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

Theoretical work on financing costs under asymmetric information has linked shifts in firms' internal funds and investment spending, holding constant investment opportunities. An impediment to convincing tests of these models is the lack of firm-level data on the relative cost of internal and external funds. We use a tax experiment, the surtax on undistributed profits in the 1930s, to identify firms' relative cost of internal and external funds by calculating surtax margins. The investment of high-surtax-margin firms was sensitive to shifts in cash flow, holding constant investment opportunities. Other firms did not display sensitivity of investment to internal funds.