Published January 1, 2003
Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk. Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott—taxes, regulatory constraints, and diversification costs—and focusing on long-term rather than short-term savings instruments. Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent. As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital. Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.
RELATED PAPERS: Staff Report 294 The 1929 Stock Market: Irving Fisher Was Right, Staff Report 309 Taxes, Regulations, and the Value of U.S. and U.K. Corporations and Quarterly Review articles (Vol. 24, No. 4, Fall 2000) The Declining U.S. Equity Premium and Is the Stock Market Overvalued?
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