Average Debt and Equity Returns: Puzzling?

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. ∗We thank Brett Hammond for providing us with data from the TIAA, and Hanno Lustig, Erzo Luttmer, Lee Ohanian, Monika Piazzesi, and Martin Schnieder for their helpful comments. We also thank the NSF for financial support. For a more detailed version of the paper and the data used in this study, see http://minneapolisfed.org/research/sr/sr313.html. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. Historically, the average return on S&P stocks has far exceeded the average return on shortterm U.S. government debt. Rajnish Mehra and Edward Prescott (1985), for example, found that the average difference was 6.2 percent per year in the 1889—1978 period. They tried to account for this difference by assuming it is a premium for bearing nondiversifiable aggregate risk, but found that risk accounted for only a tiny fraction of the difference. They concluded that there is an “equity premium puzzle.” 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. Taxes should not be ignored because individuals have faced different effective tax rates on their interest and dividend income in most years during the past century. Further, the difference in effective tax rates has varied a lot over time because of changes in both the tax code and the regulations governing financial intermediaries. Other regulatory constraints that have mattered are government regulations on households and businesses during World War II. Diversification costs should not be ignored because they have been high and have varied by asset and by period. One final difference in our analysis is the focus on long-term savings instruments, whereby long implies long enough so that assets’ liquidity values are small. Individuals do not hold 90-day U.S. Treasury bills for their retirement. Unlike Mehra and Prescott, we find that there is no equity premium puzzle. Accounting for taxes, regulations, and costs, the difference between average debt and equity returns during peacetime in the last century is less than 1 percent, with the average real debt return