, et al. (2014)). While the existing literature assumes that policy uncertainty is exogenous to firms so firms have no choice but to adjust their investment to policy uncertainty shocks, we explicitly recognize that firms act strategically and undertake actions that reduce policy uncertainty shocks. If successful, these actions dampen the effect of policy uncertainty on firm investment.
The second “procurement” hypothesis is rooted in the Murphy, Shleifer, and Vishny (1993) public rent-seeking argument and argues that politically active firms bribe government officials to obtain government procurement contracts (Tahoun (2012), Goldman, Rocholl and So (2013)). A defining characteristic of procurement is the constant pursuit of improved performance and capabilities through technological innovation (Rogerson (1995)). Because the government cannot directly purchase all innovative efforts of firms, the incentive problem is solved by allowing firms to earn positive economic profit on production contracts awarded in return for innovation. This hypothesis therefore implies that politically active firms innovate more. The third “reduced competition” hypothesis is based on Romer and Snyder (1994) and Kim (2014), who argue that combined political activism of incumbent industry firms may serve as an effective barrier to entry, which then implies that political activism lowers industry competition and reduces firm innovation.
We examine the predictions of our hypotheses and find strong support for the information acquisition hypothesis. Using a comprehensive sample of firms at the intersection of the NBER patent citations file and the FEC detailed political contributions file for the period 1979–2004, we conduct two sets of analyses. In the first set of tests, we find that firm innovation is strongly positively related to political activism. This evidence is consistent with the information acquisition and the procurement hypotheses but inconsistent with the reduced competition hypothesis. To identify a causal effect, we use the surprise Republican win in the 1994 mid-term election and the consequent surprise Newt Gingrich’s decision to appoint four junior Congressmen to committee chairman positions as an exogenous shock to the value of political contributions for those firms that supported the four new chairmen prior to the 1994 election. Because the chairman appointments were unexpected, firms could not have adjusted their contribution strategies prior to the election. Thus, if political contributions to committee chairmen are valuable (Cooper, Gulen and Ovtchinnikov (2010)) and affect firm innovation, firm patent activity should increase following the election. Consistent with this, we show that patent activity of the treatment group of firms increased significantly following the election compared to that of the control group. Specifically, the number of patent applications for the treatment firms grew steadily from an average of 4.8 applications in 1994 to 8.4 applications in 1999, a 75% increase, while the patent activity of the control group stayed essentially flat over the same period.
In the next set of analysis, we show that firm innovation, especially by politically active firms, significantly predicts future legislative changes. In particular, politically active firms are able to successfully time industry deregulation and significantly increase innovation in soon-to-be-deregulated industries prior to deregulation. In contrast, politically inactive firms do not exhibit this timing ability. We also analyze the timing of political contributions around the votes on deregulatory initiatives. Stratmann (1998) shows that firms lobbying for favorable legislation make political contributions to trustworthy politicians before the vote but hold off on contributing to untrustworthy politicians until after the favorable vote. So, if firms use political contributions for lobbying, we expect higher contributions to untrustworthy politicians soon after the favorable vote. Conversely, if firms use political contributions for information about the upcoming vote, there is little need to contribute after the vote when the outcome is public knowledge. Consistent with the passive information acquisition channel but inconsistent with the active lobbying channel, we show that the post-vote contributions to all politicians decline, and this effect is significantly stronger for untrustworthy politicians.
Turning to tests of the procurement hypothesis, we find that politically active firms innovate more in all industries, irrespective of whether or not the industries sell any output to the government. This evidence is inconsistent with the procurement hypothesis, which predicts that politically active firms innovate more relative to inactive firms but only in industries that maintain extensive trading relations with the government. Moreover, we show that controlling for the depth of the relationship between industry firms and the government does not affect the relation between our proxies for political activism and firm innovation. This evidence is also inconsistent with the procurement hypothesis.
Overall, the results in this paper add significantly to our understanding of the sources of value from political activism and indicate that political activism is an important determinant of firm innovation. Our results also show that firms are not passive with respect to political uncertainty but actively engage in strategies that minimize political uncertainty. These results add to the policy uncertainty literature and to our understanding of its impact on corporate investment.
The full paper is available for download here.
