Let's work a problem that shows how investors and firms sort themselves. Assume that taxable and tax-exempt firms each earn $1 of income.
Assume that the financial markets offer 8% for tax-exempt income and 10% for taxable income.
Assume that taxable firms and taxable investors are both taxed at 33.3%.
Show what each type of firm and investors would do.
Assume that capital gains are entirely untaxed. How would the arrangement change if the financial markets offered 9% for tax-exempt income?