Does a switch of budget regimes affect investment and managerial discretion of State-Owned Enterprises? Evidence from Italian firms

We investigate the investment decisions of Italian state-owned enterprises (SOEs) across budget constraint regimes and carry out a natural experiment that exploits a regime switch in 1987. Drawing on the theory of capital market imperfections, we apply an empirical framework for investment analysis to a panel of manufacturing SOEs in competitive industries. We identify parallels between SOEs and widely-held, quoted companies afflicted by agency problems, managerial discretion and over-investment. We argue that, in the case of SOEs, the soft budget regime increases managerial discretion, facilitates collusion with vote-seeking politicians and results in wasteful investment. Consistent with our predictions, we find that the regime switch disciplines SOE’s investment behavior. Following a hardening of the budget constraint, managers lose discretion to indulge in collusion and over-investment. JEL: E32, G31, G32, L32, M40.