An Equilibrium Analysis of Debt Financing under Costly Tax Arbitrage and Agency Problems

IN HIS RECENT PAPER, Merton Miller [12] extends the notion of tax-induced differential returns on securities into a general equilibrium framework in which firms make adjustments in the supply of corporate debt. In an environment of progressive personal taxation, the interest rates on taxable corporate bonds are greater than rates on tax exempt securities so as to compensate investors for the associated tax burden. On the supply side, value-maximizing firms have an incentive to issue additional debt so long as the personal tax-induced compensation is less than the tax savings from interest-payment deductions at the corporate level. Miller argues that in the final equilibrium, the interest rate differential between taxable and tax-exempt bonds exactly reflects the tax advantage of debt financing at the corporate level. Thus, the tax subsidy disappears in its entirety, and we are back to an environment in which corporate leverage is inconsequential to the value of any particular firm. What emerges in equilibrium is merely an optimal debt-equity ratio for the corporate sector as a whole.1 Miller derives this invariance proposition under the following assumptions: (1) progressive personal tax rates reach a maximum at a level beyond the corporate tax rate; (2) no tax arbitrage by individuals and firms is allowed; (3) there is a personal tax rate differential in favor of income from stocks; and (4) the opportunity for riskless borrowing and lending exists.2 Indeed, Miller's equilibrium analysis is based on a zero effective personal tax rate on income from stocks, but