The effects of liquidity constraints and tax policy on investment and R&D: Evidence from Korea

This thesis uses firm-level panel data to investigate the impact of the Asian financial crisis of 1997--98 on the sources and rate of Korean investment and R&D expenditures. I examine the role of liquidity constraints in financing investment and R&D in the Korean manufacturing sector, and measure the effects of tax policy, especially the impact of recent tax reforms.Large chaebol-affiliated firms, which we would expect to have better access to capital markets, show high investment-cash flow sensitivity. I interpret this pre-crisis result as a managerial agency phenomenon, rather than as reflecting liquidity constraints. Despite drastic financial reforms and industrial restructuring after the crisis which were intended to limit the preferential treatment of chaebols, non-chaebol firms with no bond-rating find it difficult to obtain external financing for investment in the post-crisis period chaebols no longer reveal the sensitivity to cash flows.In their R&D financing, before the 1997 crisis, most firms were not liquidity constrained. After the crisis, large firms and chaebol firms are found to be liquidity constrained in R&D investment financing. Since the crisis, large Korean chaebol firms have been more closely regulated by the government and tightly monitored by banks and investors. The tax effect on R&D before the crisis was sizable, but the effect after the crisis is much smaller and statistically insignificant. Many firms during and after the crisis period do not respond to marginal tax relief, because of the greater uncertainty in the economic environment and the ability to carry forward the tax losses incurred during the crisis.The tax effects on investment are also examined using firm-level data from the Korean manufacturing sector in the pre-crisis period. It has been an empirical puzzle that neoclassical fundamentals frequently fail to explain fluctuations in business investment. The tax reform of 1994 in Korea is used as a natural experiment to obtain sufficient variation in firm-specific costs of capital and tax-adjusted Qs and capture sizable tax policy effects in estimation. Estimating coefficients using tax shocks following the tax reform provides sizable and statistically significant tax policy effects on investment in equipment and structures.