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

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. Firms' 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.