How government spending affects corporations is one research puzzle that has proven to be tricky to solve, given that it is hard to attribute the changes in spending to truly exogenous factors. After all, government behaviour is influenced by developments in the private sector economy.

Changes in private sector activity confound the effects of government spending as well as the reasons behind the change in spending, according to the paper Do powerful politicians cause corporate downsizing?, presented by Harvard Business School professor Lauren Cohen at Singapore Management University (SMU). Co-authored with professors Joshua Coval and Christopher Malloy, the study identified changes in congressional committee chairmanship as one exogenous factor that could be used to shed light on this puzzle.

For one, the appointment of a state's senator or representative to the chairmanship of a powerful congressional committee would tend to affect the allocation of government funds - large and persistent increases to the states; significant retrenchment of corporations based in the state.

Besides changes to the employment activity, the researchers also noted that fiscal spending shocks dampened corporate sector investment. Such corporate behaviours were found to be common amongst firms concentrated within one geographical area, and they would be reversed partially upon the congressman's resignation.

State of the chairman's state

The congressional committee chairmanship is determined by the congressman's seniority - the most senior member of the party in power in that committee gets to be the chair. This means that the chair is vacated following a change in the party controlling that branch of congress or the incumbent's resignation / defeat. The authors argue that because these two events are dependent on political circumstances in other states, the chairman's appointment is essentially unrelated to the conditions of the succeeding chairman's home state. This justified the authors' choice of using changes in congressional committee chairmanship as a source of exogenous variation in state-level federal expenditures. So what effect did the changes in spending have on the private sector?

The authors looked at 292 instances spanning nearly four decades (1968 to 2006), where the senator or representative of a particular state assumes the chairmanship of a powerful congressional committee - and the study demonstrated that substantial federal funds would flow to the ascending chair's state. They wrote, Ascension to a powerful committee chair creates a positive shock to his or her state's share of federal funds that is virtually independent of the state's economic conditions.

In the year following the ascending chair's appointment, the chair's state would experience an increase of 50-60% in their share of federal earmark spending and a 2-3% increase in total state-level government transfers. This funding increase would persist throughout the chair's tenure, gradually reversing upon the chair's departure. The authors highlighted the example of Senator Richard Shelby, when he was appointed to the chair of Senate Select Intelligence Committee in 1997. Alabama (Shelby's home state) experienced a marked increase in its share of federal earmarks. Although earmark spending had increased substantially across the nation during this period, Alabama experienced almost double the average growth.

The authors emphasised that Alabama's share of annual earmarks increased substantially from an averaged US$6 million less than the average of other US states before Shelby's appointment, to an averaged US$90 million more than other states following his appointment. Besides securing more funds to the state, Shelby's appointment also resulted in significant flows of funds to Alabama's healthcare and sciences industries.

Impact on corporations

Following Shelby's appointment in 1997 and the increased earmarks to Alabama, HealthSouth Corp, a large healthcare service provider headquartered in Birmingham, Alabama, began to significantly reduce its capital expenditures and employee base. The reduction in its capital expenditure was substantial, from -7.4% to -1.2% as a percentage of assets. In the same period, HealthSouth Corp had negative average annual employment growth (of -2.2%), even as the industry continued to take in more employees. The company also sold one of its Birmingham hospitals to the University of Alabama at Birmingham (UAB), which received US$22 million in earmarks for medicine and sciences.

The authors argued that the example of the events - changes in government allocated funds to the state and in behaviour of the private sector in that state - represents a much more systematic pattern across the universe of US firms. They investigated the consequences of seniority shocks (changes to the chair of a powerful congressional committee) by studying the behaviour of the corporations headquartered in the congressman's state. Focusing on the investment (capital expenditure), employment, R&D, and payout decisions of these firms, the authors found a strong and widespread evidence of corporate retrenchment in response to government spending shocks.

In the year following the congressman's ascension to the chairmanship, the median firm in his state cuts back capital expenditures by about 15% and axes employment by 2%, while significantly reducing R&D expenditures by 3-20% and increasing payouts to their investors by 5-40%. These changes would persist throughout the period of the chairmanship, reversing only upon the chairman's exit.

The authors qualified that their results were mainly found in firms with geographically concentrated operations, that is, those with more operations in the headquarter state. The effects were amplified in smaller states, where the changes in the federal funds received were proportionately larger. The findings were also more pronounced among small firms, which were not as capable of insulating (much less benefiting) themselves through lobbying efforts. Finally, the authors noted that the results were weaker in states where employment levels were at or below their long-term historical average - which is consistent with Keynes' view that crowding out should only occur under conditions of full employment.

Several other findings corroborated the connection between congressional spending and corporate retrenchment. First, the link weakened as the definition of what constituted a powerful congressional committee broadened. Second, the results were weaker, in economic terms, in the House than in the Senate. The authors reasoned that this could be due to the fact that a congressional representative may have less impact on federal spending directed towards other districts within his state. Third, congressional spending had less impact on firms with more geographically diversified operations; spending shocks were confined to the state where their headquarters were based. Finally, firms cut their capital expenditures and R&D more rapidly, compared to reductions in employment. This could be due to the higher adjustment costs associated with retrenchments.

The authors proffered several mechanisms that could explain why firms respond so negatively to state-level federal spending increases. They noted that public spending appeared to increase the demand for state-specific factors of production, which compel firms to scale back on their operations and invest elsewhere instead. They pointed to the role of competition for state-specific factors of production, including labour and fixed assets, such as real estate.

Also, there might be leakage in federal transfers to state residents. This is especially so for smaller states, which could explain the larger capital expenditure adjustments in small states. The authors also noted that while their study had shed new light on the impact of government spending on private sector economic activity, it also serves as evidence on two remaining issues.

The first is that the congressional earmarks and state-level federal transfers that they focus on do not include defence spending, procurement and other material components of federal spending. The results suggest that these are likely to respond to seniority shocks with correspondingly larger economic magnitudes. An area of future research would be to explore the extent to which the results might apply to all federal dollars transferred from one state to another.


The key contribution of the authors to the literature is in using changes in congressional committee chairmanship as a source of exogenous variation in state-level federal spending. The authors found that fiscal spending shocks appear to significantly dampen corporate sector investment and employment activity. They noted that the effects are economically meaningful and the mechanism differs distinctly from the more traditional channels of interest rate and tax. They also found direct substitution of private sector economic activity by government spending. More specifically, they found that corporations, in the face of reduced investment opportunity, reduce investments in new capital, R&D, and labour while paying out more to shareholders. They also found that when the spending shocks reverse, following the relinquishing of the committee chairmanship, most of all of these corporate behaviours gradually reverse. Finally, the authors have shown that distinct from the standard interest rate and tax channels, new consid