Working Paper
Does a Switch of Budget Regimes Constrain Managerial Discretion?

This study examines the effect of the hardening of the budget constraint on the investment behaviour of Italian state owned enterprises (SOEs). It carries out a natural experiment that exploits the 1987 shift of budget regimes due to the pressure of European Union economic policies on the Italian government. Drawing from the theory of capital market imperfections, we apply the empirical framework for the analysis of investment-cash flow sensitivity to a panel of state-owned manufacturing firms during the period 1977-93. We parallel state firms to Anglo-Saxon public corporations which, under separation of ownership and control, are afflicted by agency problems, managerial discretion, misallocation of free cash-flow and overinvestment. We argue that, under a soft budget constraint, state firms’ managerial discretion and, in particular, collusion between managers and vote-seeking politicians, lead to wasteful investment. We estimate a number of investment models with additional cash flow terms and test for parameter constancy across budget regimes. Consistently with our predictions, we find that there is a significant, positive correlation between cash flow and investment when the budget regime is soft and, with a harder budget regime, the relationship disappears. Our findings support the managerial discretion hypothesis. They show that hardening the budget constraints brings about an important change in the investment behaviour of public enterprises, with managers losing the discretion necessary to indulge in collusion with politicians, empire building and wasteful investment. Furthermore, we provide empirical evidence of the efficiency enhancing effect of the European economic policies on the behaviour of SOEs in Italy. In this respect the experience of Italian SOEs provides a useful benchmark to draw policy implications for the restructuring process in EU accession, transition and emerging economies.