Social Priorities, Institutional Quality, and Investment

Authors

Amar Gande, Southern Methodist University (SMU) - Finance DepartmentFollow
Kose John, New York University (NYU) - Leonard N. Stern School of BusinessFollow
Guanmin Liao, Renmin University of China - School of BusinessFollow
Lemma W. Senbet, University of Maryland - Robert H. Smith School of BusinessFollow
Xiaoyun Yu, Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); European Corporate Governance Institute (ECGI); National University of Singapore (NUS) - Asian Bureau of Finance and Economic Research (ABFER); China Academy of Financial Research (CAFR)Follow

Publication Date

3-17-2024

Abstract

We examine the role of corporate taxation and institutional quality in aligning privately optimal investments with those that are socially optimal. We develop a theoretical framework to characterize how limited liability and non-monetized social benefits give rise to corporate investments to deviate from the socially optimal levels. Our model predicts that, while taxes bridge the wedge between the private objectives of firms and that of the society at large, the level of corporate tax required to achieve social optimality is attenuated in the presence of high-quality institutions. We provide empirical evidence in support of these predictions. Exploiting the staggered designation of strategically important industries by the Chinese government in its Five-Year Plans (FYPs) and leveraging a regulatory event that affected the corporate tax rate, we show that the government lowers taxes to spur corporate investment to a lesser extent if there is a strong local legal regime or a well-developed market-based system. The results are driven by the FYP industries which adhere to the social priorities that generate larger non-monetized benefits. Both corporate taxation and institutional quality affect the likelihood of firms expanding into FYP industries, boosting environmental investments, and transitioning to non-polluting sectors. Importantly, the investment misalignment decreases in these FYP industries, as previously underinvested (overinvested) firms speed up (slow down) their investment to a greater extent compared to peer firms in the same industry. Our findings highlight taxes as an alternative selfenforcing implicit contract in aligning private and public interests while also demonstrating the moderating effects of quality institutions.

Document Type

Article

Keywords

social optimality, taxation, investment, legal systems, externalities, environmental protection, green investment, institutions

Disciplines

Finance

DOI

10.2139/ssrn.4762358

Source

SMU Cox: Finance (Topic)

Language

English