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On the marginal source of investment funds

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  • Auerbach, Alan J.
  • Hassett, Kevin A.

Abstract

Under the new view' of dividend taxation developed in Auerbach (1979), Bradford (1981) and King (1977) the marginal source of finance for new investment projects is retained earnings. In this case, the tax advantage of retentions precisely offsets the double taxation of subsequent dividends: taxes on dividends have no impact on the investment incentives of firms using retentions as a marginal source of funds and paying dividends with residual cash flows. We find evidence that dividends do respond to investment and cash flow for the nonfinancial corporate sector as a whole in a manner consistent with the new view. We also find that this dividend pattern is weaker for firms with better access to capital markets, as measured by bond rating and the number of analysts following them. Finally, we find that, although new share issues and repurchases respond to the same firm characteristics as dividends do, the pattern of these responses is consistent with a broader interpretation of the new view that preserves the main result of dividend-tax irrelevance with respect to the cost of capital.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Public Economics.

Volume (Year): 87 (2003)
Issue (Month): 1 (January)
Pages: 205-232

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Handle: RePEc:eee:pubeco:v:87:y:2003:i:1:p:205-232

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Web page: http://www.elsevier.com/locate/inca/505578

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  1. Jason G. Cummins & Kevin A. Hassett & R. Glenn Hubbard, 1994. "A Reconsideration of Investment Behavior Using Tax Reforms as Natural Experiments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 25(2), pages 1-74.
  2. Jagannathan, Murali & Stephens, Clifford P. & Weisbach, Michael S., 2000. "Financial flexibility and the choice between dividends and stock repurchases," Journal of Financial Economics, Elsevier, vol. 57(3), pages 355-384, September.
  3. B. Douglas Bernheim, 1990. "Tax Policy and the Dividend Puzzle," NBER Working Papers 3434, National Bureau of Economic Research, Inc.
  4. Asquith, Paul & Mullins, David Jr., 1986. "Equity issues and offering dilution," Journal of Financial Economics, Elsevier, vol. 15(1-2), pages 61-89.
  5. Blundell, R. & Bond, S., 1995. "Initial Conditions and Moment Restrictions in Dynamic Panel Data Models," Economics Papers 104, Economics Group, Nuffield College, University of Oxford.
  6. B. Douglas Bernheim & Adam Wantz, 1992. "A Tax-Based Test of the Dividend Signaling Hypothesis," NBER Working Papers 4244, National Bureau of Economic Research, Inc.
  7. Bagwell, Laurie Simon & Shoven, John B, 1989. "Cash Distributions to Shareholders," Journal of Economic Perspectives, American Economic Association, vol. 3(3), pages 129-40, Summer.
  8. Alan J. Auerbach, 1989. "Tax policy and corporate borrowing," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 33, pages 136-172.
  9. Richard W. Kopcke & Eric S. Rosengren, 1989. "Are the distinctions between debt and equity disappearing? An overview," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 33, pages 1-11.
  10. Newey, Whitney K., 1987. "Efficient estimation of limited dependent variable models with endogenous explanatory variables," Journal of Econometrics, Elsevier, vol. 36(3), pages 231-250, November.
  11. Auerbach, Alan J., 2002. "Taxation and corporate financial policy," Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 19, pages 1251-1292 Elsevier.
  12. Hans-Werner Sinn, 1991. "Taxation and the Cost of Capital: The "Old" View, the "New" View and Another View," NBER Working Papers 3501, National Bureau of Economic Research, Inc.
  13. Alan J. Auerbach, 1980. "Share Valuation and Corporate Equity Policy," NBER Working Papers 0255, National Bureau of Economic Research, Inc.
  14. James M. Poterba & Lawrence H. Summers, 1984. "The Economic Effects of Dividend Taxation," Working papers 343, Massachusetts Institute of Technology (MIT), Department of Economics.
  15. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
  16. Nickell, Stephen J, 1981. "Biases in Dynamic Models with Fixed Effects," Econometrica, Econometric Society, vol. 49(6), pages 1417-26, November.
  17. Michael J. Brennan & Anjan V. Thakor, 2004. "Shareholder Preferences and Dividend Policy," Finance 0411017, EconWPA.
  18. David F. Bradford, 1979. "The Incidence and Allocation Effects of a Tax on Corporate Distributions," NBER Working Papers 0349, National Bureau of Economic Research, Inc.
  19. Auerbach, Alan J, 1979. "Wealth Maximization and the Cost of Capital," The Quarterly Journal of Economics, MIT Press, vol. 93(3), pages 433-46, August.
  20. Honore, Bo E, 1992. "Trimmed LAD and Least Squares Estimation of Truncated and Censored Regression Models with Fixed Effects," Econometrica, Econometric Society, vol. 60(3), pages 533-65, May.
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