Capital (Mis)allocation and Incentive Misalignment

Abstract

This paper studies how the allocation of capital within firms is shaped by short-termist incentives. We first present empirical evidence on the existence of a within-firm capital (mis)allocation channel caused by distortions of managerial incentives. Using the reform of the FAS 123 accounting statement in the U.S. as a quasi-natural experiment and within-firm variation across investments with different durabilities, we find that firms systematically shifted expenditures towards less durable investments in response to a shift towards more short-term incentives. This reform-induced alteration of the firm-specific capital mix effectively shortened the durability of firms' capital stock. By calibrating a dynamic model of firm investments in which managers determine investment policies, we then seek to quantify the economic impact of such incentive distortions on output, investment and capital (mis)allocation. In our model, bonus-equity incentive contracts induce managers to make quasi-hyperbolic investment decisions and raise differences in the marginal products of capital goods. Relatively small deviations in incentives induced by the accounting reform caused substantial distortions within and across firms. Overall, the reform-induced shift in capital structures away from the social optimum lowered long-run profits by about 0.54% on average.