Demand Shocks and Firm Investment: Micro-Evidence from Fiscal Retrenchment in Italy

We study the effect of a persistent demand shock on corporate factor utilization. Our identification strategy leverages a legislative change designed to permanently reduce spending in certain targeted municipalities. This change generates an arguablyexogenous drop in the revenue of procurement firms, which differs depending on each firm’s reliance for its revenue on procurement in the targeted municipalities. We find that firms responded to the demand shock by cutting capital rather than labor. We
propose a theoretical mechanism based on the irreversibility of capital investment.