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E-MailThis post is from Michal Barzuza of University of Virginia School of Law. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.
My article entitled “Delaware’s Compensation,” which was published in the Virginia Law Review, focuses on the compensation that Delaware – the state in which most public companies are incorporated – is getting from the firms it attracts. For its corporate law – and related services it offers – firms pay Delaware an annual franchise tax. The aggregate collections from this tax amount to approximately 20% of Delaware’s annual revenue. It has long been argued that this compensation provides Delaware with incentives to provide corporate law that maximizes shareholder value.
This article points out that the structure of the tax is not optimally designed to provide Delaware with incentives to maximize shareholder value. Delaware’s franchise tax is not based on firm income, market value, or any other measure of performance, but rather functions much like a lump-sum tax. Nearly half of Delaware’s revenue comes from firms who pay the maximum tax rate. For most of the rest of the firms, Delaware’s franchise tax is based primarily on the number of authorized shares. For a small group of firms, the tax is based on, among other things, their assets. Yet, if the tax increases as a result of an increase in assets, Delaware law allows firms to switch to the authorized shares method.
The current tax does not provide Delaware with incentives to improve corporate governance terms that correlate significantly with firm value – such as staggered boards or liability protection for directors and officers – even if improving them could result in an increase of several percentage points, or hundreds of billions of dollars, to the value of Delaware’s firms. Because its tax is not tied to firm performance, even those corporate law amendments that could increase firm value significantly would not increase the amount of tax per firm that Delaware would generate. And since they may antagonize some managers, resulting in some firms reincorporating outside the state, Delaware could even lose revenue from adopting them.
The paper argues that adding a tax component based on changes to corporate value or income on top of the current tax would improve the current system. It would align Delaware’s incentives with those of shareholders and induce it to offer corporate law that maximizes shareholder value. It could have this effect even if Delaware faces no competition from other states over incorporations and even if shareholders are passive.
The paper also argues that Delaware does not have sufficient incentives to change its franchise tax to a more incentive based compensation for several reasons. First, risk aversion and lack of information make Delaware officials reluctant to make any changes to the structure of its franchise tax. Second, the current tax, even though suboptimal, serves Delaware’s interests by creating a commitment that the state will cater to managers’ needs on an ongoing basis, inducing managers to incorporate in Delaware.
For the longstanding debate over the market for corporate law the analysis suggests that it should not result in a race to the bottom or to the top. While the tax that it charges restrains Delaware from racing to the bottom, it does not push it to the top either, but rather to the middle–to produce corporate law that is superior to that of other states, but that falls short of being optimal.
The full paper is available for download here.
