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Internal Finance and Investment: Evidence from the Undistributed Profits Tax of 1936-1937

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  • Charles W. Calomiris
  • R. Glenn Hubbard

Abstract

Recent theoretical approaches have linked shifts in firms' internal funds and investment spending, holding constant underlying investment opportunities. An important impediment to convincing tests of these models is the lack of firm-level data on the relative costs of internal and external funds. We use a tax experiment, the Surtax on Undistributed Profits (SUP) in the 1930s, to identify firms' relative cost of internal and external funds and analyze its effect on firms' investment decisions. Finns' responses to the surtax on retained earnings permit estimation of shadow price differentials between internal and external finance, and measurement of the link between access to capital markets and investment. Almost one-fourth of the 273 publicly-traded manufacturing firms in our sample retained in excess of 40 percent of their earnings in spite of the surtax, paying the highest marginal rates of surtax. The investment spending of these firms was sensitive to shifts in cash flow, holding constant investment opportunities (measured by the ratio of market-to-book value). No sensitivity of investment to internal funds could be detected for firms with higher dividend payout and lower surtax liability. In addition, many firms with high marginal rates of surtax were in the growth industries of the day. The sensitivity of investment spending to internal funds for firms with high marginal surtax rates appears mainly to reflect information-related capital-market frictions as opposed to the waste of corporate cash flows by entrenched managers.

Suggested Citation

  • Charles W. Calomiris & R. Glenn Hubbard, 1993. "Internal Finance and Investment: Evidence from the Undistributed Profits Tax of 1936-1937," NBER Working Papers 4288, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:4288
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    3. John R. Graham & Sonali Hazarika & Krishnamoorthy Narasimhan, 2011. "Financial Distress in the Great Depression," NBER Working Papers 17388, National Bureau of Economic Research, Inc.
    4. Naomi R. Lamoreaux & Daniel Raff, 1995. "Introduction: History and Theory in Search of One Another," NBER Chapters, in: Coordination and Information: Historical Perspectives on the Organization of Enterprise, pages 1-10, National Bureau of Economic Research, Inc.
    5. Duan, Ran, 2023. "Patent trolls and capital structure decisions in high-tech firms," Journal of Banking & Finance, Elsevier, vol. 155(C).
    6. Gambacorta, Leonardo & Mistrulli, Paolo Emilio, 2004. "Does bank capital affect lending behavior?," Journal of Financial Intermediation, Elsevier, vol. 13(4), pages 436-457, October.
    7. Efraim Benmelech & Nittai Bergman & Amit Seru, 2021. "Financing Labor [Corporate debt maturity and the real effects of the 2007 credit crisis]," Review of Finance, European Finance Association, vol. 25(5), pages 1365-1393.
    8. Christian Keuschnigg & Evelyn Ribi, 2010. "Business Taxation, Corporate Finance and Economic Performance," University of St. Gallen Department of Economics working paper series 2010 2010-04, Department of Economics, University of St. Gallen.

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    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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