Non-Tobin’s q in Tests for Financial Constraints to Investment S´ ılvio Rendon Abstract Liquidity constrained firms may be under two very well identified in- vestment regimes, constrained and unconstrained. In this paper I derive theoretical investment equations for both regimes and discuss the consequences of ignoring the specific form of the liquidity constrained regime. I also show that expressing the investment equation as a function of Tobin’s q is by no means necessary in theory and in practice, in particular, it is not required to test for liquidity constraints. 1 Introduction In this article I argue that so-called Tobin’s q is not necessary at the theoretical nor at the empirical level to explain investment behavior. All possible questions of interest, such as tests for liquidity constraints, real effects of financial variables, and others, can be answered without relying on q as a concept. It is enough to solve a dynamic problem in which investment is the solution, a function of current and past state variables; this policy function can be directly estimated from the data. The once prevailing Keynesian Tobin’s q-theory explained investment as a func- tion of a relative price q inside the IS-LM framework. In contrast, the neoclassical model of investment explained investment as a solution to a dynamic problem, that is, as a policy rule of investment as a function of current and past state variables. The prevailing Keynesian approach reacted to this challenge deriving q-theory from a choice- theoretic framework which explicitly takes account of adjustment costs as- sociated with investment. In this assimilation, the definition of q was modified from Tobin’s original formulation as a relative price to a variable that contained future investment opportunities. Instead of being a function of state variables, investment was now a function of q, the marginal value of capital over the price of capital. S´ ılvio Rendon Department of Economics, Stony Brook University, Stony Brook, NY 11794, USA. e-mail: srendon@ms.cc.sunysb.edu 1