Debate Magazine

Economic Myths: Miller & Modigliani Theorem

Posted on the 14 July 2019 by Markwadsworth @Mark_Wadsworth

The first part of the original M&M Theorem makes perfect sense:
The Modigliani-Miller theorem (M&M) states that the market value of a company is calculated using its earning power and the risk of its underlying assets and is independent of the way it finances investments or distributes dividends.
There are three methods a firm can choose to finance: borrowing, spending profits (versus handing them out to shareholders in the form of dividends), and straight issuance of shares. While complicated, the theorem in its simplest form is based on the idea that with certain assumptions in place, there is no difference between a firm financing itself with debt or equity.

So far so good. If the value of the business is more than the outstanding debts, then the shares have value; if the debts exceed the value, then the shares are nigh worthless. The total value of debts + shares remains roughly the same. The value of the bonds can't exceed value of the business and the value of the shares can't go lower than zero.
If you aren't sure whether to buy shares or bonds in a company, the best strategy is to have a mix. For example Mike Ashley/Sports Direct spent £150 million on acquiring 30% of the shares in Debenhams. Unfortunately for him, the debts ballooned to far more than the value of the business, so the lenders took over the business and his shares were wiped out (a kind of debt for equity swap).
His better strategy would have been to spend less on shares and more on acquiring Debenhams debts pro rata (say 15% of each). If the business had done well, his shares go up in value and if it does badly, his shares are wiped out but he still ends up with 15% of the business in his capacity as lender.
What's nonsense is the related claim that the tax system encourages businesses to borrow money instead of issuing shares:
Third, the use of debt is less expensive than the use of equity because debt is generally subsidized by the state through the tax system –since debtors can deduct the interest payment associated with the use of debt. Therefore, the use of debt may reduce the firm´s cost of capital.
That's a generalisation across many countries' corporation tax systems, but whether it is true or not depends on the rates of tax applied to corporate profits (at corporate level) and dividend and interest income at shareholder/lender level.
(I started as a tax adviser in 1989 and had to advise clients on 'what is better for tax', the answer depended on the circumstances. I later did an accounting and finance degree, and the lecturer trotted out the M&M tax drivel and would simply not listen to reason and logic.)
IIRC and generalising a bit, Singapore and Hong Kong governments get so much money from land rent, land auctions, stamp duty and capital gains on land that they barely need to bother with taxing incomes. So companies pay 15% corporation tax and individuals pay 15% income tax. If an individual gets a dividend, it is treated as tax paid, so no further income tax due. If an individual receives interest income, it is taxed at 15% so it is as broad as it is long.
In the UK, we had a brief period in 2012 or thereabouts (before Osborne started messing things up again), when it simply did not make a difference for corporation tax/income tax (ignoring National Insurance, which clearly distorts things, the 45% additional rate and overseas stuff).
The rates were:
Corporation tax - 20%
Basic rate income tax - 20%
Higher rate income tax - 40%
Withholding tax on interest - 20%.
* If a basic rate taxpayer received a dividend, there was simply no more tax to pay (same as Singapore or HK) because the company had already paid 20%. (Ignore the bullshit with the 10% tax credit and the 10% nominal rate, it worked out at nil, unsurprisingly).
* If a basic rate taxpayer took a salary bonus, the employer took 20% income tax via PAYE and the employee had no more income tax to pay.
* If a basic rate taxpayer received an interest payment, the company paid over 20% withholding tax/income tax on a CT61 and the individual had no more tax to pay.
* If a higher rate taxpayer received a dividend, he had to pay 25% income tax on the dividend, so the overall rate was 40%. Remember - company earns £100, pays £20 corporation tax, pays £80 dividend, individual pays £20 income tax and nets £60. (Ignore the bullshit with the nominal 10% tax credit and the 32.5% nominal rate, it worked out at 25%).
* If a higher rate taxpayer took a salary bonus, the employer took 40% income tax via PAYE and the employee had no more tax to pay, net pay £60.
* If a higher rate taxpayer received an interest payment, the company paid over 20% withholding tax/income tax on a CT61 and the individual declared the gross amount and paid a further 20% of the gross amount, net interest £60.
Osborne and Hammond then busily messed up this state of affairs and now you have to do the three calculations each time to see 'what's best for tax'.
There are lots of other wrinkles...
* Pension funds can receive interest or rent truly tax-free, but receive dividend payments out of after-tax income. It would make more sense to tax all sources at a flat, lower rate, so that they get some refund of the corporation tax on dividends but pay some tax on interest and rental income.
* Some companies have large tax losses (R&D tax credits, Film Tax Credits etc) but have distributable commercial profits, so are advised to pay dividends so that shareholders get the (slightly) lower income tax rate that applies to dividends.
* Some companies don't have distributable commercial profits, so aren't allowed to pay dividends, but can still pay salary bonuses or interest.
In a perfect world, therefore, dividends, interest, rent and wages would be taxed exactly the same way i.e. there would simply be a flat withholding tax at the same rate on each when the company pays them out.
We used to do this for dividends (Advance Corporation Tax);
Banks used to withhold 20% income tax from deposit interest;
Non-banks still have to do it for interest payments (CT61s);
PAYE applies to wages;
CIS deductions apply to sub-contractors in the construction industry;
and tenants with non-resident landlords are supposed to, by default, pay 20% of the rent to HMRC and pay the landlord the balance of 80% (though most wriggle out of this).
You wouldn't even need to bother having special rules for foreigners and there would be no need to distinguish whether it's wages, rent, dividends, interest, sub-contractor payments etc. It could all be included on one return/reporting system and paid to HMRC in one payment. As a final flourish, dividends paid net of tax would be an allowable expense for corporation tax purposes.
Individuals who have to submit income tax returns (i.e. higher rate taxpayers) can then just enter all 'net of tax' payments in one box and pay the same tax rate on the lot, minus the credit for income tax withheld at source.
Here endeth.

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