On the marginal source of investment funds

Under the ‘new view’ of dividend taxation developed by Auerbach (Quarterly Journal of Economics 1979;93:433-446), Bradford (Journal of Public Economics 1981;15:1-22) and King (Public Policy and the Corporation, Chapman & Hall, London, 1977), the marginal source of finance for new investment projects is retained earnings. In this case, the tax advantage of retaining earnings 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 show that the same invariance with respect to dividend taxes may hold under weaker conditions with respect to the source of funds, if the use of funds follows the same pattern. We find evidence that there is significant heterogeneity in our sample of US firms, with some firms exhibiting dividend behavior consistent with this expanded version of the new view, and others exhibiting behavior consistent with the traditional view that retained earnings are not an important marginal source of funds.