Capital (Mis)allocation and Incentive Misalignment

Abstract

This paper studies the impact of managerial incentives on the allocation of capital. We provide empirical evidence that short-termist incentives cause capital misallocation within firms, using a within-firm estimator and a US accounting reform as an exogenous shock to managers' incentives. Managers shift investments towards more short-lived assets, effectively reducing the durability of firms' capital stocks. We then build a model of firm investments with incentive frictions that we calibrate to the US economy. Our outcomes imply that the pass-through from incentives to investments is large: more short-termist incentives raise wedges between the marginal products of capital goods, causing declines in output and real wages.