75 Tax Notes 1893

Tax Notes

JUNE 30, 1997

DEPARTMENT: Viewpoint (VWP)

CITE: 75 Tax Notes 1893

HEADLINE: 75 Tax Notes 1893 - WHY IS STOCK SO BLOODY PROFITABLE?. (MISC) (Doc 97-19016 (2 pages))

AUTHOR: Johnson, Calvin

University of Texas

CODE: MISC

SUMMARY:

Professor Calvin Johnson explores the intriguing question of why stock is not only so much more profitable than debt, but is far more profitable than it apparently should be.

Calvin H. Johnson is professor of law at the University of Texas.

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WHY IS STOCK SO BLOODY PROFITABLE?

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by Calvin H. Johnson

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On Friday the 13th of June, the Dow Jones Average rose another 83 points to 7,795, setting yet another record. The Dow has now risen almost 20 percent in the last two months in the current rally /1/ and at that rate, stock prices will triple in a year. /2/ That is undoubtedly a bit torrid a pace to maintain, but still, over the last 70 years, stock has given an extraordinary rate of return compared to debt. The annual return on stock at 10.1 percent has been almost three times the annual interest on debt instruments at 3.7 percent over the last 70 years. A $1,000 investment in debt 70 years ago would have grown to $12,750. A $1,000 investment in stock over the same period would have grown to $842,000 or 66 times more money! /3/

The economics profession, ignoring tax, has no good explanation of why stock is so much more profitable than debt. The premium to stock over debt is an unsolved puzzle or anomaly, not yet civilized by standard economic models.

Tax in fact deepens the mystery because under reasonable assumptions, it is debt that should be paying the substantially larger returns. Given the tax treatment of debt and stock, debt should be paying between 1.4 and 1.7 times the return on stock. For much of the 70-year history, returns on stock should be as low as 30 percent of comparable interest rates if the two rates were in equilibrium. Thus, the mystery is not just why stock returns are 2.7 times higher than returns on debt (10.1:3.7), but why, considering tax, stock returns are nine times higher than they should be.

Risk Doesn't Explain It

In a good recent review of the literature, Professors Jeremy Siegel of Wharton Business School and Richard Thaler of Chicago Business School argue that the returns on stock are far too high to be explained by a premium paid to the investor for absorbing risk. /4/ Rational investors are risk averse and need to be paid a premium on riskier investments. Losses hurt an individual investor more than symmetrical gains help because gains add fat above current consumption levels and losses cut into muscle and then bone by reducing current consumption levels. The risk aversion needed to explain the premiums on stock market, however, is far too extreme to be plausible: To explain stock returns, an investor must be so afraid of fluctuations that he would be willing to pay an insurance premium of 49 percent of his wealth, just to avoid a 50 percent chance of losing half of his wealth. /5/

The puzzle is deepened, Siegel and Thaler explain, because over very long periods, debt becomes riskier than stock. The volatility of a stock portfolio decreases as time goes on, because the fluctuations tend to offset each other. The volatility of debt increases as the term goes on, however. With a 20-year horizon, debt has proven to be more volatile than stock. /6/ Investors might be also especially afraid of catastrophic losses of their investment -- including for instance the great 1929 stock market crash. The truly catastrophic losses, however, have occurred not on stocks, but on bonds: The German hyperinflation of the 1920s wiped out bond holders altogether, as did the Japanese hyperinflation after World War II. Nothing in any stock market has been as bad. /7/

Tax Deepens the Mystery

It would be nice to report that tax explains the extraordinary premium for stock, but tax in fact operates in the wrong direction. Looking only at tax, interest rates should be considerably higher than returns on stock. Tax makes interest much cheaper to pay and more expensive to receive than return on equity. Interest on debt should rise (or returns on stock should drop) to bring debt and equity back into equilibrium. All other things being equal, interest should be between 140 percent and 169 percent of equity returns, considering tax, not lower than equity.

Interest Jump-Up for Tax

Tax, first, should increase the amount of interest on debt, both because of its effect on the corporate borrower and its effect on lenders.

Corporate borrowers. Assume, for instance, that the market rate of interest for use of money is 6.5 percent in a tax-free world for some given risk and given expectation of inflation. Introduction of tax should increase the interest paid on debt to above the 6.5 percent baseline. Interest is deductible so that a corporation in the 35 percent corporate tax rate ('T') could pay interest of i/(1-T) or 6.5%/0.65 or 10 percent. The corporation that pays 10 percent will save enough tax from the deduction to bring down the after-tax cost to the baseline 6.5 percent. By reducing the cost of interest, tax should allow the interest to increase.

Individual lenders. Individuals pay ordinary tax ('t') of up to 41 percent, so that when tax is introduced into the system, the individual highest-tax-rate investor should demand i/(1-t) or 11 percent to yield the baseline 6.5 percent after tax. If the corporate debt pays 11 percent interest, tax at 41 percent would bring the individual's yield down to the baseline 6.5 percent. Thus, by reducing the interest that an individual receives, tax should force an individual to demand an increase in the amount of pretax interest he receives.

Bargaining between the corporate borrower and the individual investor should adjust to tax by increasing pretax interest to between 10 percent (what the borrowing corporation can afford with a given 6.5 percent after-tax cost) and 11 percent (what the individual bond investor will need to maintain 6.5 percent after tax).

Lower Returns for Equity

Equity returns, by contrast, are not deductible by the corporate payer nor usually taxed as heavily as debt interest on the investor side.

Corporate side. Distributions by the corporation with respect to its stock are all considered to be distributions of profits, rather than deductions. The corporation thus can save no tax on its distributions on equity and can pay only the assumed baseline 6.5 percent rental cost of capital.

Individual investors. On the investor side, tax on corporate equity will usually be very much lower than the tax on debt, so the investor will not need to demand much if any increase in the assumed baseline 6.5 percent pretax rental cost of capital to account for investor tax. Immediate dividends are taxable as ordinary income to the individual investor, just like interest, but a corporation rarely distributes all its earnings. Accumulating the earnings dramatically reduces the equity investor's tax by turning immediate ordinary income into deferred capital gain: Capital gain tax is paid only upon sale of the stock or liquidation of the company and even then at a lower 28 percent tax rate. Moreover, capital gain ceases to be part of the income tax base upon death of the equity investor, /8/ so that the investor tax on earnings still held as accumulations by the corporation at the equity-investor's death is zero. The zero tax rate for capital gain appears to be a viable option for most investment, because, empirically, most savings once saved remains unliquidated at the time of the investor's death. /9/ For earnings still accumulated at the equity investor's death, there will be no need for a premium return to cover investor tax and the return the investor needs will stay at the baseline 6.5 percent.

Nonzero but low expected investor tax. Even when tax on equity is not zero, it will still be very much lower than the tax on interest for the marginal investor. The weighted average of tax on capital gains for individual shareholders seems to be well under 10 percent, given the lower nominal rate applied to capital gain, the deferral of the capital gain until sale, and actuarial chances that make the capital gain tax disappear upon death. /10/ Corporate shareholders, investing in equity, moreover, pay tax of 10.5 percent even on immediate dividends, /11/ whereas they pay tax on debt interest of 35 percent. If we assume the marginal investor in equity expects tax of 10 percent on earnings, then the pretax return must rise from the baseline 6.5 percent to only 7.2 percent to cover the investor's tax. /12/

Debt and Equity Compared

Under current rates. In sum, tax should cause interest on debt to rise from the assumed baseline of 6.5 percent rental cost of capital in a nontax world to a pretax 10 or 11 percent in a taxable world. Comparable returns on equity should be expected to rise either not at all or only to 7.2 percent to cover tax. Considering tax, interest on debt should thus be 140 percent (that is, 10%/7.2%) to 169 percent (that is, 11%/6.5%) of comparable returns on equity. Stated inversely, returns on equity should be between 59 and 71 percent of interest on debt, not higher than interest. The actual returns on stock over the last 70 years is 10.1%/3.7% or 2.7 times higher on equity than on debt. Considering tax, the annual return on stock is 3.8 to 4.5 times higher than it should be.

Prior periods. In prior periods, the phenomenon was even more extreme. Before 1981, the corporate tax was 48 percent and the maximum ordinary income rate was 70 percent. Using those rates and the same logic as above, returns on equity should drop to between 30 and 57 percent of interest on debt. For long periods over the last 70 years, annual equity returns are as much as nine times higher than they should be.

Zero bracket investors? Investors tend to arrange themselves into tax-rate clienteles, with only the low-rate investors buying the high-tax investment such as debt. If we posit that the marginal investor in corporate debt is a tax-exempt institution, that might reduce the assumed necessary tax premium on interest. If the investor pays no tax on interest, there is no need for interest to jump up to cover investor tax. Still, assuming tax-exempt investors does not allow equity to catch up with debt in tax because interest is deductible, whereas earnings on equity are not. Given the tax deduction, interest is still cheaper to pay than earnings on equity (by 6.5%/10% or two-thirds the cost).

What Is to Be Done?

All air? The extraordinary unexplained returns on stock might suggest that the stock prices are just a speculative bubble. The large premiums, however, are measured over 70 years, so that whatever the explanation, it is not an ephemeral phenomenon. The professional investors who set the relative market price for individual stocks seem to be looking to the discounted present value of future cash flows. Variations in discount rates, for instance, do a pretty good job of explaining even the largest of the postwar crashes. /13/ Even if we assume that stock is overpriced just now, still the premiums over 70 years are hard to explain away as just irrational enthusiasms.

Stock Is Very Expensive. One bit of client advice that does arise out of the puzzle is that corporate issuers, who pay compensation or other expenses with stock, are paying in the most expensive way. Stock has value on the market only because of the future cash that the corporation is expected to distribute on the shares. Stock is nothing but a proxy for the discounted present value of future distributions that the market expects from the share. Because of the extraordinary premium on corporate equities that is demanded and received by the market, the corporate issuer will have to pay distributions compounded forward at the premium rate. Debt would be far cheaper to pay. The expiration of the discount rate -- interest -- is lower than on stock and the interest is also deductible. /14/

Conclusion

Tax, in any event, is no help in explaining the puzzle of why equity returns are so much higher than interest. Looking to tax alone, the pretax returns on stock should be lower than prevailing interest rates. Tax, unfortunately, cannot explain everything.

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FOOTNOTES

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/1/ Financial Times, 1st Sec., at 1 (June 14, 1997).

/2/ (1.2)6 = 2.99.

/3/ Jeremy J. Siegel and Richard H. Thaler, 'Anomalies: The Equity Premium Puzzle,' 11 J. of Econ. Perspectives 191 (Winter 1997).

/4/ Id.

/5/ Id. at 192.

/6/ Id. at 195.

/7/ Id. at 194.

/8/ Section 1014.

/9/ Gravelle, Jane G., and Lawrence B. Lindsey, 'Capital Gains,' Tax Notes, Jan. 25, 1988, p. 397, 400, estimate that 76 percent of national gains are held until death. Weighted by tax, the proportion of gains held by tax should be considerably larger because the tax itself suppresses the gains.

/10/ Calvin Johnson, 'The Undertaxation of Holding Gains,' Tax Notes, May 11, 1992, p. 807.

/11/ Section 243 allows a corporation to exclude 70 percent of dividends received from unrelated corporations. So the assumed 35 percent tax rate times the unexcluded 30 percent of dividends yields the 10.5 percent tax on dividends.

/12/ 7.2% - 10% of 7.2% = 6.5%.

/13/ Burton G. Malkiel, 'Is the Stock Market Efficient?' 243 Science 131 (Mar. 10, 1989) (explaining the October 1987 stock market crash in terms of surprise increase in discount rates, with 'some ambiguity in the evidence').

/14/ See, e.g., Calvin Johnson, 'The Legitimacy of Basis From a Corporation's Own Stock,' 9 American J. of Tax Policy 155 (1991); Calvin Johnson, 'Expenses Paid With Stock Are Legitimate Deductions,' Tax Notes, June 1, 1992, p. 1281.

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