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On the Marginal Source of Investment Funds

  • Alan J. Auerbach
  • Kevin A. Hassett

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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7821.

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Date of creation: Aug 2000
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Publication status: published as Auerbach, Alan J. and Kevin A. Hassett. "On The Marginal Source Of Investment Funds," Journal of Public Economics, 2003, v87(1,Jan), 205-232.
Handle: RePEc:nbr:nberwo:7821
Note: CF PE
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  1. 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.
  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. 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.
  4. 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.
  5. 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.
  6. Blundell, Richard & Bond, Stephen, 1998. "Initial conditions and moment restrictions in dynamic panel data models," Journal of Econometrics, Elsevier, vol. 87(1), pages 115-143, August.
  7. 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.
  8. Brennan, Michael J & Thakor, Anjan V, 1990. " Shareholder Preferences and Dividend Policy," Journal of Finance, American Finance Association, vol. 45(4), pages 993-1018, September.
  9. Nickell, Stephen J, 1981. "Biases in Dynamic Models with Fixed Effects," Econometrica, Econometric Society, vol. 49(6), pages 1417-26, November.
  10. Auerbach, Alan J., 1979. "Share valuation and corporate equity policy," Journal of Public Economics, Elsevier, vol. 11(3), pages 291-305, June.
  11. Alan J. Auerbach, 1980. "Wealth Maximization and the Cost of Capital," NBER Working Papers 0254, National Bureau of Economic Research, Inc.
  12. Alan J. Auerbach, 2001. "Taxation and Corporate Financial Policy," NBER Working Papers 8203, National Bureau of Economic Research, Inc.
  13. 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.
  14. B. Douglas Bernheim, 1990. "Tax Policy and the Dividend Puzzle," NBER Working Papers 3434, National Bureau of Economic Research, Inc.
  15. Asquith, Paul & Mullins, David Jr., 1986. "Equity issues and offering dilution," Journal of Financial Economics, Elsevier, vol. 15(1-2), pages 61-89.
  16. Alan J. Auerbach, 1989. "Tax policy and corporate borrowing," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, vol. 33, pages 136-172.
  17. James M. Poterba & Lawrence H. Summers, 1984. "The Economic Effects of Dividend Taxation," NBER Working Papers 1353, National Bureau of Economic Research, Inc.
  18. Phoebus J. Dhrymes & Mordecai Kurz, 1967. "Investment, Dividend, and External Finance Behavior of Firms," NBER Chapters, in: Determinants of Investment Behavior, pages 427-485 National Bureau of Economic Research, Inc.
  19. 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.
  20. Hans-Werner Sinn, 1991. "Taxation and the Cost of Capital: The "Old" View, the "New" View, and Another View," NBER Chapters, in: Tax Policy and the Economy, Volume 5, pages 25-54 National Bureau of Economic Research, Inc.
  21. 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.
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