The Hindu Business Line : There's a shared stake in arresting managerial diversion

A NEW working paper from the National Bureau of Economic Research is provocatively titled: Theft and taxes. It has been written by Mihir A. Desai, Alexander Dyck and Luigi Zingales, and is about a new approach called a corporate governance view of taxes (CGVT), to look jointly at taxation and corporate governance.

Aren't the two, viz. theft and taxes, just the same, you may wonder, but the theft that the paper talks about is what insiders siphon off. The paper's abstract informs that a higher tax rate increases the amount of income insiders divert and thus worsens corporate governance. Instead, when tax enforcement is strong, tax burden may be more but diversion reduces; and the company's share price may increase. When corporate governance is weak, the Finance Minister's calculations can go awry because "an increase in the tax rate can reduce tax revenues."

Largest minority shareholder

In the intro, the authors argue that corporate governance should be studied in relation to taxation because "the state, thanks to its tax claim on cash flows, is de facto the largest minority shareholder in almost all corporations." A novel way of looking at the corporate scene, this is, though you'd agree that the state could be an oppressing minority.

The three players in the system are the state, insiders, and outside shareholders, and "each bilateral interaction has important spill-over effects on the third party." Among the three players, the state and outside shareholders have a common goal, "a natural alignment of interests": Reducing managerial diversion.

Dispersal of ownership impacts cost of evasion, explains the paper. In privately held companies it is easier for shareholders to reach an agreement and "minimise their collective tax liability through mechanisms such as charging fictitious expenses" and then "redistribute their tax savings among themselves with side contracts". But the situation is "considerably more complicated" and transaction costs of evasion higher in widely held companies.

Something more insidious can take place too: Collusion between the government and the insiders! A quote cited in the paper is of Yukos Oil's former CEO Mikhail Khodorkovsky who had argued, "As long as the tax regime is unjust, I will try to find a way around it." Thus, in exchange for bribes from insiders, the state may overlook diversion from outside shareholders.

This is no unmixed blessing: One, there is no guarantee against insiders getting pestered with "additional requests for bribes"; and two, the state may find it thorny "to limit the skimming of proceeds by its delegated agents".

Why corporate tax

For those who wish for the scrapping of corporate tax, the paper has bad news: It supports `a separate tax on corporate profits' because the government would then verify income, "ameliorating the agency problem between insiders and outside shareholders."

The authors cite a quote of William H. Taft, who as the President of the US had defended the introduction of the first federal corporate excise tax in 1909 by extolling supervision over the annual accounts and business transactions of all corporations. He had said: "While the faculty of assuming a corporate form has been of the utmost utility in the business world, it is also true that substantially all of the abuses and all of the evils which have aroused the public to the necessity of reform were made possible by the use of this very faculty.

"If now, by a perfectly legitimate and effective system of taxation, we are incidentally able to possess the Government and the stockholders and the public of the knowledge of the real business transactions and the gains and profits of every corporation in the country, we have made a long step toward that supervisory control of corporations which may prevent a further abuse of power." That was almost a hundred years ago. Imposition of tax resulted in improved corporate governance, the authors trace, looking at how reliability increased as tax returns had to be audited, and need was felt "for a standard definition of income and other accounting variables", leading to uniform accounting standards in 1914.

Three insights

The paper concludes by summarising its three main insights: First, corporate tax system can influence not only the amount of diversion that takes place in a country but also the valuation of firms. Second, what is more important for achieving corporate tax revenues is not tax rate but the quality of corporate governance. And third, corporate tax serves a useful function, of certifying the company's income to outside shareholders.

The paper's model suggests that tax level is complementary to the quality of the corporate governance. "Hence, countries with better governance can use taxes more aggressively to further improve corporate governance, while countries with poor governance to begin with should be leery of using taxes to improve governance, because this might backfire." Is that a clue for the next Budget to work on?

AccountSpeak@TheHindu.co.in

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