Debt and Taxes

Miller, Merton H., “Debt and Taxes,” The Journal of Finance, Vol 32, No 2 (1977), 261-275.

Purpose:  To argue that, even if debt repayments are tax deductible, a firm’s value is independent of its capital structure.

Arguments:

  • The [potential] direct bankruptcy costs of debt seem too small to be balanced by the tax savings.
    • Corporations do not have as much debt as models suggest they should have – fear of bankruptcy has to be very high for debt levels in the models to match the empirical evidence.
    • The potential indirect costs of bankruptcy are probably not very big, either.
  • Between the 1920s and the 1950s, taxes increased 400% while corporate capital structures changed very little (and change through the end of the 1970s appears unlikely).
  • Investment bankers and corporate financial officers are aware of the tax implications of debt.
  • The only explanation left is that the tax savings of debt are much smaller than researchers generally believe.

Tax Advantages of Debt:

  • If there are no taxes, there are no tax advantages.
  • If there are corporate taxes but no personal income taxes, then the tax advantage of debt is the corporate tax rate multiplied by corporate debt.
  • If there are personal income taxes, and the personal tax on share income is less than the tax on bond income, then investors will prefer that corporations use equity financing over debt financing, thus negating the tax advantages of debt.
    • Corporations holding very little debt and/or paying small dividends will be preferred by shareholders in high tax brackets.
    • Corporations with high leverage and/or high dividends will be preferred by shareholders in low tax brackets.
    • One shareholder class is as good as another, so capital structure is, again, irrelevant.