TAXES AND CAPITAL MARKET EQUILIBRIUM
UNDER TJNCERTAIlf"Y*
+ Fischer Black'
Let us assume that real investments differ in their risk characteristics
and in the extent to which their returns come in the form of taxable
income or in the form of unrealized capital gains. We will assume that
corporations and partnerships differ substantively only in the way
they are taxed, and that corporate income is taxed at a flat rate of 50%.
We will assume that corporations pay no dividends, and that holders of
corporate shares never realize capital gains. Thus the effective tax
rate on investment income for holders of corporate shares is 50%. This
means that investors in tax brackets below 50% will hold partnership
shares, while investors in tax brackets above 50% will hold corporate
shares. We will assume that corporations may hold partnership shares,
so a given real investment organized as a partnership may be held
partly by individuals and partly by corporations.
There will be a tendency for investors in low tax brackets to hold
partnership shares in ventures that give a large amount of their returns
in the form of taxable income. And for investors in high tax brackets
to hold corporate shares in ventures that give a large amount of their
returns in the form of unrealized capital gains. Investors in each tax
bracket will hold shares of investments in all tax brackets, however,
because of the gains in diversification that they Ct.rl achieve.
I -
We will assume that no short selling of risky assets is allowed. We
will assume that any borrowing done is at the riskless short term interest
rate. Borrowing at the short term rate is made riskless because the
borrower always provides collateral with a value greater than the
amount borrowed. As the value of the collateral changes, the amount
of the borrowing is changed so that the margin between the collateral
value and the loan value does not vanish.
-2-
We will explore below the consequences of having no restrictions on
borrowing or lending, and the consequences of imposing certain restrictions
on corporations or individuals. For each set of restrictions,
the resulting equilibrium will give a proposed real investment a cost
of capital that depends on both its risk characteristics and its tax
status. Since investors in different tax brackets hold different
portfolios, it will not be possible to summarize the relevant risk
characteristics in one number. Holding its risk characteristics constant,
the more taxable a proposed investment's return is, the higher
its cost of capital will be.
If corporations are allowed to lend without limit, and if individuals
are allowed to borrow without limit, and if, interest payments are fully
tax deductible for individuals, then there will be tax arbitrage that
will reduce each individual's personal tax bracket to 50%. Each individual
will hold his own corporation. His corporation will choose a
portfolio of partnership shares and direct investments combined with
borrowing or lending that maximizes the expected utility of his aftertax
return, treating his tax bracket as 50%. Then the corporation will
reduce its borrowing (or increase its lending), and he will increase
his borrowing by an equal amount, until his marginal personal tax bracket
actually falls to 50%. So no investor will have a tax bracket in
equilibrium that is higher than 50%. Note that since each investor
holds his own corporation to fit his risk preferences and his tax
bracket, we have the most extreme form of the "clientele hypothesis."
Every corporation has a clientele of one investor, and chooses its
capital structure to fit that investor's needs.
The tax authorities may not want every investor to be able to reduce his
tax bracket to a maximum of 50%, so there may be some restrictions on
corporate lending, or personal borrowing. Suppose first that the
restriction takes the form of a prohibition of personal borrowing. (Or
equivalently, a provision that interest payments by an individual are
not deductible for tax purposes.)
-3-
Again, each individual will have his own corporation. His corporation
will hold a portfolio of partnership shares and real assets mixed with
borrowing (or lending) that maximizes the expected utility of its
after-tax return for the individual. There will be a right amount of
borrowing for each corporation. Since it is held by only one individual
(or by a group of individuals with the same risk preferences), it does
not really make sense to ask what the effect on the price of its shares
would be of changing its capital structure. If individual A's corporation
changed its policies sO that it was more suitable for individual B than
for individual A, then presumably B's corporation would simply change
its policies so that it was more suitable for A than for B. The two corporations
would switch places, and neither would have any change in its
stock price.
Individuals who hold corporate shares will do no lending. If an individual
wants a risk position that involves lending, it is better for him
to lend through his corporation than to lend personally. His corporation's
tax bracket is only 50%, while his tax bracket is higher than 50%. Thus
a prohibition on personal borrowing means that individuals who hold corporate
shares will neither borrow nor lend. All their borrowing and lending will
be done through their corporations.
Alternatively, suppose that the restriction imposed by the tax authorities
takes the form of a prohibition on corporate lending. Then corporations
will neither borrow nor lend. It will always be better for an individual
to borrow personally than to borrow through his corporation. Individuals
will hold mixtures of corporate shares with borrowing or lending. In
this situation, a corporation that borrows will decrease the value of its
shares.
Thus in a world where individuals are primarily concerned with maximizing
the expected utility of their after-tax returns, it is not true that
there is a tax subsidy associated with corporate debt. Corporate
shares will be held only by those whose personal tax brackets are above
(or equal to) the corporate tax bracket. Such individuals will prefer
personal borrowing to corporate borrowing, and will prefer corporate
lending to personal lending.
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If they are allowed to, individuals in tax brackets above the corporate
rate will combine personal borrowing with corporate lending until their
tax brackets fall to the corporate rate. If these individuals cannot
borrow, they will do all of their borrowing and lending through their
corporations. If their corporations cannot lend, they will do all of
their borrowing and lending personally.
If corporations are doing the borrowing and lending, a change in capital
structure by one corporation will be offset by an opposite change by
another corporation, and neither will have a change in the price of its
stock. If individuals are doing the borrowing and lending, a corporation
that borrows will cause the price of its stock to drop. This is the
opposite of what we would expect if there were a tax subsidy on corporate
debt.