This paper argues that taxation of retained profits is particularly distortionary in an economy with good growth prospects and poorly developed financial markets because it primarily reduces the investment of financially constrained firms, investment that has marginal product greater than the after-tax market real interest rate. Contrarily, taxes on distributed profits or capital gains primarily reduce the investment of financially unconstrained firms. Chile experienced a banking crisis over the period from 1982 to 1986 and in 1984 reduced its tax rate on retained profits from 50 percent to 10 percent. We show that, consistent with our theory, there was a large increase in aggregate investment after the reform which was entirely funded by an increase in retained profits. Further, we show that investment grew by more in industries that depend more on external financing, according to the Rajan and Zingales (1998) measure. Finally, we present some weak evidence from comparisons of investment rates across firms for several different measures of their likelihood of being financially constrained.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
12104.
Length: Date of creation: Mar 2006 Date of revision: Handle: RePEc:nbr:nberwo:12104
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Find related papers by JEL classification: H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm E22 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Capital; Investment; Capacity D92 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Firm Choice and Growth, Investment, or Financing O54 - Economic Development, Technological Change, and Growth - - Economywide Country Studies - - - Latin America; Caribbean O16 - Economic Development, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Hassett, Kevin A. & Hubbard, R. Glenn, 2002.
"Tax policy and business investment,"
Handbook of Public Economics,
in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 3, chapter 20, pages 1293-1343
Elsevier.
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