The Effects of Corporate Taxation on the Cost of Equity Capital

Abstract

Last year as a result of a major study [2], the New York Stock Exchange predicted that a minimum of $250 billion in net equity shares will be needed between 1976 and 1985 and concluded that U.S. business may not be able to market enough equity capital to meet this need. Although it is predicted that institutions should purchase about $220 billion in equities through 1985, foreign investment should total only $30 millon, and households are projected to remain net sellers at an approximate volume of $75 billion over the same period. From all sources, then, only about $175 billion of the required amount should be readily forthcoming, which leaves a predicted equity shortfall of approximately $75 billion. Although other studies [1] assuming much greater restraint on fiscal deficits may lessen the impact of these predictions, the potential for a significant equity capital shortage seems almost undeniable. It is doubtful that the potential shortfall can be alleviated by institutional investors, who have built up substantial equity positions already, nor, according to the Exchange, by foreign investors. The individual investor seems to be the answer to this rising problem, and efforts should be made to bring him back into the market, not as a net seller but as a net buyer. As is obvious, some means of better balancing equity finance with the use of debt finance is needed. (From 1964 to 1974, the debt-to-equity r tio among U.S. manufacturers increased from 25 to 42%.) Various methods of accomplishing this have been suggested, almost all of which advise major tax changes. Recommendations for deductions, credits, differentials, and other provisions to be added to our current system of co porate taxation have all been made. However, academic scrutiny over the theoretical effects of various methods of corporate taxation has been insufficient. By coincidence, a great deal of attention is being devoted to the selection of a corporate tax system for overall application in the European Economic Community. Yet, even there, possibly due to the lack of a developed capital market, l ttle attention has been given to the specific effects of such systems on the cost of capital. The heterogeneity of European corporate tax systems, as with other social, economic, and political conditions, provides a very relevant and convenient source of valuable information useful in understanding the affairs of the Unit d State . The 3 systems currently existing in the European Economic Community, the classical, dual-rate,