TY - JOUR AU - Calomiris,Charles W. AU - Hubbard,R. Glenn TI - Internal Finance and Investment: Evidence from the Undistributed Profits Tax of 1936-1937 JF - National Bureau of Economic Research Working Paper Series VL - No. 4288 PY - 1995 Y2 - November 1995 UR - http://www.nber.org/papers/w4288 L1 - http://www.nber.org/papers/w4288.pdf N1 - Author contact info: Charles W. Calomiris Graduate School of Business Columbia University 3022 Broadway Street, Uris Hall New York, NY 10027 Tel: 212/854-8748 Fax: 212/316-9219 E-Mail: cc374@columbia.edu R. Glenn Hubbard Graduate School of Business Columbia University, 101 Uris Hall 3022 Broadway New York, NY 10027 Tel: 212/854-3493 Fax: 212/864-6184 E-Mail: rgh1@columbia.edu, ws2187@columbia.edu AB - 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. ER -