Paul L. Caron

Wednesday, February 14, 2018

Simkovic: Taxing Limited Liability

Michael Simkovic (USC), Limited Liability and the Known Unknown:

Limited liability is a double-edged sword. On the one hand, limited liability may help overcome investors’ risk aversion and facilitate capital formation and economic growth. On the other hand, limited liability is widely believed to contribute to excessive risk taking and externalization of losses to the public. The externalization problem can be mitigated imperfectly through existing mechanisms such as regulation, mandatory insurance, and minimum capital requirements. These mechanisms could be more effective if information asymmetries between industry and policymakers could be reduced. Private businesses will typically have better information about industry-specific risks than policymakers.

A charge for limited liability entities—resembling a corporate income tax but calibrated to risk levels—could have two salutary effects. First, a well-calibrated limited liability tax could help compensate the public fisc for risks and reduce externalization. Second, a limited liability tax could force private industry actors to reveal information to policymakers and regulators, thereby dynamically improving the public response to externalization risk.

Charging firms for limited liability will lead private firms to sort themselves by riskiness and reveal information to policymakers. Policymakers will then be able to focus their attention on the industries that have collectively self-identified as high risk and develop more finely tailored regulatory responses. Because the benefits of making the proper election are fully internalized by individual firms, whereas the costs of future regulation or limited liability tax changes will be borne collectively by industries, firms will be unlikely to strategically mislead policymakers in their elections. By helping to reveal private information and focus regulators’ attention, a limited liability tax could accelerate the pace at which policymakers learn and therefore the pace at which regulations improve.

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Can I assume Prof Simkovic has never made an investment in a private business? You know, we used to have this idea called a general partnership or a sole proprietorship. But then this thing called lawyers came along. Today, you'd have to be completely nuts to operate a business with limited liability protection.

Posted by: Dale Spradling | Feb 17, 2018 6:34:25 PM

The anonymity in this comment thread sure is mysterious!

Posted by: Unemployed Northeastern | Feb 17, 2018 12:32:50 PM

There are no entity level taxes on passthrough entities. How would you cut their taxes from zero?

Everyone with an LLC gets a check from uncle same?

Everyone with an LLC doing real estate and private equity work (but not medicine or consulting or law) gets to pay less in social security, payroll and individual income taxes on their ordinary labor income, per widely lampooned republican tax plan?

Posted by: tax cuts | Feb 17, 2018 9:24:46 AM

The paper doesn't claim that limited liability produces net-negative externalities. The claim is that charging for limited liability would sort firms and generate / reveal information which would reduce net-negative externalities over time.

You want firms to self-sort and effectively price limited liability themselves by their choices, which reveal willingness to pay and internal beliefs about risk.

If you cut taxes on unlimited liability, you wouldn't know how much to cut them and you wouldn't generate the same kinds information because the government would have to make all the decisions without private sector input.

Posted by: sorting | Feb 17, 2018 9:21:59 AM

The solution to distortionary corporate welfare is even more corporate welfare?

You tax negative externalities. You don't subsidize people for agreeing to produce fewer negative externalities.

Posted by: subsidy | Feb 16, 2018 11:01:23 PM

Without assessing the merits of the claim that the LL status produces net negative externalities, why not discourage LL status by reducing the tax burden of unlimited liability structures?

Posted by: MG | Feb 14, 2018 1:57:01 PM