Firms do not respond solely to market fundamentals – they watch and learn from nearby corporations. These peer effects in corporate finance shape firms’ investment behavior and have implications for local business cycle dynamics. In this paper, we examine empirically how peer effects work in corporate investments.

Peer effects shape human behavior in virtually all aspects of life: students perform better when surrounded by studious friends, while people tend to exercise more if their close friends are doing so. As well as being fundamental aspects of an individual’s life, social interactions and peer effects also shape the actions of corporations. Based on the findings of empirical research, firms operating in close proximity often exhibit similar corporate investment patterns. Understanding the underlying nature of these similarities in corporate investment is key to comprehending local business dynamics and the propagation of economic shocks. If firms behave in a similar manner because they are exposed to comparable underlying shocks, it is not surprising that they make similar investment choices. However, if their investment behavior is primarily influenced by that of their peers, local business cycles may fluctuate even in the absence of economic shocks.

Companies influence the investment behavior of neighboring firms…

While a positive correlation between the investment patterns of firms in the same geographic area has been documented in previous work, this does not necessarily indicate a causal relationship. In this paper, we identify the causal link between companies’ investment behavior and peer firms’ investment decisions based on the fact that companies are affected differently by changes in corporate income taxes. Specifically, we draw on the fact that only a subset of firms in a geographic area is affected by a rise in corporate income taxes due to their location. We then document that increases in corporate income tax are followed by reduced investments on the part of these firms. On this basis, we go on to assess whether and in what way this tax-related reduction in corporate investment affects the investment behavior of neighboring firms. 

…especially when there are clear benefits to learning from peers’ investments

We find evidence of strong and positive peer effects in corporate finance, as firms tend to follow suit when neighboring peers reduce their investments. We perform a series of robustness checks to show that these peer effects are not due to (a) supply chain relationships, (b) companies’ exposure to similar underlying shocks in economic demand, or (c) a reduction in firms’ expansion opportunities. Interestingly, these peer effects in corporate investment are also evident in separate analyses of investments in physical and intangible capital. These patterns are consistent with theories that firms follow their neighbors’ investment decisions as they learn from them. For example, if a firm sees that many of its neighbors are expanding, it will also decide to ramp up its investment in physical capital. Similarly, a knowledge-intensive firm may decide to increase its investment in R&D if it observes that many of its neighbors are starting to invest in R&D. We find that similar patterns and peer effects are more pronounced when firms have a greater incentive to learn from their peers.

Our findings highlight the importance of local interactions when studying corporate investment behavior. Local business communities tend to provide important networks for distributing information among firms. This shapes local economic business cycles and is important for the transmission of economic shocks. Understanding peer effects in corporate finance is also important for the design and implementation of appropriate policy responses to counter potentially adverse business cycle dynamics.