Can Taxes Mitigate Corporate Governance Inefficiencies?

Noam Noked is assistant professor of law at The Chinese University of Hong Kong. This post is based on his recent article, published in the William & Mary Business Law Review.

Policymakers have long viewed tax policy as an instrument to influence and change corporate governance practices. Certain tax rules were enacted to discourage pyramidal business structures and large golden parachutes, and to encourage performance-based compensation. Other proposals, such as imposing higher taxes on excessive executive compensation, have also attracted increasing attention. Contrary to that view, this article contends that the ability to effectively mitigate corporate governance problems and increase efficiency through the use of corrective taxes is very limited. The existing corrective taxes should be reconsidered, and in certain cases revoked and replaced with other more efficient forms of regulation.

Several factors limit the effectiveness of corrective taxation in mitigating corporate governance inefficiencies. First, the same conditions that gave rise to the agency problem also undermine the effectiveness of corrective taxes. Firms with better governance are more likely to alter their practices in response to a corrective tax, whereas firms with worse governance are more likely to incur the tax penalty without changing their practices. Managers in poorly-governed firms are more likely to shift the tax burden onto the firm without changing the practices that benefit the managers. The experience with many firms deciding to adopt non-performance-based compensation and golden parachutes that trigger tax penalties indicate that taxation might not be an effective means of changing practices in poorly-governed firms. Therefore, unlike negative externalities that can be internalized through corrective taxation, corporate agency problems might not be effectively countered through the use of taxation, because the same conditions that gave rise to the agency problem might undermine the effectiveness of corrective taxes.

Second, where the tax is imposed on the managers, shifting the tax burden onto the firms, in whole or in part, would reduce their benefit and the overall efficiency gain from imposing a corrective tax. From the shareholders’ standpoint, a tax would be beneficial if it reduces the firm’s agency costs to an extent exceeding the tax burden shifted onto the firm. Shareholders might also benefit when the increase in tax revenue results in a decrease in other taxes. From a broader efficiency perspective, corporate agency costs reduce investment in the corporate sector and distort the allocation of capital. If some of the corrective tax were borne by the firm, it would reduce the social benefit from that corrective tax.

Third, the same corporate governance practices might be harmful in some situations and beneficial in others. If these practices were uniformly harmful, a prohibition would be desirable, but it might be suboptimal to ban practices where the effect is mixed. Imposing a tax that discourages the harmful uses of a particular practice would discourage beneficial uses as well. Golden parachutes encourage managers to find beneficial sales, and help in overcoming managerial entrenchment, although they might lead to harmful changes in control. Some related-party transactions might be used for tunneling, as discussed below, whereas others might increase the firm’s value. Anti-takeover arrangements might be used by an underperforming management to entrench itself, whereas the same measures may assist an excellent management against harmful bids that could destroy the firm’s long-term value. Strengthening other mechanisms that can distinguish between harmful and beneficial applications, and allowing only the latter ones, might be superior to taxation.

Fourth, the tax system is limited in its ability to assess real risk and performance goals. The tax penalty under Section 162(m) could be easily avoided, and the deferral under Section 83 could be easily received, by granting compensation conditioned on easily attainable performance targets. The tax authorities’ limited ability to assess these factors raises doubts about the effectiveness of using tax rules to incentivize pay-for-performance compensation schemes that actually reward good managerial performance. Strengthening corporate governance mechanisms, such as board and shareholders’ approval processes for executive compensation packages, may be superior to using the tax system for incentivizing adopting performance-based compensation schemes.

Fifth, taxation might not have many advantages over other forms of regulation in mitigating corporate governance inefficiencies. If the government knows what the best governance terms are, command and control regulation is preferable. Taxation would be preferable where the government does not know which governance terms are optimal, but can assess the externalities generated by the relevant behaviors and practices, and can impose a tax equal to these externalities. With respect to pyramidal business groups, the case for limiting this practice through a ban is more compelling. The harm caused by these structures is well documented, whereas it is hard to impose a corrective tax equal to the externality induced by each layer of the pyramid. Nonetheless, in respect of some other corporate governance practices, there is a significant difficulty on both ends: it is hard to determine what the optimal corporate governance practice is, and it is also hard to design a tax equal to the negative externality from each practice. Unlike a ban on a particular practice, a tax allows an action to take place if the benefit exceeds the cost of the tax. A tax would allow an action to take place where the benefit from a particular action exceeds the tax, whereas a ban would prevent any action regardless of the size of the benefit. However, if insiders, and not the firm, receive the benefit while the firm is harmed from that action, the firm would be better off under a regulation forbidding that action. In addition, it may be more politically feasible to adopt a tax rather than a ban. An alternative to taxation and command and control regulation is to strengthen mechanisms, both internal and external, that can distinguish between harmful and beneficial applications of the relevant corporate governance practices, and allow only the latter ones.

The complete article is available for download here.

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