On the Marginal Source of Investment Funds

52 Pages Posted: 3 Aug 2000 Last revised: 2 Apr 2001

See all articles by Alan J. Auerbach

Alan J. Auerbach

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Kevin A. Hassett

American Enterprise Institute (AEI)

Date Written: August 2000

Abstract

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.

Suggested Citation

Auerbach, Alan Jeffrey and Hassett, Kevin A., On the Marginal Source of Investment Funds (August 2000). NBER Working Paper No. w7821. Available at SSRN: https://ssrn.com/abstract=238145

Alan Jeffrey Auerbach (Contact Author)

University of California, Berkeley - Department of Economics ( email )

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CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

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Kevin A. Hassett

American Enterprise Institute (AEI) ( email )

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United States
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202.862.7177 (Fax)

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