Can Taxes Encourage Better Corporate Behavior?

Researchers say that regulations aren’t the only option the government has for discouraging companies from taking on too much risk.

Researchers say that regulation isn't the only way to manage a corporation's risky bets. (Wayne Parry / AP)

Listen to any recent presidential debate, and you’ll hear candidates emphatically backing plans that alternately promise to lower or raise the share that corporations turn over to the government each year in taxes. The argument on one side is that hiking corporate income taxes will harm businesses and their workers, hampering hiring, innovation, and growth. On the other side, proponents of tax increases argue that large, rich corporations should pay their fair share, especially as average Americans struggle to make ends meet and many companies manage to lower their actual tax rates by exploiting loopholes in the tax code.

But corporate tax rates aren’t just policy points or a means of forcing firms to contribute to the larger public pot—they’re also a way, according to a new paper, for the government to stoke or curb companies’ appetite for risk-taking.

For most companies, some level of risk is necessary for growth, innovation, progress, and profits. While in general more risk can result in a more significant financial payoff,  what’s considered the appropriate amount of risk can vary from industry to industry and company to company. For instance, pharmaceutical companies might take on additional risks by funneling more research funds  into finding a lucrative treatment for a rare illness. Or a technology firm can take on additional risk by branching out into a new domain, such as driverless cars or virtual reality. But excessive risk-taking can not only cripple a company, but an entire economy, as the most recent recession proves: When banks became overburdened with risky, subprime debt, they threatened to bring down not only themselves, but the industry and large swaths of the economy as well.

Regulation is often thought of as the most obvious tool in the quest to find the optimal amount of corporate risk-taking. Industry regulators can force companies to conduct exhaustive due diligence, to clear risky financial bets, and to keep enough cash on hand to prevent a massive financial disaster.

As a new National Bureau of Economic Research paper documents, tweaking taxes can also play a role in determining the degree of risk companies are willing to take on. The paper’s authors, Alexander Ljungqvist of New York University, Liandong Zhang of City University of Hong Kong, and Luo Zuo of Cornell,  took a look at the impact that fluctuations in state taxes had on a company’s earnings, using increased earnings volatility as a signal of having taken on more risk. They found that ultimately, hiking taxes curbed a company’s willingness to take risks—which makes sense, because companies facing higher taxes have to hand over a bigger share of their earnings to the government, instead of keeping it for themselves. Taking big risks and having to fork over a significant percentage of the gains is less appealing.

But the researchers also found something less intuitive: Lowering taxes didn’t have the expected effect of inducing more risk. The authors conclude that this may be the case because regulators or investors also weigh in, dissuading companies from taking on risky new endeavors. In other words, taxes can be a blunt tool for curbing risk-taking, but they don’t seem to be useful for encouraging it.

Of course, risk calculations aren’t solely tied to increasing or reducing taxes. The ability to offset losses, for instance, plays a major role in how effective a tax increase can be. When companies are able to write off their losses, they can decrease the amount of money they pay to the government, forcing the state to share in some of the potential downside of their risky bet. Thus, limiting a firm’s ability to reduce its taxes through such moves would be a critical step when it comes to changing risk-taking behavior.

Taxation certainly won’t serve as a substitute for careful, nuanced regulation, but when it comes to managing risk and reward in the corporate sector, governments might be able to play a crucial role in creating more balance.