The authors investigate and document the negative impact of policy and regulatory uncertainty on firm-level capital investment decisions. Providing empirical evidence, they explain how uncertainty may have a negative economic impact and cause investments to be canceled or delayed, especially for firms that are dependent on government spending and firms that exhibit a high degree of investment irreversibility.

Politicians and regulatory institutions frequently make decisions that alter the business environment, causing uncertainty regarding future economic or regulatory policy. The authors focus on finding empirical evidence that supports the thesis that corporate investment is negatively related to the level of policy uncertainty. Their analysis indicates that policy uncertainty depresses corporate investments by inducing precautionary delays because of investment irreversibility.

The authors estimate that a doubling of the level of overall policy uncertainty results in an average decrease in investment rates of approximately 8.7%. They note that during the recent financial crisis, the policy uncertainty index nearly tripled. The authors suggest that the increase in policy uncertainty between 2007 and 2009 may account for roughly one-third of the 32% fall in capital investments during the period.

The relationship between policy uncertainty and capital investment is not uniform for all firms. Policy uncertainty has a particularly strong impact on firms with a high degree of investment irreversibility and on firms that are dependent on government spending.

The authors note that periods of high policy uncertainty may negatively affect investment levels for up to eight quarters into the future. They conclude that a significant amount of time is needed to recover from the effects of policy uncertainty.

This comprehensive study may be useful for investors who try to take advantage of the momentum of an economic recovery. Policymakers also may be interested in the magnitude of the negative impact of the uncertainty surrounding their decisions.

The authors use quarterly firm-level data from Compustat for US companies from January 1987 to December 2013. Other data sources used for the study include the Chicago Board Options Exchange for the VXO Index and the US Congressional Budget Office for tax provisions. The authors use a sample of 10,278 unique firms for the study.

Using an aggregate uncertainty index, the authors measure the overall level of policy uncertainty in the economy. The measure is based mainly on a news component, which focuses on the frequency of specified uncertainty-related terms appearing in newspaper articles. Other components capture dispersions in economic forecasts and in tax provisions that reflect the level of tax-related uncertainty. Each of the three components is normalized and weighted to build an overall uncertainty index.

In a cross-sectional analysis, the authors calculate the correlations of the overall uncertainty index and of the three components with key economic measures and corporate investment growth. The authors run a number of robustness tests that confirm a negative correlation of uncertainty with GDP growth and a positive correlation with uncertainty about future equity returns (i.e., the VXO Index). Finally, using vector autoregressions of a policy uncertainty index and firm-based measures, the authors construct a time series to capture the effect of high-uncertainty periods on corporate investment rates.

A high degree of policy uncertainty definitely discourages corporate investments, and this study empirically measures that effect. The authors also estimate how long it takes the economy to recover from a policy uncertainty shock, which partly explains the sluggish recovery following the 2008–09 financial crisis. The authors document the impact of uncertainty on the US market. Emerging markets may be even more sensitive to policy uncertainty; in those markets, uncertainty can even lead to divestiture decisions if there is a risk of complete loss because of capital restrictions.