The following post comes to us from David M. Schizer, Dean Emeritus and the Harvey R. Miller Professor of Law and Economics at Columbia Law School. It is based on his recent paper, “Tax and Corporate Governance: The Influence of Tax on Managerial Agency Costs,” which is forthcoming in the Oxford Handbook on Corporate Law and Governance and is available here.
Tax can influence managerial agency costs in a broad range of ways. Sometimes tax exacerbates these costs, and sometimes it mitigates them. Corporate law experts need to understand these effects in order to target managerial agency costs more effectively. Armed with this information, they have a better sense of how vigorous a contractual or corporate law response they need. It is also valuable for tax experts to understand these welfare effects. After all, tax policy is more likely to enhance welfare if policymakers weigh all possible welfare effects, including managerial agency costs. In some cases, a change in tax rules may be justified.
Overall, the U.S. tax system’s record in influencing agency costs is not encouraging. After all, a tax system’s priority is not to reduce agency costs, but to raise revenue efficiently and fairly. Government tax experts do not usually have the expertise or motivation to tackle corporate governance problems. Tax also is a poor fit because it typically applies mandatorily and uniformly, while responses to agency cost should be molded to the context. For example, promoting stock options or leverage will be valuable in some settings, but disastrous in others. There also are political hurdles to be overcome. Accordingly, when tax rules target agency costs, the results often are poorly tailored or even counterproductive.
Even so, the effects are not all bad. On the positive side of the ledger, U.S. tax rules encourage performance-based pay, albeit in blunt ways. In addition, by taxing intercompany dividends, the U.S. keeps block-holders in one firm from indirectly controlling other firms. U.S. tax rules also encourage leverage, which usually (but not always) mitigates managerial agency costs. Likewise, some tax rules favor long-term ownership, which can motivate shareholders to monitor management more carefully. The need to disclose financial information on a corporate tax return can also discipline management. Discouraging the use of offshore accounts and off-balance sheet entities can keep managers from cheating shareholders, as well as the fisc.
On the other side of the ledger, U.S. tax rules can be a reason (or excuse) for flawed pay. Managers also can use tax as a pretext to retain earnings, and also to oppose takeovers that put their jobs at risk. Tax also can be invoked to justify “empire building” acquisitions as well as hedging, each of which appeals more to undiversified managers than to diversified shareholders. U.S. tax rules also encourage firms to incorporate offshore or to use pass-through entities, even though these steps can weaken shareholders’ corporate law rights.