Do Firms Save Too Much Cash? Evidence from a Tax on Corporate Savings∗

Do Firms Save Too Much Cash?

Evidence from a Tax on Corporate Savings ^∗

Hwanki Brian Kim

Baylor University

Woojin Kim

Seoul National University

Mathias Kronlund

University of Illinois at Urbana-Champaign

November 14, 2019

∗Hwanki Brian Kim is at Baylor University; Hankamer School of Business; One Bear Place; Waco, TX 76798; U.S.A.; Email: Brian Kim6@baylor.edu. Woojin Kim is at Seoul National University; 1 Gwanak-ro, Gwanak-gu, Bldg 59; Seoul, 08826; Korea; Email: woojinkim@snu.ac.kr. Mathias Kronlund is at the University of Illinois at Urbana-Champaign; Gies College of Business; 1206 South Sixth Street; Champaign, IL, 61820; U.S.A.; Email: kronlund@illinois.edu. Yongseok Kim and SeongMyeong Kang provided excellent research assistance. We thank Heitor Almeida, Peter DeMarzo, Brent Glover, Kristine Hankins, and seminar and conference participants at the 2019 BYU Red Rock conference, ESSFM Gerzensee 2019, FMA 2019, the Korean Securities Association 2019, Seoul National University, the University of Illinois at Urbana-Champaign, the University of Melbourne, the University of New South Wales, and Virginia Tech for many helpful comments. A previous draft of this paper was circulated under the title “Discouraging Corporate Savings”.

Do Firms Save Too Much Cash?

Evidence from a Tax on Corporate Savings

November 14, 2019

Abstract

Corporations have accumulated record amounts of cash. Are these savings optimal or excessive? We examine this question by exploiting a Korean tax reform that sought to discourage cash savings by imposing a surtax on earnings that were not paid out to shareholders or invested. This tax applied only to firms with book equity above 50 billion wons or that belonged to a Chaebol. Difference-in-differences tests show that the treated firms reduced cash savings and increased payouts, wages, and investments.

These additional investments appear profitable, and an event study analysis shows that shareholders viewed the reform as value-enhancing. These results are consistent with the accumulation of excessive savings before the reform, and we find evidence consistent with both agency-based and behavioral channels underlying such excessive savings.

JEL category: G32, G35, G38

Keywords: Corporate cash, investment, wages, payout policy, natural experiment, tax

1 Introduction

Corporate cash balances have risen dramatically over the last few decades. In the United States, cash on corporate balance sheets now totals over $3 trillion (Faulkender, Hankins, and Petersen, 2019), and the trend toward growing corporate cash balances is prevalent also in many other countries (Kalcheva and Lins, 2007; Pinkowitz, Stulz, and Williamson, 2015).

This phenomenon is often referred to as a “corporate savings glut” or “cash hoarding.”¹ Still, it remains an open question whether all of this cash represents excessive hoarding or optimal savings.

It is challenging to determine whether corporations are saving too much and investing too little, as the “cash hoarding” narrative would suggest. Corporate decisions about cash policies, investments, and payouts are endogenously determined and driven by multiple factors that are difficult to control for in empirical tests. To address the question of whether firms save too much, we ideally need both a shock to firms’ cash policies—where some companies exogenously change their savings behavior—and a way to measure the value impact of these changes.

The main objective of this paper is to address this question through the lens of a recent natural experiment in South Korea, where the government intentionally sought to stem the tide of corporate cash by imposing a new 10% surtax on any “excess” cash savings above a specific threshold of earnings.² This tax reform became effective on January 1, 2015. A crucial feature of the reform for identification purposes is that it applied only to firms that had a level of shareholder’s equity above 50 billion Korean wons (equivalent to around $50 million USD), and to firms that were part of large business conglomerates (chaebol ), whereas non-chaebol firms below the 50-billion threshold were not subject to the new tax. This setting

1For example, a 2016 Financial Times article argued that “The failure of companies to invest their cash pile has frustrated investors who say companies are not plowing enough back into their underlying businesses, in research and development”; www.ft.com/content/368ef430-1e24-11e6-a7bc-ee846770ec15

2In the next section, we discuss the exact formula that determined the surtax and relevant exclusions.

allows us to study how the firms that were treated by the tax law changed their savings and investment policies, and to measure the resulting consequences for firm value. This evidence thus helps us assess whether saving less enhanced firm value, or whether the law merely distorted corporate cash and investment policies.

Korean firms are among the most cash-heavy in the world: Compared with U.S. firms, Korean firms hold three times more cash as a fraction of GDP: Corporate cash balances are equivalent to 50% of GDP in Korea, compared with around 15% in the U.S..³ The law was motivated by the idea that money sitting on corporate balance sheets could be used more productively in the hands of shareholders or employees, or in the form of new investments.⁴ Our empirical strategy employs a difference-in-differences analysis, in which we compare changes from two years before the tax reform (2013–14) to two years after (2015–16) in firms’

cash savings, payouts, and investments between the firms that were treated by this reform versus firms that were not treated. An attractive feature of the 50-billion-wons threshold that determined treatment is that this threshold is plausibly exogenous to firms’ future savings and investment policies, and also unrelated to any other governmental reforms of which we are aware that could have differentially affected the treated and non-treated firms around the same time. Crucially, this surtax on cash savings was also significant in economic magnitude:

a ten-percentage-point surtax implies an almost 50% increase on top of the standard corporate tax rate, which was 22% during our sample period.

Our results show that the treated firms responded by significantly cutting savings. The economic magnitude of this effect is also large: the savings rate among the treated firms was

3This phenomenon is most evident among the largest business groups (chaebol ). In 2017, the top four chaebol together held the equivalent of around 500 Billion USD in cash. See The Economist, September 27, 2014, at www.economist.com/leaders/2014/09/27/a-25-trillion-problem; and Financial Times, June 11, 2017, at www.ft.com/content/966fcbd8-4f13-11e7-bfb8-997009366969

4From an economy-wide perspective, money on corporate balance sheets is not “idle”; some of it is directly invested in other corporations’ stocks and bonds (Gilbert et al. 2017), and cash that is held as bank deposits is deployed as a source of lending.

cut by 0.3–0.6 percentage-points as a fraction of assets, compared with an average savings rate of around 1 percent of assets.

A firm must necessarily either spend money that is not saved or pay it out to investors.

We show that the treated firms responded by significantly increasing payouts to shareholders.

Specifically, the treated firms pay out 0.2 percentage points more (as a fraction of assets) after the reform, about a 30% increase relative to the sample mean of 0.7%. We also find that the investment rate for the treated firms increased by around 20

To determine whether these actions were value-improving—and thus, whether the treated firms’ savings before the reform might have been excessive—we next study the profitability and valuation consequences for the treated firms. First, we show that the relative increases in investments among the treated firms were especially concentrated among firms and industries that exhibited high profitability before the reform. This implies that the marginal investments were focused primarily in areas where these investments were likely to be more profitable.

Even if the additional investments by the treated firms were profitable; however, that does not rule out the possibility that the shadow value of savings was even higher. We therefore study the valuation consequences for the firms that were treated by the tax reform. Using an event study design, we find that the cumulative abnormal returns (CAR) for the treated firms around the days when the law was proposed and passed were positive. This finding is consistent with investors believing that firms’ cash savings before the reform were excessive and that saving less would raise firm value. The positive valuation effects are particularly notable because a direct negative valuation effect for the treated firms is that they are subject to higher taxes; this implies that investors viewed the responses by the treated firms as more than outweighing these direct costs.

Cross-sectionally, we find stronger responses in terms of changes to savings, payout, and investments among the firms that had high pre-reform earnings and that, therefore, would be

required to decrease their savings to the greatest extent to avoid the surtax. These firms also experience more positive valuation effects around the passage of the law, which is consistent with investors anticipating that these firms would change their behavior to the greatest extent.

We finally explore two possible channels through which firms’ cash savings could have been excessive before the reform and why being incentivized to save less might have improved firm value. First, firms could have saved excessively because of agency conflicts (Bertrand and Mullainathan, 2003; Gao, Harford, and Li, 2013; Nikolov and Whited, 2014). Second, firms might have employed overly cautious cash policies because of behavioral biases (Malmendier, Tate, and Yan, 2011); this would have occurred, for example, if managers have been scarred by past crises such as the Asian Financial Crisis of 1997–98. In the final part of the paper, we investigate these two possible mechanisms that might have induced firms to save too much, and we find evidence consistent with both of these channels at work.

We conduct a battery of robustness tests for our findings. The crucial identification assumption—as in any difference-in-differences design—is the “parallel trends” assumption.

To support this assumption, we show that there are no significant differential pre-trends between the treated and control firms. We also conduct a “placebo” test by exploiting the feature that the 50 billion threshold is relevant only for non-chaebol firms, by showing that there are no effects around this threshold on firms that belong to chaebol and are therefore treated regardless of their size. These results indicate that our results are not driven by differential trends that might be related to a firm’s size.

We further show that our difference-in-differences regressions are robust to a variety of controls, including controls for the distance to the treatment threshold (as in a regression discontinuity), size, leverage, cash flow, and cash levels. The results are also similar when we focus on a range around the threshold (firms with a shareholder’s equity between 10 and 90

billion wons). These tests also help ensure that any effects we find are not spuriously driven by differential trends from the smallest or largest firms in Korea.

The Korean setting represents a unique opportunity to study the effects of a government policy that was aimed at curtailing corporate savings. A historical episode involving a similar reform was the “undistributed profits tax,” which raised taxes on retained corporate earnings in the United States between 1936 and 1937. Poterba et al. (1987) show that the undistributed profits tax resulted in more payouts. Christie and Nanda (1994) use an event study methodology to show, similarly to our findings, that the undistributed profits tax was associated with positive abnormal returns, and they argue that this tax also alleviated agency problems whereby firms had been paying out too little of their profits. The recent experiment in Korea has at least two primary benefits compared with studies of the undistributed profits tax in the U.S. First, crucially, the Korean experiment has a control group of firms that were not subject to the new tax, whereas the undistributed profits tax had no such natural control group. Second, the Korean experiment takes place in recent times when the nature of firms’

balance sheets differ substantially from what it was in the 1930s.

Our study further contributes to the literature on the value of cash. Faulkender and Wang (2006) estimate that the marginal value of cash on average is $0.94, but that this varies across firms, depending on their financial constraints. Dittmar and Mahrt-Smith (2007) find further that the value of cash is lower for poorly governed firms and Harford (1999) shows that cash-rich firms tend to do more acquisitions of other firms and that these acquisitions tend to be value-decreasing.⁵

We also contribute to the literature on the determinants of corporate cash. Studies have cited several reasons that firms hold more cash than they once did, including more precautionary savings (Opler, Pinkowitz, Stulz, and Williamson, 1999; Bates, Kahle, and

5However, Opler, Pinkowitz, Stulz, and Williamson (1999) do not find that excess cash predicts more acquisitions, capital expenditures, or payouts.

Stulz, 2009), lower opportunity costs (Azar, Kagy, and Schmalz, 2016), increased competition (Lyandres and Palazzo, 2016), costs of repatriating foreign earnings (Foley, Hartzell, Titman, and Twite, 2007; Faulkender, Hankins, and Petersen, 2019), and higher levels of intangible capital (Falato, Kadyrzhanova, Sim, and Steri, 2018).⁶ While most of this literature has focused on cash levels rather than savings, two exceptions include Almeida, Campello, and Weisbach (2004) and Riddick and Whited (2009), who examine what we can learn about firms’ financial frictions from the sensitivity of firms’ savings to cash flows.

Finally, this experiment also relates to more recent studies on the “tax holiday” of the

“American Job Creation Act”(AJCA) of 2004, which allowed firms to repatriate foreign earnings. Blouin and Krull (2009), Dharmapala, Foley, and Forbes (2011), and Faulkender and Petersen (2012) examine what firms do after the ACJA when they enjoy (cheaper) access to previously saved foreign cash. Blouin and Krull (2009) and Dharmapala, Foley, and Forbes (2011) show that most of the money that was repatriated during the tax holiday was spent on buybacks, while Faulkender and Petersen (2012) also find an increase in domestic investment after the AJCA.

Our paper proceeds as follows. In the next section, we describe the legislative history and the implementation of the law. In section 3, we describe our data on Korean firms and summary statistics. In section 4, we present results on firms’ responses to the tax reform, and in section 5, we describe several robustness tests. In section 6, we examine the valuation effects. In section 7, we analyze cross-sectional variation in firms’ responses and valuation effects; these tests shed light on the possible channels that could drive firms to save excessively.

We conclude in Section 8.

6The literature on the determinants of cash is surveyed by Almeida, Campello, Cunha, and Weisbach (2014).

2 Legislative History and Institutional Background

On July 16, 2014, the newly appointed then-Minister of Strategy and Finance in Korea, Choi Kyoung-Hwan, announced in his inaugural address a plan for tax reforms. Among them was the new tax on corporate savings. He pronounced that his team was considering taxes on firms’ retentions of unspent earnings, with the aim of incentivizing corporate investments and boosting domestic demand. The prevailing view was that money sitting on corporate balance sheets could be put to more productive use if only firms were incentivized to spend their cash on plants, equipment, labor, or payouts to shareholders.

The official proposal for the tax reform was made on August 6, 2014, the National Assembly passed the law on December 2, 2014, and the law took effect on January 1, 2015.

The law did not target all firms but applied only to those that satisfied at least one of the following criteria: 1) having shareholders’ equity greater than or equal to 50 billion Korean wons as of the previous fiscal year, or 2) belonging to a large business group, i.e., a chaebol.

Firms that did not satisfy either criterion were not subject to the new tax.

For the treated firms, the reform imposed a 10% surtax on “excess saving,” defined as earnings above a certain threshold after deductions for investments, wage increases, and payouts to shareholders. The first surtaxes were assessed in April 2016 based on end-of- 2015-fiscal-year accounting information. Firms could choose between two separate rules for determining the tax amount:

(Rule A): tax amount = [net profit ×0.8

− (investments + wage increases + payouts)]×0.1 (Rule B): tax amount = [net profit ×0.3 - (wage increases + payouts)]×0.1

For example, according to Rule A, treated firms that spent more than 80% of their net income on investments, wage increases, or payouts during a given year would be fully exempt from the tax, while treated firms that saved more than the threshold amount would be taxed at 10% on the residual. Rule A was the relatively more favorable rule for firms that tend to make substantial investments,⁷ whereas Rule B was more favorable to firms that do not make large investments. Even though firms could choose which of the rules they would adhere to initially, they were bound to their chosen rule for at least the next three years.⁸

This surtax was also significant in economic magnitude: A ten-percentage-point surtax implies an almost 50% increase on top of the standard corporate tax rate, which was 22%

during our sample period. Also, note that this surtax was not a tax on cash balances, but instead the tax applied to excessive accumulation of retained earnings as non-invested capital.⁹ The law made important exclusions related to the deductions for wage increases and investments that were allowed. The law explicitly did not allow wage increases awarded to top managers to count as deductions. Regarding the deduction for investments, there was a concern that firms might seek to “store” money in the form of physical investments rather than cash, such as by buying land. The law therefore required that firms taking a deduction for buying land also would be required to start building facilities on the land by the end of the year. The law further imposed a retroactive tax if a firm sold or leased any such land for a period of up to two years after the completion of any construction on the land. While payouts to shareholders was an allowed deduction, firms nevertheless were not allowed to claim an equivalent deduction for paying back debt.

This reform was controversial and received significant pushback from the private sector.

On the one hand, an argument supporting the reform was that this measure was designed

7Specifically, for firms whose capital expenditures represents more than 50% of net earnings.

8We do not have data indicating which rule each treated firm chose to follow, but we can nevertheless calculate a lower bound on the tax amount based on the most favorable rule for each firm.

9Cash balances already incur an implicit tax penalty because interest is subject to corporate taxes (e.g.

Gamba and Triantis (2008)).

to push corporate cash savings toward households through investments, wage increases, or payouts. One concern quite broadly shared by politicians and policymakers was that Korean firms had accumulated cash excessively after the financial crisis.¹⁰ A common view was also that a corporate tax cut that had been passed in 2009 had resulted in even higher cash accumulation in place of the intended effect of increasing investment activities. An implicit assumption behind this argument was that firms were saving more cash than was optimal, and that directing more of this cash towards households would result in higher aggregate consumption.¹¹

On the other hand, other observers raised doubts about the effectiveness of the new tax. These views were based primarily on the assumption that retention rates are optimally determined, and that any additional taxation or “forced” spending on payouts or invest- ments would drive firms to make suboptimal decisions. It was also argued that the reform would effectively increase the corporate tax rate, which would eventually suppress corporate investment and growth.

3 Data and Empirical Strategy

In this section, we discuss our empirical strategy, sample construction, and variable definitions, and we report summary statistics.

10As of 2014, Korean firms reported the second-largest corporate savings among OECD member nations as a fraction of GDP, trailing only Japan. See https://www.economist.com/leaders/2014/09/27/a-25-trillion- problem.

11For example, when he was a nominee as the minister, Choi emphasized in a press interview that he would measure success by welfare improvements for the household economy (https://thediplomat.com/2014/06/south- koreas-incoherent-economic-policy/).

3.1 Empirical strategy

Studying the effects of changes to corporate savings is generally challenging because it is difficult to find a source of exogenous variation in savings across firms. To overcome this challenge, we exploit the Korean tax reform as a natural experiment. We employ a difference- in-differences strategy by comparing firms that were treated by this reform with firms that were not treated, from two years before the reform (2013–14) to two years after (2015–16).

An important advantage of using the Korean reform as a natural experiment is that the assignment of treatment is plausibly unrelated to omitted variables that could influence changes in future corporate savings and investment policies and thereby invalidate the parallel trends assumption.

We define an indicator variable ’Treated ’ to denote a firm that is treated by the tax reform, and estimate the following baseline difference-in-differences model:

y_i,t = θ + β0Treatedi+ β1After_t

+ β₂Treated_i× After_t+ η⁰· X_i,t+ ϕ_i+ τ_t+ ψ_j,t+ ε_i,t,

where i indexes firms, j indexes industries,¹² and t indexes years. y_i,t denotes outcome variables, such as investments, wage increases, and payouts; After is an indicator variable for the post-reform years; X is a vector of control variables based on firm characteristics.¹³ ϕ_i denotes firm fixed effects to control for unobserved time-invariant firm heterogeneity; τ_t denotes year fixed effects to control for unobserved market-wide shocks for each year; and

12The Korean industry classification uses a six-digit code. To ensure that we have sufficiently many firms in each industry classification, we use a five-digit industry code that roughly corresponds to two- or three-digit aggregation of industries using U.S. SIC codes.

13Because of a possible “bad controls” concern (Angrist and Pischke (2008), p. 64), we first report results from these difference-in-differences regressions without these additional control variables. We then report the results with the control variables later for a robustness check.

ψ_j,t denotes industry-by-year fixed effects to control for unobserved industry-wide shocks for each year.¹⁴

The main coefficient of interest is β₂, which captures the average treatment effects for each of the outcome variables. We cluster standard errors throughout at the firm level for stand-alone firms or, alternatively, at the Chaebol level for firms belonging to a chaebol group.

All variables are winsorized at the 1% and 99% levels.

Because treatment is based on a firm’s shareholders’ equity, one may nevertheless be concerned about the possibility that a firm’s equity size could be spuriously correlated with differential trends; for example, suppose that larger firms tended to perform better after the reform, but for reasons unrelated to the reform. To address this concern, we repeat the baseline difference-in-differences estimation while limiting the sample to firms for which the pre-reform shareholders’ equity is within a narrower bandwidth around the treatment threshold of 50 billion Korean wons. Specifically, we employ a bandwidth that ranges between 10 billion and 90 billion Korean wons to make it sufficiently narrow so that firms are more comparable and less likely to be affected by differential trends, while also maintaining a reasonably large sample to ensure sufficient statistical power.

3.2 Data and sample construction

Most of the data for this study, including accounting information, stock prices (for firms publicly listed on the stock exchange), and other firm characteristics, are collected from DataGuide, which is a comprehensive database on both private and public firms in Korea.¹⁵

14Because we include both firm fixed effects and year fixed effects in all specifications, the Treated and After variables are in practice subsumed by those fixed effects.

15Korean auditing regulations require that all corporations whose total assets are greater than KRW 10 billion (roughly USD 10 million) hire an external auditor (accounting firm) to audit their financial statements every fiscal year, which is the source of information for private firms.

To determine more precisely which firms are affiliated with chaebol groups, we manually double-check the accuracy of our data using an annual report by the Korean Fair Trade Commission. We obtain data on corporate governance scores from the Korea Corporate Governance Service, and data on the probability of default for public firms from the Risk Management Institute of the National University of Singapore (NUS RMI).

Beginning with these data on all public and private firms in Korea, we employ several filters to further refine the sample. We first eliminate firm-year observations for which data on shareholders’ equity are missing, as this variable determines treatment. We further exclude financial firms and utilities. We next screen out firms that have total assets of less than 1 billion Korean wons (approximately $1 million) and firms with very negative levels of capital expenditures (less than -10% of total assets). As a final filter, we drop three specific firms—Hyundai Motors, Kia Motors, and Hyundai Mobis—as these firms made a massive investment in real estate during our sample period but that had been planned a long time before the tax reform.¹⁶ After restricting our sample period to four years around the tax reform, i.e. from 2013 through 2016, our final sample consists of 80,494 firm-year observations across 20,916 unique firms.

3.3 Main variables and summary statistics

Because the tax reform was aimed directly at discouraging savings while encouraging payouts, investments, and wage growth, we start our empirical analysis by studying changes to these outcomes as dependent variables. Cash savings (∆Cash/assets), payouts (Payout ), investment (Investment ), and wage growth (Wage increase), are defined, in turn, as changes in cash holdings during the year, total cash dividends plus share repurchases, capital expenditures,

16Including these firms would make the estimated effects on investments stronger, but would less accurately reflect the impact of the tax reform.

and changes in a firm’s wage bill for non-executive employees during the year.¹⁷ All of these variables are normalized by lagged total assets. Definitions for all variables are described in Table A11 in the Internet Appendix.¹⁸

While the definitions of most variables are straightforward, it is worth paying extra attention to that of our measures of share repurchases: We follow Fama and French (2001) and Almeida et al. (2016) and focus on purchases of stock, because the tax reform did not penalize sales of stock. In other words, we measure repurchases as purchases of stock if they are not missing, and replace them with increases in common Treasury stock if stock purchases are missing or zero and Treasury stock is not missing for the current and prior year. If neither data on purchases of stock nor changes in Treasury stock are non-missing, repurchases are set to zero.

Table 1 summarizes the panel data over our sample period (2013 through 2016). In Panel A, we report summary statistics on firm characteristics.

Table 1 About Here

In Panel B of Table 1, we report statistics on how many firms were treated and not treated by the reform by each criterion for treatment. Of the sample firms, 1,052 are chaebol -affiliated, and 3,451 firms report shareholders’ equity that is greater than 50 billion Korean wons, while 599 firms are treated based on both of these dimensions. In total, 3,904 firms were treated, i.e. subject to the tax reform. We will exploit this “two-dimensionality” of the treatment as part of our identification strategy and in our “placebo” robustness tests.

As we describe in Section 3.1, we also examine a subsample of firms around the treatment threshold of 50 billion Korean wons to sharpen our difference-in-differences analyses further.

17As described in section 2, wage increases for executives did not count as a deduction from the surtax.

18We multiply these asset-scaled variables by 100 throughout to aid interpretation, as this defines the variables in percentage terms.

In Table A1 in the Internet Appendix we compare firm characteristics of the treated and non-treated firms in this restricted subsample, which shows show that treated and non-treated firms in the narrower bandwidth around the treatment threshold are overall similar across many observable characteristics. The crucial identification is nevertheless the ‘parallel trends’

assumption, that we will examine formally in Section 5.

4 Main Results

In this section, we employ the difference-in-differences methodology to study the effects that this reform had on firms’ financial and investment policies. These results crucially show whether the reform had any “bite” in affecting how firms save, and the results also shed light about the margins along which firms respond most strongly. It is nevertheless important to note that these results regarding how firms respond to the law do not tell us whether these responses enhance firm value or not; we will turn to that crucial question in the following section.

4.1 Effects on cash accumulation

We begin by studying how the reform affected corporate cash savings. In a simple theoretical framework, firms should equate the marginal cost of increasing cash holdings and thus potentially sacrificing valuable investment opportunities today with the marginal benefit of having available internal cash to invest in the future (e.g., Opler et al. (1999); Almeida, Campello, and Weisbach (2004)). The surtax raises the marginal cost of saving, so we might naturally expect firms to save less.

This simple theoretical prediction is nevertheless made somewhat less evident because the law provided no symmetric tax credit for dissaving (negative cash accumulation). The

reform thus creates a wedge between saving and dissaving: Saving above a certain threshold of earnings is taxed, but payouts or investments that result in dissaving in another year does not provide firms with an equivalent credit. As a result, we might expect treated firms to smooth their savings to a greater extent and avoid years of dissaving. The overall effects of the reform on savings are thus ambiguous.

In Table 2, we report difference-in-differences results on how the tax reform affected cash savings in the treated firms. In Panel A (Panel B), the dependent variable is defined as changes in cash holdings (and investments in long-term marketable securities) scaled by total assets.¹⁹ In Columns 1 and 2 we report the results for the full sample and in columns 3 and 4 we focus on firms that fall within a narrower bandwidth of shareholders’ equity around the treatment threshold (in a range between 10 and 90 billion wons). We control throughout for firm fixed effects, as well as year or industry-by-year fixed effects.

Table 2 About Here

Our results show that treated firms responded by significantly reducing cash savings to a greater extent than the non-treated firms after the tax reform, regardless of whether we include investments in long-term securities as a component of cash holdings or not: The coefficients on the Treated × After interaction terms are significantly negative in all specifications. The economic magnitude of this effect is also substantial: the savings rate among the treated firms was cut by around 0.3 percentage points when normalized by assets, relative to an average savings rate of around 1 percent. These results are qualitatively similar but slightly larger when we focus on the narrower range of firms around the treatment threshold, as seen in columns 3–4.

19Our primary measure of cash holdings is defined as the sum of ‘cash and cash equivalents’ plus ‘investments in short-term marketable securities’. Firms may also hold “cash” in the form of investments in long-term securities such as available-for-sale financial assets with long-term maturity, and we present robustness results that includes this item as part of a firm’s cash holdings.

In Panel A of Figure 1, we show this effect graphically. In this figure, we match each treated firm to one non-treated control firm that is most similar (its “nearest neighbor”) before the reform, and the figure shows that while these treated and control firms displayed similar cash savings behavior in every year before the reform, the treated firms saved significantly less in the years after the reform.²⁰

Figure 1 About Here

4.2 Effects on payout policy

In the previous section, we showed that the treated firms significantly reduced cash savings after the tax reform. Given this reduction in cash accumulation, we now examine how firms spent the cash that was not saved. We start by examining how payout policy is affected by the reform, and in the following sections, we study effects on wage increases and investments, respectively. It is nevertheless important to note that cash savings, payouts, wages, and investments do not exhaust all the possible uses (or sources) of corporate cash flows, and thus, the total effects on these alternative uses of savings do not necessarily add up precisely to the estimated decrease in savings. We nevertheless study these specific effects as they are the ones explicitly targeted by the law.

We measure payout as the sum of cash dividends and share repurchases scaled by total assets (multiplied by 100, so that any effects can be interpreted as a percent fraction of assets). Table 3 reports results. The results reported in columns 1 and 2 of Table 3 show that the treated firms increased payouts following the tax reform: the economic magnitude is around 0.2 percentage points of assets, which is around 30% of the sample mean payout of 0.7%. In columns 3 and 4, we restrict the sample to a narrower bandwidth around the

20In the matching procedure, we require an exact match on industry, and further match on the pre-period Cash/assets, payouts, wage increases, and investment based on the Mahalanobis distance.

regulatory threshold and find similar results. Panel B of Figure 1 also shows these results graphically for the matched treatment-control sample.

Table 3 About Here

We next examine the components of payouts, i.e. dividends and repurchases separately.

The results reported in Table A2 in the Internet Appendix indicate that while both forms of payout significantly increased for treated firms following the tax reform, dividends increased more than repurchases in absolute magnitude. Guay and Harford (2000) and Jagannathan, Stephens, and Weisbach (2000) argue that firms tend to use dividend increases to distribute cash from relatively permanent shocks, whereas they use repurchases to distribute transitory shocks. Thus, to the extent that dividends signal payouts that are more permanent, this result suggests that the treated firms established a permanently higher level of payouts after the surtax came into effect. The differences between the increases in dividends and repurchases can also reflect the fact that dividends overall represent a much larger share of total payouts in this sample, which in turn is related to the fact that the majority of the sample firms are private. Average dividend levels equal 0.59% of assets, whereas average repurchases equal only 0.1%, which means that the repurchases increased more in percent (by around 50%) than dividends (30%).

4.3 Effects on wage increases and investments

We next focus on the effects on two real outcome variables: wage increases and investments.

Higher wages and investments were also among the outcomes that were explicitly targeted by the tax reform, as these were allowed to offset the surtax on retained earnings.

In Table 4, we report how the growth in wage bills changed around the tax reform for the treated firms. We measure wage increases as changes in firms’ non-executive wage bills

scaled by total assets. The results reported in columns 1 and 2 indicate that treated firms increased wage bills. These results continue to hold when we consider the narrower sample around the threshold (see columns 3 and 4).²¹

Table 4 About Here

We next examine the effects on investments. We measure investments as changes in tangible assets plus depreciation scaled by total assets. The results reported in columns 1 and 2 of Table 5 indicate that the treated firms increased their investments compared with non-treated firms. The economic magnitudes are significant as the investment rate for the treated firms relative to untreated firms increased by around 20%-30%. In columns 3–4, we report the results for the narrower sample around the treatment threshold, and the estimated effects on investment here are even greater in magnitude. Panels C and D of Figure 1 graphically show the results on wage increases and investment for the matched treatment-control sample.

Table 5 About Here

One advantage of the data on Korean firms is that it further allows us to identify what kinds of investments are made. When we focus on these separate components of capital

21For a subset of firms (around 10% of the sample), we have data on both the total wage bill and the number of employees, which further allows us to break down these wage bill changes into wages for new hires and wage increases to existing employees. In Table A3 in the Internet Appendix, we report the results we obtain after separately examining the effects on these two outcome variables: wage per employee and the number of employees. These results are nevertheless not entirely conclusive. When we do not limit the sample based on shareholder’s equity being relatively close to the threshold, the results indicate that the treated firms did raise wages to existing employees while there is no significant effect on the number of employees.

On the other hand, when we consider the narrower sample around the treatment threshold, we instead find larger effects on the number of employees.

expenditures, we find that the treated firms increased investments about equally in Land, Buildings, and Equipment. These results are reported in Table A4 in the Internet Appendix.²² Why did firms increase investments? On the one hand, these results are consistent with firms’ having available positive-NPV projects that previously were unfunded (Fazzari, Hubbard, and Petersen, 1988). If the treated firms had no such investments, they could alternatively avoid any surtax by increasing payouts instead of increasing investments. The fact that firms did invest more thus implies that firms viewed the value of these investments as sufficiently high to outweigh the alternative of paying out more money to shareholders. On the other hand, it is also possible that investing more could be a sign of an agency problem in the form of “empire-building.” In Section 7.3, we examine this possibility in detail.

4.4 Other effects: Leverage and profitability

Saving less could potentially have negative consequences for a firm’s risk of finding itself in financial distress. Did these changes contribute to higher risk? We find that the treated firms have higher leverage after the reform went into effect and report the results in Table 6 (columns 1 and 2), which is consistent with higher risk. The economic magnitude is around one percentage point in higher book leverage. Part of the increase in net debt is driven by a reduction in cash documented earlier, but this effect is also driven by an increase in debt:

The results reported in Table A5 in the Internet Appendix show that treated firms issued more debt (net of repayment of existing debt) after the tax reform. The higher post-reform net debt issuances by treated firms can help explain why the total increases in payouts and investments by treated firms that we documente in Tables 3, 4, and 5 is higher than these firms’ reductions in cash savings that we documented in Table 2.

22The results for the narrower sample are similar, but each of the separate components of investment is no longer individually statistically significant.

Table 6 About Here

Observing higher leverage for the treated firms is not surprising, as these firms start saving less cash and paying out more.²³ Whether or not this leverage increase is concerning depends on the firms’ initial leverage, which nevertheless was relatively conservative at a mean of 31% (with a median of 27%).

We see evidence of such muted effects on default risk when considering the estimated treatment effects on the probabilities of default.²⁴ That is, despite the higher leverage of the treated firms, we observe an effect on the probability of default that is both economically and statistically indistinguishable from zero. This result is similar if we measure distress risk over a two-year horizon (see columns 3 and 4 of Table 6) and a three-year horizon (columns 5–6). If the trends in lower savings and higher payouts continue for the treated firms also in the long run, however, we would eventually expect the divergence in leverage to increase further, potentially causing significantly added risks of distress.

What effect did these actions have on firms’ overall levels of profitability? In Table A6 in the Internet Appendix, we report results pertaining to the operating performance of the treated firms, measured by Return on Invested Capital (ROIC, measured as EBITDA scaled by total invested capital) as well as by profit margin (net sales less the cost of goods sold as a percentage of net sales).

We find that the treated firms display improved profitability. These results suggest that the actions that firms took in response to the law did not hurt profitability and that these actions, if anything, improved their overall returns on capital. The economic magnitude of

23The reform notably treated payments to debt and equity investors in a non-neutral way, as it does not allow debt repayment to count as a tax-reducible item.

24The probability-of-default measure is based on data from the NUS Risk Management Institute. This measure is calculated based on their methodology, which is described in detail at http://www.rmicri.org. One downside of the probability of default data is that it is only available for a subset of the public firms.

these profitability changes is also meaningful. These results do not, however, by themselves represent conclusive evidence that these actions were value-improving—a question that we will analyze more formally in section 6.

5 Robustness

In this section, we conduct a battery of robustness tests of our findings.

We begin by exploiting the “double-dimensionality” in the assignment of treatment, i.e., the fact that treatment was based on satisfying one of two inclusion criteria. As is typical in a difference-in-differences setting, the key identification assumption is the “parallel trends” assumption. One might nevertheless be concerned that particularly the chaebol firms could follow different trends from the non-chaebol firms, which in turn could be spuriously contributing to our results. To account for this possibility, in Panel A of Table 7 we report results from the difference-in-differences tests while restricting the sample to only non-chaebol firms that fall in the narrower range around the treatment threshold. For these firms,

“treatment” is based solely on whether shareholders’ equity is above 50 billion wons. The results show that the economic magnitudes and statistical significance of the effects remain largely similar to what we found with the full sample. Thus, chaebol firms do not drive the overall effects, and these results are robust to examining effects within non-chaebol firms.

Table 7 About Here

Next, even within the relatively narrow range between 10 and 90 billion wons, we might be concerned that the slightly larger firms above the 50 billion threshold might be following a different trend that was unrelated to the reform, compared with the trend that the slightly smaller firms below the threshold follow. To address this concern, we therefore limit the

sample to only chaebol firms in the 10–90 billion range and report the results in Panel B of Table 7. This test thus serves as a “placebo” test, because the 50 billion threshold has no impact on treatment for these firms. Consistent with this idea, we find no effect (or, in the case of investment, even an effect that is the opposite of what we observe with our baseline results) around the threshold across all of the dependent variables.

In sum, the results reported in Panels A and B of Table 7 show that the 50 billion threshold predicts an effect among the non-chaebol firms while we find no effect within the

“placebo” sample that uses the same threshold among only the chaebol firms. These findings reinforce the results according to which the documented effects are driven by the treatment from the tax reform, and not spuriously driven by differences caused by a violation of parallel trends that are related to shareholders’ equity or chaebol membership.

To examine whether the results for the full sample are robust to controlling for other variables, we also report the results from separate specifications with additional control variables, including Shareholder’s equity - 50 billion wons (i.e., distance to threshold, as in a regression discontinuity design), size, cash flow, debt, and Cash/assets, and report the results in Panel C. Here, the results show that the estimated effects remain the same or become even stronger when we control for these additional firm characteristics. To address a concern about “bad controls” that could confound these results (Angrist and Pischke, p. 64), we do not use these results as our baseline specification.²⁵

In Panel D, we report the results employing a difference-in-differences matching procedure.

For each treated firm, we pick one control firm that is most similar (the “nearest neighbor”);

we require an exact match on industry, and further match on the pre-period Cash/assets, payouts, wage increases, and investment based on the Mahalanobis distance. Then, using the sample of the matched treated-control pairs of firms, we estimate the baseline difference-in-

25The full sets of the estimated coefficients from our baseline difference-in-differences specifications are reported in Table A7 in the Internet Appendix.

differences model. Panel D shows that this matching procedure generates similar estimated treatment effects even despite using a smaller sample.

To further support the parallel trends assumption, in Table 8, we report results pertaining to differences in “pre-trends” among our main outcome variables between the treated group and the non-treated group. Panel A reports the results for all firms while Panel B focuses on the firms that fall within the narrower range around the treatment threshold.

Table 8 About Here

These tests also show that our results are unlikely to be confounded by a violation of the parallel trends assumption, as we do not observe any significant differential pre-trends between the treated and untreated firms. This holds both across the full sample, and also when we focus on the narrower range around the threshold. If anything, we typically observe pre-trends that run in the opposite way of our main results; this is, for example, the case for our investment variable in the narrow range, where the treated firms see slightly lower trends in investment in the years leading up to the law.

We may additionally be concerned about whether firms close to the threshold intentionally shrink to avoid the tax, and whether such behavior may have an impact on our results.

We address this concern in two ways. First, we examine how many firms move across the threshold to examine whether a large number of firms show behavior consistent with avoiding the tax. We find little evidence that firms are shrinking to avoid the surtax; while 39 firms move from above to below the threshold between 2014 and 2015, 185 firms move from below to above (the fact that more firms are growing is consistent with overall growth in the economy over this period). Second, we re-estimate our results using a “Donut RD” empirical strategy, where we focus on the 10–90B wons range, but further exclude firms in the 45–55 billion wons range for whom the incentives to shrink to avoid the tax may be the strongest. The

results, which are reported in Table A8 in the Internet Appendix, are similar, and if anything, generally stronger than in our baseline tests.

Finally, we analyze whether these results differ depending on whether we focus on private or public firms, or whether the results are unique to either of these groups of firms. Previous research has shown that private firms overall tend to hold less cash than public firms (Gao et al., 2013). We nevertheless find no significant differences between private and public firms in their responses to the law.²⁶

6 Valuation consequences

Our results thus far have shown that the treated firms responded to the reform by saving less cash, paying out more to shareholders, and spending more on investments and wages. The question nevertheless remains whether or not firms were saving optimally before the law, and thus whether the treated firms’ responses to the tax reform represent an improvement or not.

In other words, whether discouraging savings is desirable from a policy perspective depends crucially on why firms are saving in the first place: If high savings rates before the law were optimal, then using the tax system to discourage savings will merely destroy firm value by distorting firms’ cash policies.²⁷

Theoretically, firms should equate the marginal cost of saving cash with the marginal benefit of doing so (e.g., Opler et al. (1999); Almeida, Campello, and Weisbach (2004)).

The main cost of saving involves potentially sacrificing profitable investment projects today and a “double-taxation” penalty from earning interest, whereas a principal benefit is that a cash buffer can enable firms to better weather recessions and respond to future investment opportunities (Lins et al., 2010). This is especially true when a firm may face financial

26These results are not separately tabulated in the paper but available from the authors.

27Previous empirical evidence (Brav et al., 2018; Kaplan, 1989) as well as agency theories (Jensen, 1986) might instead suggest that over-investment rather than excessive savings could be the larger problem.

constraints that can make internal financing significantly cheaper than external financing (Almeida et al., 2004; Acharya et al., 2007). It is challenging to assess whether the treated firms’ post-reform savings and investment behavior represent an improvement because it is hard to measure the (shadow) value of cash savings and of any marginal investments. In this section, we seek to address this question by employing an event study analysis around the proposal and the passage of the law.

We analyze how investors viewed the valuation consequences of the law for the treated firms, by employing an event study methodology around the date when the law was proposed and the date when it was passed. The idea is that we may be able to distinguish between excessive and optimal savings by looking at abnormal returns around the time the law was passed. These returns can plausibly capture investors’ expectations regarding the long-term consequences of the law for firm value, also accounting for expectations for how firms will react to the law regarding any changes to their savings, payouts, and investments.²⁸

To the extent that high savings and high cash balances before the law were optimal, then using the tax system to distort firms’ savings and investment policy must destroy firm value, and we would expect any valuation effects for the treated firms to be negative. This negative effect consists of two parts: an indirect effect from the tax change distorting corporate policies, plus a direct effect from paying higher taxes to the extent that firms do not change their policies sufficiently to avoid the surtax completely. On the other hand, if investors viewed any changes that firms take in response to the reform to be value-improving, we might expect somewhat less negative announcement returns to the extent that these indirect effects from changes in firm policies cancel out the direct negative effects of higher taxes, or even positive announcement returns if these indirect effects are viewed as sufficiently value-improving and

28Studying announcement returns around several dates related to the passage of the same law in Korea that we exploit for our study, Semaan (2017) finds that firms that were more likely to be subject to surtaxes experienced negative abnormal returns, but that this effect was muted for firms that were more likely to engage in tax avoidance.

firms are able to make sufficiently large changes to mostly avoid any surtax.²⁹ That is, if firms’ savings were excessive before the reform, then discouraging savings through the tax system could result in improved firm outcomes, and possibly even higher firm values for the treated firms despite the prospect of higher taxes.

To examine investors’ reactions to the tax reform, we compute the three-day cumulative abnormal returns (CAR), from one day before to one day after the proposal of the law on August 6, 2014, as well as the three-day-CARs around the passage of the law on December 2, 2014. We choose these two days because, even though rumors of such a law had existed before the proposal, these are the first days when the information indicating which firms would be treated and which firms would not be treated was released. We then take the sum of these two CARs for each firm and regress it on the Treated indicator.

In Table 9, we report the results from the event study analysis.

Table 9 About Here

The results show that abnormal returns (CAR) for the treated firms around the days when the law was proposed and passed were positive. This implies that investors believed that the cash accumulation before the law was excessive and that encouraging firms to increase payouts and investments enhances firm value. The economic magnitudes are estimated to be around 2% of firm value. These effects are similar regardless of whether we include industry fixed effects or not, whether we use the full or narrower sample, and whether we limit the sample to only non-chaebol firms. These results are notably similar to the findings reported

29Anecdotal evidence suggets that investors indeed tended to view the tax reform as value-enhancing. For example, according to a 2014 article by Korea JoongAng Daily, one of the country’s three major newspapers,

“the majority of institutional investors expect that the tax reform would have a positive impact on the stock market... Equity investors predict that dividends in particular will increase in response to the reform, which could help valuations of firms.”; See https://news.joins.com/article/15353993 (translated from Korean).

by Christie and Nanda (1994), who find positive market reactions of about 1% around the announcement of the undistributed profits tax of 1936–37 in the U.S.

The positive CAR for the treated firms is especially notable because the tax itself has a direct negative valuation effect, as at least some treated firms are likely to pay higher taxes—

specifically, those firms that do not avoid the tax by increasing payouts and investments sufficiently to avoid the surtax). The positive returns among the treated firms imply that investors expected the treated firms’ responses to sufficiently enhance their value to more than outweigh the direct negative effects from higher taxes. These results broadly support previous findings regarding that investors tend to view a marginal dollar in the hands of a corporation as being worth less than a dollar (Faulkender and Wang, 2006; Dittmar and Mahrt-Smith, 2007).

7 Cross-sectional variation and channels

We next investigate whether firms that had high earnings before the reform responded differently to the tax, as these firms were likely to be more heavily affected by the new surtax.

In the following sections, we use cross-sectional splits to study the mechanism through which the tax reform affected corporate policies, which in turn can help shed light on why firms might have been saving excessively in the first place.

7.1 High earnings

Firms with high earnings are more heavily affected by the new surtax, and the law also requires these firms to effect relatively larger changes in their investment and savings behaviors to minimize the surtax. We might thus expect these firms to change their savings and investment policies to a greater extent around the reform.

To examine the differential effects on firms with high earnings, we split the sample based on firms’ pre-reform earnings, measured as operating cash flows (the ratio of EBITDA to total assets). We define a variable High earnings based on whether these earnings are above the median. We then estimate triple-difference regressions for the effects on savings, payouts, and investments, where we interact T reated and Af ter with High earnings. We report the results in Panel A of Table 10.

Table 10 About Here

Overall, we observe that the treatment effects on corporate policies are significantly more pronounced for firms that garnered higher earnings in the pre-reform period.

Because the high-earnings firms change their savings and investment policies after the law more extensively, we might also expect investors to react more strongly to the passage of the law for these firms—assuming that investors correctly anticipate these reactions. Consistent with this hypothesis, the results we report in Panel B of Table 10 show that the positive valuation effects are indeed more pronounced for high-earnings firms.

7.2 Behavioral bias

We next study a possible channel that might explain why Korean firms prior to the enactment of the law may have exhibited excessive savings in the first place, which is related to possible behavioral biases caused by past experiences. Previous studies have documented links between past experiences and future financial decisions. For example, Malmendier and Nagel (2011) and Kn¨upfer, Rantapuska, and Sarvim¨aki (2017) find that individuals who experienced depression periods are more likely to be risk-averse in their investments in financial assets.

In the corporate setting, Dittmar and Duchin (2015) find that firms with CEOs who have worked at a company that has undergone financial difficulties hold more cash.

We similarly examine the role of behavioral biases reflecting a “crisis mentality” among firms and executives that might have been formed during the 1997 Asian financial crisis. The idea is that if firms depended heavily on external financing and experienced the crisis, they might have come out of the crisis with the belief that they need to build ample cash buffers to weather the next crisis. The basic idea is that either a firm’s CEO may personally remember the effects of the crisis, or even if the CEO has changed, the firm may have an “institutional memory” from the crisis.

To classify firms according to whether they may suffer from biases from a past crisis, we define an indicator variable CrisisMemory as equal to one if either 1) the firm’s CEO was an executive of a firm during the Asian crisis that was operating in an industry that depends heavily on external financing, or 2) if the firm itself was established before the crisis and operated in an industry marked by heavy dependence on external financing. The degree to which firms in an industry depends on external financing is defined, following Rajan and Zingales (1998), as capital expenditures minus operating cash flow; the use of this measure within the specific context of the Asian financial crisis is based on Almeida, Kim, and Kim (2015), who find that Korean firms that operate in industries that depend heavily on external financing experienced more severe liquidity shocks during the crisis. We employ triple-difference regressions and employ this indicator variable as an additional interaction term in the baseline difference-in-differences. We hypothesize that firms that fit the definition of the CrisisMemory variable were more likely to hoard cash excessively before the tax reform and thus were more heavily affected by the new tax law.

Consistent with higher pre-reform savings for firms with memories of a past crisis, in Panel A of Table A10 in the Internet Appendix, we report results supporting a correlation between CrisisMemory and the pre-reform level of cash. Controlling for firm size and cash flow, we observe in general that firms with a stronger memory from the crisis did accumulate more cash before the tax reform.

We then report the results of our triple-difference analysis of the CrisisMemory variable in Table 11. In Panel A we report the triple-difference results regarding the effects on savings, payouts, wage increases, and investments. We see that firms with a crisis memory reduced cash savings to a greater extent and also increase payouts, wages, and investments to a greater extent after the tax reform, although some of these results are statistically significant at the 10% level only. This suggests that the tax reform had a larger effect in terms of nudging these firms to change their behavior.

Table 11 About Here

The results we report in Panel B in Table 11 show the differences in market valuation responses around the law announcements for the crisis-memory firms vs. those firms without such memories from the previous crisis. The results indicate that the positive announcement returns (CAR) for treated firms are concentrated among firms with a crisis memory.

As a robustness test, we next confirm that our results capture not only industry-level differences related to external financing needs, but are related specifically to a firm’s or CEO’s memories from the past. In Table A9 in the Internet Appendix we report results from a placebo test where we replace the CrisisMemory variable with a variable indicating whether a firm operates in an industry with high dependence on external financing but either the firm or CEO were not operating in 1997 when the Asian financial crisis hit. These placebo tests show that there is no relationship between firm responses around the reform and their dependence on external financing, but that the results in Table 11 are indeed driven by the interaction of both being dependent on external finance and remembering the previous crisis.

The results we report in Table A9 similarly show that there are no effects merely involving

“old” firms or CEOs (defined as having been operating in 1997) unless the firm also relied heavily on external financing.

The results discussed in this section together indicate that firms operating with a crisis mentality saved more cash before the new reform, but also responded more strongly overall to the reform, and moreover that these responses were viewed more positively by the market.

These results are consistent with a behavioral hypothesis whereby some firms and CEOs may have been traumatized by the crisis and therefore engaged in excessive savings.

7.3 Corporate governance

Finally, we study the extent to which differences in firms’ levels of corporate governance affected how firms and investors responded to the tax reform. Agency conflicts and poor governance are one of the main reasons why we might expect firms to engage in overly cautious precautionary savings before the reform (Bertrand and Mullainathan, 2003; Gao, Harford, and Li, 2013; Nikolov and Whited, 2014). It is thus possible that the reform had a larger impact on firms with relatively worse governance quality. The results we report in Table A10 (Panel B) in the Internet Appendix show that poorly governed firms indeed tended to carry more cash on their balance sheets before the reform.

To measure corporate governance quality, we employ a governance index score created by the Korea Corporate Governance Service (KCGS). KCGS calculates these scores every year for all public firms listed in the KOSPI market, and this measure is therefore limited to only the subset of public firms. This governance score is calculated as a sum that encompasses four distinct aspects of governance: 1) the protection of shareholder rights, which is given a score between 0 and 81, 2) the internal workings and processes of the board, which is given a score between 0 and 69, 3) the workings of monitoring organizations, which is given a score between 0 and 43, and 4) transparency in disclosures, which is given a score between 0 and 47. These scores are then summed to create a total governance score. Note that higher scores denote increasing governance quality, differing from the GIM-index or E-Index scores in

the U.S., which denote decreasing governance quality. We then define an indicator variable High-G as equal to one if a firm is assigned an above-median total governance score.

In Panel A of Table 12 we first report results about how differences in corporate governance quality affected post-reform changes in cash savings, investments, and payouts for the treated firms.

Table 12 About Here

We find that there are no significant differences in changes in cash savings between poorly governed and well-governed firms. That is, treated firms in both of these groups reduce their savings equally after the law was enacted.

How firms used this money that was not saved differs in a predictable pattern, however, depending on the quality of governance. The positive treatment effects on payouts are concentrated among well-governed firms: treated firms demonstrating good governance on average increase payouts following the tax reform by approximately 0.35 percentage points of assets while poorly governed treated firms do not. On the other hand, the positive treatment effects on investments and wage increases are much stronger among poorly governed firms.³⁰ This evidence is broadly consistent with “empire-building” among these poorly governed firms.

As seen in Panel B of Table 12, we further find that the investors’ value reaction to the reform was much higher for the well-governed firms. This suggests that investors expected the better-governed firms to respond more efficiently to the tax reform, apparently realizing that the reform could encourage empire-building, particularly among poorly-governed firms. The

30The magnitudes of the average differences in the outcome variables between well-governed and poorly governed firms are quite large relative to those of our baseline treatment effects. This is partly a result of the fact that the magnitudes of the “baseline” treatment effects are even larger among this subsample of firms for which the governance score is available.

coefficients on the interaction term indicate that the announcement day CAR for a treated firm is about 2% lower among poorly-governed firms.

This result thus reveals a dark side of the reform. Even if some firms were saving too much, pushing firms to do something else with that money may not necessarily improve firm value. For example, instead of hoarding cash, firms could alternatively overinvest or engage in other forms of “empire-building,” which can result in even worse consequences.

8 Conclusion

Corporations all over the world have accumulated unprecedented levels of cash on their balance sheets. Many observers say this trend has gone too far and increasingly criticize firms for “hoarding” cash. Does this cash represent optimal precautionary savings by firms, or could this money instead be put to more productive uses if firms saved less and instead spent more on payouts, wages, or new investments? Can tax policy reduce corporate savings?

And if so, what are the consequences? To investigate these questions, we exploit a unique tax reform in South Korea that explicitly sought to curb corporate savings by imposing a surtax on excessive savings.

We employ a difference-in-differences methodology to exploit this natural experiment and show that firms that were discouraged from saving instead spent more on payouts, wages, and investments. Whether saving less and spending more on payouts and investments is desirable depends on whether the treated firms’ savings and investment policies were optimal before the law. Exploiting an event study methodology, we find that the valuation consequences from being treated by the law were positive. This result suggests that investors expected firms’ responses to the law to be value-improving, indeed sufficient enough to more than outweigh the direct negative valuation consequences of facing higher taxes.