Taxation and the Sectoral Allocation 

of Capital in the U.S. 

Joseph J. Cordes* 

Department of Economics 

The George Washington University 

Steven M. Sheffrin* 

Department of Economics 

The University of California-Davis 

OTA Paper 49 June 1981 

*Brookings Economic Policy Fellow 

Office of Tax Analysis

U.S. Department of the Treasury 

OTA Papers are circulated so that the preliminary findings of 

tax research conducted by staff members and others associated 

with the Office of Tax Analysis may reach a wider audience. 

The views expressed are those of the authors, and do not 

reflect Treasury policy. Comments are invited, but OTA 

Papers should not be quoted without permission from the 

authors. TManaging editors are Michael Kaufman and 

Gary Robbins. 7 -' 

Office of Tax Analysis 

U.S. Treasury Department, Room 4040 I, Washington, D.C. 

-1981.

2023.0 \,*. > "' "*'J . r - Issued: c%r 
Contents 

I. Introduction 

11. Sectoral Allocation of Capital in 

Miller Equilibrium 

111. Natural Deferral Industries 

IV. Incomplete Adjustment to Miller 

Equilibrium 

V. Summary and Conclusions 

Appendix 

Page 

1 

5 

10 

15 

24 

26 
I. INTRODUCTION 

The current structure of U.S. corporate and personal 

income taxation is traditionally believed to distort the 

allocation of capital among different sectors of the economy. 

This view is based on general equilibrium models of tax 

incidence initially developed by Harberger and updated by 

Shoven (1976). 

The prevailing view was first questioned by Stiglitz 

(1973, 1976) who argued that corporate financial behavior was 

an important element in a complete analysis. A significant 

implication of Stiglitz's analysis is that income from 

corporate capital is not taxed more heavily at the margin 

than noncorporate capital because of adjustments in corporate 

financial structure made in respGnse to taxation. In 

particular, Stiglitz argues that when corporations finance 

investment through issuing debt, the corporate income tax 

does not misallocate scarce capital between sectors. 

Feldstein and Slemrod (1980) have also reappraised the 

incidence of the corporate income tax. Feldstein and Slemrod 

extend Harberger's 1962 analysis to an economy with two 

groups of capital owners, one group facing high marginal tax 

rates on capital income, the other facing low tax rates. It 
-2-

has long been recognized that for some holders of corporate 

equity, corporate taxes plus taxes on dividends and on 

capital gains may be less than personal income taxes. For 

such investors, corporate equity investments would be a form 

of tax shelter, and corporations would have an incentive to 

finance investments with equity. Feldstein and Slemrod argue 

that this feature of the corporate tax may, under plausible 

circumstances, actually favor corporate over noncorporate 

investments. 

Both the Stiglitz and Feldstein-Slemrod analyses imply 

either that the corporate income tax does not misallocate 

capital, or that the degree of misallocation is less than 

that predicted by the Harherger model. However, the analyses 

diverge in terms of roles played by debt and equity finance. 

In the Stiglitz model, a critical assumption is that all 

investment is financed at the margin by debt. In the 

Feldstein-Slemrod model, however, it is the ability of 

corporations tG issue (tax-preferred) equity that is 

relevant. Indeed, in the absence of diversification motives, 

the Feldstein-Slemrod model implies a very strong incentive 

for equity finance. 

Merton Miller (1977) has recently shown that the 

interaction between c~rporateand personal taxes may produce 

an equilibrium in which corporations would be indifferent 
- 3-

between issuing debt or equity. This result contrasts with 

the types of corporate financial structure implicit in the 

Stiglitz and Feldstein-Slemrod anlayses. 

The primary objective of this paper is to integrate and 

reconcile these differing points of view. Using Miller's 

model, we first show that the tax system will not cause 

sectoral misallocations of capital when : (1) earnings 

retention by corporations is the only way in which ordinary 

income may be transformed into income which is tax-preferred, 

and (2) the tax advantage of debt finance is fully 

capitalized into the relative prices of debt and equity. 

That is, the return paid to debt holders exceeds the return 

paid to equity holders by the tax advantage to debt. 

However, these are strong assumptions. The remaining 

sections of the paper, therefore, consider the consequences 

of relaxing each assumption. 

Section I11 examines the implications of relaxing the 

first assumption. Though corporate earnings retention is a 

convenient way of transforming ordinary income into 

tax-favored income, it is not the only way. Of particular 

interest are features of the tax code which permit income 

earned in certain activities to be taxed in the same 

tax-preferred way as corporate equity without requiring that 

such favored activities be incorporated. High-income 

investors would have at least as strong an incentive to 
- 4-

invest in such "natural deferral industries" as they would in 

corporate equity. Hence, corporate equity investments may 

provide less of a tax shelter than implied by the 

Feldstein-Slemrod model. Perhaps more significantly, capital 

will be misallocated among sectors in a manner similar to 

that implied by Harberger's anlaysis. However, the sources 

of such misallocations are the natural deferral provisions of 

the tax code, rather than the corporate income tax. 

Section IV considers the case in which full 

capitalization of the tax advantage to debt finance does not 

occur. It has long been recognized that firms will not be 

indifferent between debt and equity finance because of 

bankruptcy costs. More recently, DeAngelo and Masulis (1980) 

have shown that firms will nct be indifferent because of the 

interaction between interest deductions and other "non-debt 

corporate tax shields," such as depreciation allowances and 

investment tax credits. The presence of either bankruptcy 

Costs, or significant ncn-debt tax shieids results in 

incomplete capitalization of the tax advantage to debt. This 

leads to a misallccaticn cf capital between c~rpcrateand 

non-corporate sectors. 

E The principal ccnciusicns are summarized in Section V. 

One important policy implication is that tax policies which 

either broaden or narrow the range of activities which 

qualify for natural tax deferral, or which increase or reduce 

the value of non-debt ccrporate tax shields, may have 
important effects on the sectoral allocation of capital. 

Hence, efficiency in the allocation of capital can be 

achieved through changes in tax policy other than integrating 

the corporate and personal tax systems. 

11. SECTORAL ALLOCATION OF CAPITAL IN MILLER EQUILIBRIUM 

Though interest payments on debt are deductible at the 

corporate level of taxation, interest payments are taxed at 

the personal level at a higher rate than equity returns. 

Because debt and equity are treated differentially under the 

corporate and personal income taxes, the before tax yields on 

these financial claims will differ even in a certain 

world. L/ 

Let ti and t i be the effective tax rates on debt and

D E 

equity income respectively faced by investor i. -2/ Because 

equity income is taxed mGre favorably than debt income, 

ti < ti6 Specifically, assume that the tax rate on equity

T 

is a fixed fraction 8 of the tax rate on debt income. An 

claims if: 

where rD and r E are the yields on debt and equity, 

respectively. As tax rates ti increase, the required

D 

This before tax yield on debt relative to equity increases. 
- 6-

leads to the upward sloping "demand" curve for corporate debt 

in Figure 1. That is, interest rates must rise to entice 

investors with higher marginal tax rates into the market for 

corporate debt. 

Firms will be indifferent between issuing debt and 

equity claims if rD(l-tc) = rE, where tc is the corporate tax 

rate. This implies that firms would be willing to supply 

debt elastically as shown in Figure 1 at a return given by, 

Equilibrium in the market for corporate debt occurs 

when the supply of debt equals the demand. At that point, 

the return on bonds and equity must satisfy equation (1) for 

the marginal investor i*. Substituting for the bond rate 

from equation (1) and cancelling terms yields: 

(l-tc)(1-t; 

. *e) = (1-ti* 

D 

The supply of corporate debt by firms will adjust until this 

equality is satisfied for the marginal investor. Investors 

in personal tax brackets below t i* will hold only debt; 

D 

investors in higher tax brackets will hold only equity. In 

equilibrium investors hold the securities that provide the 

highest post-tax rate of return and firms cannot increase 

their market value by changing their capital structure. 
-7 -

Figure 1 

r

D 

SUDD~V 

r

E 

I CorDorate 

D* Debt 

me Market for Corporate Debt: 

Miller Equilibrium 
-- 

-8-

In financial market equilibrium, a corporation financing 

an investment on the margin by debt faces the first-order 

condition: 

(l-tc)FF = rD(l-tc) (3) 

where F: is the marginal product of corporate capital. 

Since rD = r equation (3) can be rewritten as: 

1-F_ 

(l-tc)Fk = r E' 

This is the first-order condition for an equity financed 

firm. In equilibrium, investment decisions are independent 

of the financing decision. -3/ 

If corporate earnings retention is the only means of 

systematically transforming ordinary income into equity 

income, then only corporate investments would qualify for 

preferential tax treatment. Income from investments in the 

unincorporated sector would therefore be taxed at the 

personal level in the same manner as bonds--that is, as 

ordinary income. In a world of certainty this would imply 

that: (1) only investors in tax brackets below that of the 

marginal investor would invest in unincorporated activities, 

and (2) the capital stock would be allocated efficiently 

between corporate and noncorporate sectors. 
-- 

-9-

The first proposition follows from equation (2). 

Investors with marginal personal tax rates greater than t i* 

D 

would earn a higher after-tax return on corporate investment. 

The opposite would be true for those with marginal personal 

tax rates less than t i*. Deriving the second proposition is 

n 

also straightforward. The after-corporate and personal tax 

return to corporate equity investment is (l-tc)(1-ti 0 ) F:. 

D 

The after-tax return to non-corporate investment is (l-ti)F U . 

k 

However, the equilibrium condition for the marginal investor 

i * requires that (1-t i*) = (1-tc)(l-tDB ). Hence, Ff = F: 

D 

the pre-tax marginal products of capital are equal in both 

sectors. Capital is allocated efficiently because it earns 

the same before tax return in both sectors. 

Intuitively, efficiency in the sectoral allocation of 

capital follows from the assumption that income from 

corporate capital qualifies for a personal tax preference not 

given to income earned by non-corporate capital. Net 

earnings from an investment in the corporate sector are 

initially taxed at the corporate rate. However, retention of 

some portion of earnings permits the shareholder to enjoy the 

personal tax advantages of deferral and preferential taxation 

of capital gains. These tax advantages are, however, 

obtained at a price; namely the earnings available for 

retention are net of corporate taxes. In contrast, 

nun-corporate investments are taxed only once at the personal 

level. However, the income from such investments is also 

assumed to be taxed immediately and at ordinary rather than 

I 
-10-

capital gains tax rates. Thus, income from corporate capital 

is taxed twice, but receives a personal tax advantage. 

Income from noncorporate capital is taxed only once, but 

receives no personal tax advantage. 

111. NATURAL DEFERRAL INDUSTRIES 

One unsatisfactory implication of Miller equilibrium is 

that corporate equity should be held exclusively by 

high-bracket, taxpayers, while investments in the noncorporate 

sector should be made exclusively by low-bracket taxpayers. 

This predicted pattern of investment is not consistent with 

observed portfolios. 

Feldstein and Slemrod have argued that portfolio 

diversification is a primary reason why both high- and 

low-income taxpayers would invest in both sectors. While 

risk may be a determinant of observed patterns of corporate 

and noncorporate ownership, certain features of the tax code 

ignored in the Feldstein-Slemrod analysis also make 

investments in particular unincorporated activities 

attractive . 

From the investor's perspective, the ideal investment 

activity would be one which benefitted from the tax 

advantages of both the corporate and the personal tax system, 

while incurring the disadvantages of neither. Such an 
-11-

activity would permit the investor to defer tax liabilities 

and convert ordinary income into capital gains while paying 

taxes only once at the personal level. Any industry closely 

c approximating this ideal would be a "natural deferral 

industry. I' 

As noted by Galper and Zimmerman (1977), the interaction 

of tax depreciation rules and tax rules for defining and 

computing capital gains in the U.S. tax code has created a 

number of industries which approximate the "natural deferral" 

ideal. The industries identified by Galper and Zimmerman 

include: real estate; livestock feeding and breeding; fruit, 

tree, nut and vegetable farming and forestry; and oil and gas 

extraction. Agricultural activities in addition to those 

identified by Galper and Zimmerman would also qualify as 

natural deferral industries since returns to capital are 

primarily reflected in appreciation of land values. 

The distinctive feature of investments in such 

industries is that incorporation is not required in order frjr 

investors to be able to defer tax liabilities and convert 

ordinary income into capital gains. This has twcl 

implications. First, the incremental personal tax benefits 

of incorporation, namely, deferral and capital gains 

treatment through corporate earnings retention, would be less 

valuable for natural deferral industries than other 

industries. Hence, the share of output produced by 

unincorporated firms should certeris paribus be larger in 
-12-

natural deferral industries than in other industries. 

Second, the existence of natural deferral industries would 

encourage high tax-bracket individuals to invest in the 

non-corporate sector for reasons quite distinct from 

portfolio diversification motives. 

Table 1 provides comparative data on the relative 

importance of unincorporated firms in various sectors. The 

share of output produced by unincorporated firms is largest 

in those industries which closely approximate the natural 

deferral ideal: agriculture, forestry and fishing, and real 

estate. 
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-14-

The share of unincorporated firms in oil and gas extraction, 

is smaller than the shares in the other deferral industries 

though substantially greater than the comparable share in 

manufacturing. 

Investments in noncorporate activities which closely 

approximate the natural deferral ideal would be favored by 

the tax system relative to investments in the corporate 

sector and the non-deferral unincorporated sector. This 

preferential treatment results in a misallocation of capital. 

Since firms in l'purellnatural deferral industries would face 

tax incentives to remain unincorporated, the pattern of such 

misallocation would appear to be the same as that in the 

Harberger model; namely, a greater than optimal amount of 

capital would flow into the non-corporate sector. 

There are, however, two distinct differences between 

these results and those implied by the Harberger model. 

First, the sources of the misallocations are the natural 

deferral features of the personal income tax rather than 

double-taxation of corporate income. This implies that 

integrating the corporate and the personal income taxes would 

not improve the allocation of capital between natural 

deferral and other industries. Second, our analysis 

demonstrates that the industrial composition of the 

non-corporate sector is not exogenous, but instead is partly 

determined by provisions in the tax structure. 
-15-

IV. INCOMPLETE ADJUSTMENT TO MILLER EQUILIBRIUM 

The previous section demonstrates that natural deferral 

provisions in the personal income tax code will result in 

sectoral misallocations of capital even when Miller 

equilibrium is attained. However, an important 

characteristic of this equilibrium is the full capitalization 

of the tax advantage to debt. If complete capitalization 

does not occur, the equilibrium described in Section I1 does 

not obtain; and the corporate income tax will misallocate 

capital between corporate and non-corporate sectors. 

Some empirical evidence implies that financial and 

capital market equilibrium of the sort described in Section 

I1 has not been attained. Specifically, the marginal 

investor in corporate debt faces a personal tax rate on 

i* ordinary income, t

D given by equation (2): 

(2) (1-t?) = (l-tc) 

If, for simplicity, the effective tax rate on equity income 

is assumed to be zero, so that 8 = 0, equation (5) implies 

that the marginal investor faces a marginal tax rate equal to 

the corporate tax rate of 46 percent. 
-16-

When 0 = 0, equation (1) implies that the equilibrium 

relationship between rD and rE should be: 

(5) rE = rD (l-tDi* ) = rD(l-tc) = rD (1-.46). 

That is, the marginal investor should accept a return on 

tax-exempt securities equal to 54 percent of the return to 

taxable debt. However, actual yields on tax-exempt bonds have 

been estimated to be roughly 70 percent of yields on 

comparable taxable issues. If the assumption of a zero tax 

rate on equity income is relaxed, this empirical anomaly 

becomes even more serious since ti* would then have to exceed

D 

tC in Miller equilibrium. That is, the marginal investor 

would accept returns on tax-exempt securities of less than 54 

percent of the return to taxable debt. 

Thus, actually observed relative returns to fully taxed 

and tax-exempt assets are not consistent with the equilibrium 

depicted in Figure 1. They wouid, however, be consistent 

with an equilibrium such as that in Figure 2 where the debt 

supply curve slopes downward. In this case the equilibrium 

relation between the returns to debt and equity would satisfy 

the relation rD(l-tc) < rE' The marginal investors in 

Figures 1 and 2 would in general, be different individuals; 

however, the portfolio equilibrium condition for the marginal 

investor is the same in both cases. It can easily be shown 
-17 -

Figure 2 

r

D 

1-tc 

* 

r

D 

r

E 

I 

I Corporate Debt 

* 

D 

The Market for Corporate Debt: Incomplete Capitalization 
that at equilibrium in Figure 2, the tax rate of the marginal 

investor must be less than the corporate tax rate. 

In Figure 2, corporations do not supply debt elastically 

at a rate rD = rE/(l-tc). Instead, the interest rate that 

corporations are willing to pay falls as the quantity of debt 

supplied increases. This is economically rational only if 

there are economic disadvantages to issuing debt which offset 

the tax advantages of debt finance, and which increase as 

supply of debt increases. 

The potential costs from increased exposure to 

bankruptcy have traditionally been cited as one disadvantage 

of debt finance. The effect of potential bankruptcy costs on 

corporate investment behavior and debt-equity decisions have 

recently been examined by Gordon and Malkiel (1980). 

DeAngelo and Masulis (1980) have argued further that 

excessive debt in a firm's capital structure may lower 

taxable income sufficiently so as to reduce the ability of 

the firm to take advantage of non-debt tax shields such as 

depreciation deductions and tax credits. 

The possibility of increased exposure to bankruptcy or 

loss of non-debt tax shields implies that the after-tax cost 

of debt falls short of the cost of equity or rD(l-tc) < rE. 

When this is true, the corporate income tax misallocates 

capital between the corporate and non-cporporate sector. 
-19-

The reason for this misallocation is that corporate 

firms will be financing at least some fraction of their 

investments with equity which is a more costly source of 

funds than debt. The extent of the misallocation depends on 

both the gap between the after-tax costs of debt and equity 

finance and the fraction of the investment financed by debt. 

The misallocation increases with the gap between the 

after-tax costs of debt and equity and with the fraction of 

equity finance. Letting S denote the ratio of the cost of 

equity to the after-tax cost of debt 

rE and j 

(S= 

( 1-tc) ) the fraction of the investment financed by debt, we show in 

the Appendix that the misallocation is an increasing function 

of the difference between the expression [S(l-j) + j] and 

one. 

Taxation and Capital Market Equilibrium 

The extent of capital misallocation clearly depends on 

the values of S and j. The term (S (1-j) + j) increases with 

S, the relative cost of equity finance; and decreases with j, 

the fraction of investment financed by debt. These 

I 

parameters are affected by the interaction between interest 

deductions and other non-debt tax shields which consist of 

depreciation deductions and tax credits. The ability of any 

given firm to take full advantage of such tax shields depends 
-20-

on: (1) the magnitude of non-interest tax shields relative 

to taxable corporate income, (2) the maximum fraction of 

gross tax liability which can be offset by tax credits, and 

(3) the availability of loss carrybacks and carryforwards. 

Other things equal, a. firm's taxable income, and therefore 

its tax liability will be lower the greater the magnitude of 

its interest deductions. Firms with low taxable incomes and 

corporate tax liabilties will be less able to take full 

advantage of other non-interest tax shields. Thus, above 

some threshhold level of debt, the marginal tax benefit of 

debt would be partially offset by the marginal opportunity 

cost of foregone non-interest tax shields. Above this 

threshhold, the debt supply schedule would be downward 

sloping, S would be greater than 1, j < 1, and capital would 

be misallocated. 

There is considerable evidence that U.S. corporations 

are above this threshhold debt level. Table 2 presents data 

on utilization of investment tax credits by different sectors 

in 1976. The ratios in column (3) indicate that firms are 

unable to fully use tax credits to offset current tax 

liabilities. That is, the ability to fully utilize their 

investment tax credits appears to be a binding constraint 

facing firms in their financing decisions. 

More direct evidence is provided by a simple experiment 

performed using the U.S. Treasury Department Corporate Tax 
-21-

Model described in Nester (1977). Specifically, we simulated 

the impact on corporate tax liabilities of increasing debt 

interest deductions by a small amount, holding other factors 

constant. If there were no opportunity costs to debt 

finance, each additional dollar of interest would reduce 

corporate tax liabilities by the marginal corporate tax rate. 

However, we estimate that each additional dollar of interest 

deductions reduces corporate tax liabilities by the smaller 

amount of approximately 34 cents. The reason is that each 

additional dollar of debt deductions results in a loss of 

other non-interest deductions and tax credits. 
-2 2-

Table 2 

Utilization of Tax Credits 

(Dollar Amounts in Thousands) 

Total Credits Total Credit Used Ratio of "Used" to 

Industry Earned in 1976 Aqainst - 1976 Tax Total Credits

Liabilities Earned: 

Manufacturing

Food Manufacturing

Tobacco Manufacturing

Textile Mill Products 

Textile Apparel

Lumber and wood 

Furniture & Fixtures 

Paper Products 

Printing & Publishing

Chemicals 

Petroleum & Refining

Rubber & Plastic 

Leather Products 

Stone, Clay, & Glass 

Metal (Primary)

Metal (Fabricated)

Machinery

Electrical Equipment

Motor Vehicles 

Transportation Equipment

Instruments, Etc. 

Other Manufactuirng

Total 

Utilities 

Rail Transportation 

Air Transportation

Other Transportation

Electric Utility

Gas Utility

Other Utility

Total 

All Other Sectors 

(2)/(1) 

(1) (2) (3) 

$ 375,456 

45,312 

$ 305,373 

44,863 

.82 

.99 

85,687 

27,386 

69,438 

22,514 

.81 

.82 

156,560 118,782 .76 

19,038 13,561 .71 

243,936 182,035 .75 

109,931 

725,850 

1,101,309 

91,917 

576,829 

673,536 

.84 

.79 

.61 

77,390 57,746 .75 

10,091 8,190 .81 

113,810 83,735 .74 

511,636 129,127 .25 

166,685 128,672 .77 

345,774 267,773 .77 

344,290 259,249 .75 

284,450 259,069 .91 

129,817 74,066 .57 

91,586 83,853 .91 

33,025 25,361 .77 

$4,999,020 $3,476,690 .70 

$ 355,524 $ 83,971 .24 

100,156 23,690 .24 

308,992 138,540 .45 

824 I 722 514,173 .62 

270,971 251,193 .93 

595,909 414,315 .93 

$2,456,274 $1,425,952 .58 

$3,744,633 $2,600,456 .69 

Office of the Secretary of the Treasury

Office of Tax Analysis 

November 4, 1980 

Source: U.S. Treasury, Office of Tax Analysis 
-23-

Measures such as making tax credits refundable and 

lengthening carry-back and, carry-forward periods, would 

lower the opportunity costs of debt finance. This in turn 

would cause j to rise and S to move toward 1. That is, the 

debt-equity ratio would increase and the relative returns to 

debt and equity would more fully reflect the statutory tax 

advantage to debt finance. Both of these effects would cause 

the term (S (1-j) + j) to move closer to 1, thereby reducing 

the size of the distortion between corporate and noncorporate capital. Conversely, increasing the level of 

allowable tax credits and non-interest deductions without 

simultaneously increasing the ability of firms to utilize 

such non-interest tax shields will decrease j and cause S to 

increase, thereby potentially increasing the tax distortion 

between corporate and non-corporate capital. 

This view of corporate financial decisions and sectoral 

allocations of capital adds another perspective to the debate 

over whether the investment tax credit should be made 

refundable. Currently, the argument in favor of 

refundability is that desirable investment opportunities are 

foregone because some firms do not have sufficient tax 

liabilities to utilize the credit fully. The counterargument is that refundability would simply subsidize 

"losers". We suggest that refundability would lead to more 

debt finance, and thereby improve the allocation of capital 

between the corporate and non-corporate sectors. 
-24-

It should be emphasized that the two explanations 

offered for the observed divergence from Miller equilibrium 

have quite distinct policy implications. If the primary 

disadvantage to debt finance is increased exposure to 

bankruptcy, policies which encourage debt finance will impose 

increases in real bankruptcy costs which may offset any gains 

in allocative efficiency. If the primary disadvantage to 

debt finance is potential loss of non-interest tax shields 

and bankruptcy costs are negligible, encouraging debt finance 

must lead to a reduction in deadweight losses. 

V. SUMMARY AND CONCLUSIONS 

Since the work of Harberger, it has been widely believed 

that the current structure of corporate and personal income 

taxation in the U.S. has caused capital to be misallocated 

among sectors. Reducing or removing such distortions has 

often been identified as a desirable consequence of 

integrating the corporate and personal income taxes. This 

prevailing view has, however, been challenged in recent years 

by a number of authors who, for differing reasons, have 

argued that the corporate tax does not distort the relative 

returns to corporate and non-corporate investments. 

However, the view that the tax system does not affect 

the sectoral allocation of capital rests on two specific 
-25-

assumptions. The first is that corporate earnings retention 

is the only means of systematically earning capital income 

which is tax-preferred. The second is that the tax advantage 

to debt is fully capitalized into relative prices of debt and 

equity. We have shown that the evidence supports neither 

assumption. Natural deferral activities provide investors 

with the opportunity to earn tax-preferred income without 

also requiring incorporation. The abundance of non-interest 

tax shields makes debt finance less attractive, thereby 

preventing complete capitalization of the statutory corporate 

tax advantage to debt. 

However, the analysis also demonstrates that integration 

of the corporate and personal income taxes is neither 

necessary nor sufficient for achieving an efficient sectoral 

allocation of capital. Tax policy changes which enhance the 

ability of firms to utilize available tax credits and 

non-interest deductions will induce the same reallocations of 

capital as those predicted to result from integration. 

Moreover, corporate/personal income tax integration would not 

remove tax preferences currently granted to natural tax 

deferral industries. 
-26-

Appendix 

If the cost of equity exceeds the after tax cost of 

debt, capital will be misallocated between the corporate and 

non-corporate sectors. Letting S denote the ratio of of the 

after-tax costs of equity to debt 

r

E 

(s= 

‘D (l-tc) 

and j the fractionn of investment financed by debt, the 

distortion depends on the difference between the expression 

[S (1-j) + jl. 

To demonstrate this point, note that investments in the 

non-corporate sector will be undertaken to the point where 

(l-tD) Fk = (l-t$rD, or where Fi = rD. In the corporate 

sector, investment will be undertaken until: 

Recalling the definition of S, equation A1 may be 

rewritten as: 

(A3) Fi = r D (S (1-j) + j 1. 

C 

So long as S > 1, and j < 1, Fk will exceed rD. That is, 

the pre-tax marginal product of corporate capital exceeds the 
-27-

return to debt, and hence, the pre-tax marginal product of 

capital in the non-corporate sector. The ratio of the 

pre-tax marginal products of the corporate to the 

noncorporate sector equals [S (1-j) + j]. The misallocation, 

therefore, depends on the extent to which the value of this 

expression exceeds one. 
-28-

Footnotes 

-1/ The critical factor in the theoretical analysis is the 

relative personal taxation of debt and equity income. 

For a given inflation rate, equity income will still be 

taxed more favorably than debt income. Hence we 

abstract from inflation in the analysis. 

-2/ For some empirical evidence on the extent to which 

capital income is actually taxed, see Steuerle (1980). 

-3/ Miller's equilibrium requires restrictions on 

transactions between investors at different tax 

brackets. In particular, there are incentives for 

high-bracket individuals to borrow from low-bracket 

individuals to purchase equity and for low-bracket 

individuals to sell-short equity and purchase bonds. In 

principle, this profitable "tax arbitrage" can continue 

until all taxpayers face the same marginal rate. 

Auerbach and King (1980) provide a thorough discussion 

of the role of restrictions necessary for Miller's 

equilibrium. 
-29-

References 

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(9) Steuerle, C. Eugene 1980 "Is Income From Capital Subject 

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(12) Stiglitz, Joseph E., 1976, "The Corporation Tax," 

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