TaxProf Blog

Paul L. Caron
Dean





Friday, May 17, 2024

Weekly SSRN Tax Article Review And Roundup: Roberts Reviews The Missing “T” in ESG By Chaim & Parchomovsky

This week, Tracey M. Roberts (Cumberland; Google Scholar) reviews a new work by Danielle A. Chaim (Bar-Ilan; Google Scholar) and Gideon Parchomovsky (Penn; Google Scholar), The Missing “T” in ESG, 77 Vanderbilt L. Rev. 789 (2024).

Roberts (2020)

In The Missing T in ESG, Danielle Chaim and Gideon Parchomovsky take a magnifying glass to ESG investing and the large asset management firms that have been promoting it in recent years. Environmental Social and Governance or “ESG” standards describe a broad array of criteria. Environmental factors examine environmental impacts (such as waste management and greenhouse gas production). Social factors focus on human rights violations and violations of labor laws (such as human trafficking and child labor in the supply chains), among other things. Governance factors consider longer-term value, positive and negative spillover effects, and whether a corporation has implemented structures and personnel with diverse perspectives to avoid the kinds of group-think that led to the mortgage crisis and Great Recession. Ultimately, ESG ratings allow investors, with an aversion to longer-term risks and with preferences beyond short term profit, to pick and choose where they invest their money.

According to Chaim and Parchomovsky, large asset managers, such as the Black Rock Group, State Street Global Advisors, and the Vanguard Group, and the institutional investors they advise, have stepped into a new role as the sole purveyors of good governance by promoting ESG investments and by requiring the corporations in which they hold a significant interests to disclose information on which an ESG score may be based. Chaim and Parchomovsky then argue that these firms are not the saviors of the greater good or the solution to governmental shortcomings, but systematic contributors to the problems that ESG criteria are designed to address. These firms are, in fact, leaders in corporate tax avoidance, undercutting the government's very ability to promote the greater good of society.

To address this problem Chaim and Parchomovsky argue in favor of incorporating into ESG ratings an additional criterion, “T” for taxation, to evaluate corporate tax avoidance behavior. While some of the ratings organizations may account for aggressive tax avoidance behavior to some extent, most ignore it. Furthermore, most of the large asset managers have advocated against incorporating tax criteria into ESG ratings, despite the broad social and economic consequences of corporate tax avoidance. (These firms themselves enjoy significant tax relief as well as regulatory relief; this may explain their reluctance to push for tax transparency, lest their own practices be subject to scrutiny.) Chaim and Parchomovsky note that there is an inverse relationship between corporations’ ESG scores and their effective tax rates. They describe this situation as a “paradox” since corporations, institutional investors, and large asset managers are being called upon to solve the very problems they are creating.

Examining these developments from a broader perspective, however, one may set aside as mere hyperbole the description of large asset managers and institutional investors as “saviors.”  These firms, far from being regulators, are instead responding to demands by investors for more information. Fortunately, to examine ESG ratings from a wide-angle lens, there is a robust literature from which to draw. ESG is a form of private governance, private regulation. While ESG ratings are part of a much broader set of private governance mechanisms that have been employed in response to political gridlock (as Vanderbilt Law Professor Michael Vandenbergh has explained) and regulatory ossification (as Virginia Law Professor Michael Livermore has explained), private governance has old roots in the boycott campaigns of temperance activists and abolitionists from the 1800s. In the U.S., Michael Vandenbergh has provided extensive coverage of environmental approaches, Yale Professor Daniel Esty has published an edited edition in view of international trade, Edward P. Stringham has given a historical account from the European perspective, and Elinor Ostrom won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2009 for her collection and analysis of private governance of the commons. Private governance has historically been bottom-up, consumer- and investor-driven. If large asset managers are making efforts to adopt ESG criteria in assembling their portfolios of assets, this is the outcome of three or four decades of investor demand for corporate accountability. [In fact, it’s even more likely that the large asset managers have used ESG reporting to troll for deals that would qualify for massive subsidies available via the Infrastructure Investment and Jobs Act and the Inflation Reduction Act, but that is a separate line of inquiry.] In its earlier forms, ESG was known as corporate social responsibility (CSR) and socially responsible investing (SRI), which used social and environmental criteria to screen and package investments that conform to ethical, environmental, and other parameters.

Why are investors seeking this information? Two answers: (1) the rise of the Friedman Doctrine, also known as the theory of shareholder primacy, as the dominant normative model for business ethics, and (2) globalization. In his 1962 book Capitalism and Freedom, Milton Friedman explained that "there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." Friedman’s theory assumes that the corporations are actually playing by the rules of the game. These assumptions may be unwarranted. First, competition is not always open and free. In recent years, market consolidation has allowed major corporations to engage in monopoly pricing (as FTC Chair Lina Khan has argued) at the cost of consumers, to use monopsony power (as Chicago Professor Eric Posner has argued) to the detriment of workers, and to create barriers to entry, reducing competition. Furthermore, there are fewer pathways to discern whether corporate operations or stock transactions are marked with deception or fraud, given the nested nature of entity ownership and stock holdings through pension funds and retirement accounts.

Under Friedman’s theory, shareholders hold a property right to any profits that result after satisfying the statutory, contractual, and common law claims of a company’s creditors, employees, and other stakeholders, such as the government. This brings us to the second driver of shareholders’ use of private governance to gain access to information: globalization. Since World War II, globalization has obscured the pathways to profit. Corporations have moved their operations abroad to avoid (i) U.S. environmental regulations (statutory claims), (ii) U.S. labor regulations (statutory and contractual claims), and (iii) U.S. taxes (governmental claims). Beyond the reach of the U.S. government taxing and regulatory authorities, corporations may enhance profits through child labor, human trafficking, unrestrained pollution, dumping of toxic wastes, and zeroing out of tax liability. As a result, U.S. shareholders have enjoyed wealth aggregation at the expense of the rest of the world. Out of sight, out of mind.

Friedman argues that the sole social responsibility of business is to increase profits and maximize shareholder wealth. To those advocating for corporate social responsibility and sustainable investments, Friedman responds that investors should simply enjoy their outsized profits and then use the extra cash to achieve their social goals. Friedman’s account never considers the incidence of the costs associated with generating those profits, however. Those who bear the costs of extractive capitalism are rarely the ones who enjoy investor and corporate munificence. The inequities become even more pronounced when the profits enjoyed by U.S. investors are generated in other countries.

Fortunately, many U.S. and European investors and consumers recognize that the costs of externalized harms sometimes come back to haunt us. When we throw things away, there is no such place as “away.” A globalized food system means that we consume food grown on the very lands and drawn from the very waters we are poisoning. Migrants seeking refuge in the United States are often escaping exploitation, abuse, and environmental devastation wrought in the countries where U.S corporations have replicated and perfected the extractive economies first forged by colonialism. Corporate tax avoidance also shifts the tax burden from those who earn profits from property to those who pay taxes on compensation from labor. Furthermore, these actions may give rise to tort and regulatory risks that may have a more immediate effect on profitability. In selecting ESG investments, shareholders may also take an ethical stance, funding their retirement with something other than the surplus from others’ suffering. To make these choices, investors need more information about the environmental, labor, and governance profiles of the companies than currently available through securities filings.  Blackrock, Vanguard, and State Street have responded to this demand by using ESG rankings to score companies within their portfolios.

Chaim and Parchomovsky argue that to improve ESG, three changes should be made. First, the ratings agencies should require corporations to disclose their tax payments, which would allow the agencies to calculate their effective tax rate (average tax rate) by dividing their profits by their tax payments, as well as their Country-by-Country (CbC) reports. The Organisation for Economic Cooperation and Development (OECD) Base Erosion and Profit Shifting Action Plan, which 140 countries have begun to implement, provides for CbC reporting to the government, but not to the public. Second, they argue that tax compliance should be given greater weight in determining an ESG(T) corporate score. Third, they argue that the ESG ratings agencies should disclose the criteria and processes by which they make ratings determinations, information that is currently withheld as proprietary. They argue that “[i]f the rating agencies insist on withholding the rating criteria from the public, they should be ordered to disclose their criteria by regulation.”

Chaim’s and Parchomovsky’s demand for greater transparency is laudable. However, it’s unclear whether their proposed changes would have the desired effect. First, ESG ratings are voluntary. Corporations are unlikely to share their tax secrets voluntarily, lest they waive the attorney and accounting privileges of confidentiality, open themselves up to an IRS audit, or lose the competitive advantage they gain from tax avoidance. Furthermore, corporations may have low effective tax rates for a variety of reasons. Historically, the US has used tax credits to attract equity investments to fund the construction of affordable housing and the development of renewable energy resources. Corporations that are investing in the development of these quasi-public goods should be promoted, not sanctioned. Moreover, the regulatory impact of the ratings may already be limited, given that the only enforcement mechanism is exclusion from a portfolio or stock grouping.  Corporations performing a cost-benefit analysis might learn that the rewards of tax avoidance exceed those of inclusion in an ESG portfolio.

Second, the ratings agencies are diverse in the way they rank the same corporation. The various criteria sometimes conflict or offset one another and the overall result may be skewed by disparities in weighting. In the private environmental governance arena, following the creation of the Forest Stewardship Council and its voluntary regime to certify sustainably harvested wood, the timber industry created its own alternative regimes that were far more favorable to industry profits, the Sustainable Forestry Initiative (SFI) and Programme for the Endorsement of Forest Certification (PEFC). The multiplicity of agencies and ratings schema has diluted their regulatory power in the forestry industry. The same thing is likely occurring among ESG rating agencies.

Third, anti-ESG legislation being proposed at the state level has given the large asset managers pause in their push for corporations to submit to ESG ratings. Some states are barring their pension managers from investing in ESG portfolio funds and barring state contracts with corporations that submit to ESG scrutiny. Far from being regulators themselves, the big asset managers are simply riding the wave of investor demands.

Finally, Chaim’s and Parchomovsky’s proposal to use legislation to regulate ratings agencies loses track of the main reason investors have resorted to private governance in the first place. Private voluntary regulation is designed to fill the gaps that result when state and federal governments fail to regulate harmful externalities and correct market failures. If we are to achieve something through regulation, surely the legislation should be leveled directly at the harmful behavior. Otherwise, requiring public disclosure by the entities whose profits derive from such behaviors (rather than simply from agencies that rate them) would send a stronger and clearer market signal. For example, the publication of the Toxic Release Inventory in the mid-1980s has had important and beneficial market effects with respect to corporate environmental compliance. Public disclosure of tax information could have similar salubrious effects on the market.

Notwithstanding these matters, Chaim and Parchomovsky have raised an important issue in the field of corporate governance and one that should not be elided or overlooked. Tax avoidance has at its core the same economic motivations and rewards as regulatory exit. Tax avoidance also foments noncompliance and regulatory disfunction and undercuts public “governance for all,” which sits at the core of our political debates today.

Here’s the rest of this week’s SSRN Tax Roundup:

https://taxprof.typepad.com/taxprof_blog/2024/05/weekly-ssrn-tax-article-review-and-roundup-roberts-reviews-the-missing-t-in-esgby-chaim-parchomovsky.html

Scholarship, Tax, Tax Daily, Tax Scholarship, Tracey Roberts, Weekly SSRN Roundup, Weekly Tax Roundup | Permalink