Are financing constraints binding for investment? Evidence from natural experiment


This paper empirically tests the effects of financing constraints and cost of capital on investment using the 2006 Canadian income trusts tax reform as a natural experiment. Income trusts are two-layer Canadian flow-through entities that are not taxed at the trust level if they distribute all their cash flows. They consist of an income trust and an operating company. The popularity of the income trust structure can be attributed to two distinct tax advantages. The first one is the ability to decrease corporate income tax at the operating company level due to facilitating higher leverage, the second one is lower total tax on distributed profits for ultimate owners. Earnings, which might otherwise have been retained and used as a low cost source of finance for investment, are eliminated (by higher related-party debt) at the operating company level and cannot be retained (at the trust level) without foregoing the tax advantage. Therefore on one hand an income trust has a lower cost of capital for all sources of financing due to elimination of corporation tax, but on the other hand it has to rely more on the more expensive external sources to finance its investment. I investigate these conflicting forces and their effects on investment by looking at both immediate and longer run effects of the 2006 reform announcement, which imposed corporation tax on income trusts starting from 2011 and, by offering them an option to return to being a corporation, relaxed the financing constraint. The results show that financing constraints are binding. The 2006 reform announcement did not affect investment of income trusts until they converted back to corporate form. The availability of cash is more important for investment than cost of capital. Investment of income trusts increased after the reform, in spite of an increase in the cost of capital.