Miller The Effect of Corporate and Personal Taxes

Merton Miller (this time without Modigliani) later brought in the effects of personal taxes.11 He noted that all of the income from bonds is generally interest, which is taxed as personal income at rates (Td) going up to 39.1 percent, while income from stocks generally comes partly from dividends and partly from capital gains. Further, long-term capital gains are taxed at a rate of 20 percent, and this tax is deferred until the stock is sold and the gain realized. If stock is held until the owner dies, no capital gains tax whatever must be paid. So, on average, returns on stocks are taxed at lower effective rates (Ts) than returns on debt.

Because of the tax situation, Miller argued that investors are willing to accept relatively low before-tax returns on stock relative to the before-tax returns on bonds. (The situation here is similar to that with tax-exempt municipal bonds as discussed in Chapter 4 and preferred stocks held by corporate investors as discussed in Chapter 5.) For example, an investor might require a return of 10 percent on Strasburg's bonds, and if stock income were taxed at the same rate as bond income, the required rate of return on Strasburg's stock might be 16 percent because of the stock's greater risk. However, in view of the favorable treatment of income on the stock, investors might be willing to accept a before-tax return of only 14 percent on the stock.

Thus, as Miller pointed out, (1) the deductibility of interest favors the use of debt financing, but (2) the more favorable tax treatment of income from stock lowers the required rate of return on stock and thus favors the use of equity financing.

Miller showed that the net impact of corporate and personal taxes is given by this equation:

Here Tc is the corporate tax rate, Ts is the personal tax rate on income from stocks, and Td is the tax rate on income from debt. Miller argued that the marginal tax rates on stock and debt balance out in such a way that the bracketed term in Equation 13-7 is zero, so VL = VU, but most observers believe that there is still a tax advantage to debt. For example, with a 40 percent marginal corporate tax rate, a 30 percent marginal rate on debt, and a 12 percent marginal rate on stock, the advantage of debt financing is:

"Merton H. Miller, "Debt and Taxes," Journal of Finance 32, May 1977, 261-275. Miller was president of the American Finance Association, and he delivered the paper as his presidential address.

"Merton H. Miller, "Debt and Taxes," Journal of Finance 32, May 1977, 261-275. Miller was president of the American Finance Association, and he delivered the paper as his presidential address.

Thus it appears as though the presence of personal taxes reduces but does not completely eliminate the advantage of debt financing.

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