Personal Taxes and the Fair Rate of Return Doctrine

In setting the allowable rate of return of public utilities, U.S. regulatory agencies and the courts continue to rely on the standard discounted-cash-flow (DCF) method based on the Gordon-Miller-Modigliani model of share valuation under constant growth - a model which ignores personal taxes. That model and derived cost of equity capital (cutoff rate) were refined by a number of authors during the 1970s and early 1980s by including the impact of personal taxes. Despite its theoretical and intuitive appeal, the corrected model has never been recognized by practitioners, possibly due to a subtle confusion between the standard tax-free cutoff rate and the revised pre-tax cutoff rate. Our comparison of the two models shows that the apparent exclusion of personal taxes under the standard formulation implies their inclusion in a distorted way: Personal taxes enter the standard formulation indirectly, through their impact on the current share price. The resulting estimated cutoff rate may contain a substantial bias that varies with the firm's retention and growth rates, shareholders' marginal tax rate, and the extent of tax exemption accorded capital gains. In particular, the allowed rate of return under the standard formulation understates the cutoff rate for external equity financing, and overstates the cutoff rate for internal financing. As a result, regulated utilities are discouraged from competing for external equity funds and are allowed excessive return on internally generated funds. The first bias is inconsistent with the social objective that public utilities be allowed to maintain a competitive edge in the capital market; the second bias is inconsistent with the objective of limiting the profit of protected monopolies