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.
Published in: _AER, Papers and Proceedings_ (Vol. 93, No. 2, May 2003, pp. 392-397) https://doi.org/10.1257/000282803321947407.
See related papers:
[Staff Report 294: _The 1929 Stock Market: Irving Fisher Was Right_](https://doi.org/10.21034/sr.294)
[Staff Report 309: _Taxes,Regulations, and the Value of U.S.and U.K. Corporations_] (https://doi.org/10.21034/sr.309)
Quarterly Review articles (Vol. 24, No. 4, Fall 2000) [_The Declining U.S. Equity Premium_](https://doi.org/10.21034/qr.2441) and [_Is the Stock Market Overvalued?_](https://doi.org/10.21034/qr.2441)
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