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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

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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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4288.

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Date of creation: Nov 1995
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Handle: RePEc:nbr:nberwo:4288

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Find related papers by JEL classification:
G3 - Financial Economics - - Corporate Finance and Governance
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

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  1. Jackie Krafft, 2006. "Business history and the organization of industry," Post-Print hal-00211780_v1, HAL. [Downloadable!]
  2. Christian Keuschnigg & Evelyn Ribi, 2009. "Profit Taxation and Finance Constraints," University of St. Gallen Department of Economics working paper series 2009 2009-05, Department of Economics, University of St. Gallen. [Downloadable!]
    Other versions:
  3. Randall Morck, 2004. "How to Eliminate Pyramidal Business Groups - The Double Taxation of Inter-Corporate Dividends and Other Incisive Uses of Tax Policy," NBER Working Papers 10944, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Baer, Herbert L. & France, Virginia G. & Moser, James T., 1994. "Opportunity cost and prudentiality : an analysis of futures clearinghouse behavior," Policy Research Working Paper Series 1340, The World Bank. [Downloadable!]
  5. Maria Angelica Arbelaez & Juan Jose Echavarria, 2002. "Credit, Financial Liberalization and Manufacturing Investment in Colombia," RES Working Papers 3145, Inter-American Development Bank, Research Department. [Downloadable!]
  6. Ugo Albertazzi & Leonardo Gambacorta, 2006. "Bank profitability and the business cycle," Temi di discussione (Economic working papers) 601, Bank of Italy, Economic Research Department. [Downloadable!]
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