Government Spending Shocks and Firm Innovation

Abstract

Increases in defense spending – the largest portion of discretionary government spending in the United States – are negatively associated with private sector firm innovation. We show that the extent to which defense spending hinders innovation is dependent on a firm’s cash flow sensitivity to consumer demand. The negative effects are stronger for firms with low tangible collateral that rely on internal cash flow to finance projects. The demand mechanism operates independently of resource diversification and public debt crowding-out mechanisms documented in prior studies. Our results are robust to alternative measures of firm innovation and different estimation methodologies.