Miller's 1977 Model: Personal Taxes and Leverage
Merton Miller argued that once personal taxes on interest and equity income are factored in alongside corporate taxes, the advantage of corporate debt can shrink or vanish at the level of the whole economy, even though it still helps any single firm.
The classic argument for using debt is that interest payments are tax-deductible for a company, while dividends are not, so borrowing shrinks the total tax bill and raises the value of the firm. Merton Miller's 1977 paper pointed out this ignores the other side of the ledger: the investors receiving that interest and dividend income also pay personal taxes, and those two tax rates aren't equal.
Corporate debt is only cheaper in aggregate once you also account for the fact that bondholders typically pay ordinary income tax on interest, while equity investors often pay a lower rate on dividends and capital gains — a gap that can offset some or all of the corporate-level tax benefit of debt.
The logic
If interest income is taxed more heavily in investors' hands than equity income, lenders will demand a higher pre-tax return to compensate, clawing back at the personal level some of what the corporation saved by deducting interest. Miller showed that under certain assumptions about tax rates, the corporate tax saving from debt and the personal tax penalty on receiving that debt's interest can exactly cancel out in equilibrium, leaving no clear economy-wide incentive to lever up.
Worked example
Suppose a corporate tax rate of 25%, a personal tax rate on interest income of 30%, and a personal tax rate on equity income of 10%. The after-all-tax return to a dollar of corporate earnings paid out as interest is (1 − 0.30) = 0.70 of pre-tax earnings. Paid out as equity, after both corporate and personal tax, it is (1 − 0.25) × (1 − 0.10) = 0.675. Here debt still wins slightly, 0.70 versus 0.675 — but narrow that personal-tax gap further (say interest taxed at only 26%) and the two routes converge, illustrating Miller's point that the debt tax shield's real value depends on all three tax rates together, not the corporate rate alone.
Related concepts
Further reading
- Miller (1977), 'Debt and Taxes', Journal of Finance