Working Paper: NBER ID: w4288
Authors: 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.
Keywords: internal finance; investment; undistributed profits tax; 1936-1937
JEL Codes: G31; H25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased internal funds (O16) | Higher investment levels (E22) |
| Higher marginal surtax rates (H29) | Increased sensitivity to internal funds (G31) |
| Lower dividend payouts and higher surtax liabilities (G35) | Greater sensitivity to internal funds (G31) |
| Working capital accumulation (D25) | Responsive to cash flow for firms with high tax margins (H32) |
| High tax margins (H29) | Utilize internal funds strategically to smooth fixed capital investments (G31) |
| External financing remains costly (G32) | Less preferred by firms (L29) |