One of the awkward questions left exposed by the ebbing of the financial crisis is whether the “limited liability company,” a cornerstone of the world’s economic system for more than a century, played a part in causing and prolonging that crisis—and now needs urgent reform.
Of course, from one side that seems nonsense. The notion of limited liability, with its roots in Victorian times (or on some analysis, in ancient Rome), which means that a company and its owners have only limited exposure to any damaging consequences of its actions, underpins the economies of modern capitalist societies. It has made possible the globalisation of capital, and much of the spread of new products and techniques of production. How could we challenge it?
The retort is that the original bargain has broken down. In the beginning, the state granted companies limited liability in return for paying tax and observing other obligations. But it has become the privilege of power without responsibility. It clearly creates the chance for shareholders and senior directors to enjoy the upside from the venture, through rising share prices or big bonuses, while limiting their exposure in the event of failure or bankruptcy or extensive environmental damage. If you add to that the agility of many multinational companies in avoiding paying much tax at all, it looks like a bargain that has thoroughly unravelled.
The drawbacks of limited liability both helped cause the 2008 financial crisis, and are undermining the recovery, as well as the ability of national governments to raise the revenues they need. It is clear that reform is needed; the question is whether incremental steps will be enough, or whether we should consider something much more radical, in scrapping the bargain entirely.
Studies of the effects of corporation tax have tended to show that, in the end, it gets reflected in prices. Companies eventually pass the cost on to consumers, leaving themselves with the same profit margin after tax. Compared with value-added tax (VAT) or other sales taxes, it penalises successful, profitable companies in favour of the less successful, to the detriment of growth. Given all the drawbacks and distortions described here, there is a case for phasing it out in favour of VAT or sales taxes.
The roots of the principle of limited liability have been traced back to ancient Rome (see box p38) but in its modern form, it was formally devised in the 19th century, beginning in the United States, as companies sought to raise capital for the expansion of railroads and factories. It is, when you get down to it, an immense privilege; it allows owners (and senior directors) of the company to pursue profit through its commercial activity, while limiting their exposure to its losses or other damaging consequences of its actions. Adam Smith was concerned from the beginning about the skewed incentives it gave owners and directors. In today’s terminology, we say they have been given a “free option” to pursue those rewards.
In principle, in a free market, those dealing with limited liability companies are aware of this. They judge their risks accordingly, with “eyes wide open.” But as the free market system also suggests there is no such thing as a free lunch, we still need to ask who pays for this “free option” given to shareholders. The answer is ordinary taxpayers, or society in general in the case of environmental damage. The experience of the private sector over the past two decades hardly justifies the idealisation of free markets. People dealing with companies do not have full information, whatever the theory says.
The 2008 financial crisis exposed more of the serious weaknesses of limited liabilityThe 2008 financial crisis exposed more of the serious weaknesses of limited liability. Start with banks. The crisis showed that, under the existing regulatory regime, liabilities of international banks had to be accepted by the state in which they happened to be headquartered—that is, by the taxpayers of that country. The collapse of Iceland’s three international commercial banks in 2008 illustrated this point all too well, threatening to bankrupt a country of only 320,000 people. Alex Salmond, in making the case for Scottish independence, was severely discomfited at that point trying to explain how an independent Scotland could have bailed out Scottish banks (although he could reasonably have argued that the responsibility for big international banks needs to be accepted internationally, and that the spectacle of bank failures in tiny countries makes exactly this point.)
The situation we have now unfairly benefits companies, and hurts taxpayers in the societies in which they operate, in at least three ways.Yet these cases don’t point to a problem only with banks. They hint at the flaw in the entire system of limited liability. If taxpayers are likely to be the ultimate backstop, then they should be compensated for taking this risk. They should be paid a premium, if you like, for the insurance that they are effectively providing. This was indeed, the original deal when limited liability was devised; in exchange for that privilege, companies would pay corporate tax on their profits. By the 1860s, when limited liability was in place in Britain, the US and France, this deal had been explicitly codified.
Globalisation has helped erode this deal. The situation we have now unfairly benefits companies, and hurts taxpayers in the societies in which they operate, in at least three ways. The most obvious is that international firms pay less, often virtually no, tax (see box p39). This means that they pay the societies in which they make their profits almost nothing for the privilege of limited liability. This privilege, too, largely accrues to the rich, as shareholders typically have income and wealth well above average.
A second, less obvious point is that multinational firms gain a big advantage compared to smaller, domestic companies that have far fewer opportunities to shift income out of the tax collector’s reach. As smaller, domestic companies are likely to be the source of much invention—as well as providing the bulk of employment in most economies—this is damaging.
However, the third source of inequity may be the most damaging of the three, although it is the least visible, embedded deep in the forces shaping the world economy. It arises because the world currently has a glut of savings. You can see that from the way that interest rates in major currencies are staying so low, even though there is a dangerous run-up of debt compared to income (whether in the private sector or government, or both). Some claim that reflects monetary policies. But the relentless fall in inflation gives the lie to this—clear evidence that monetary policy is not too slack.
The key point is that if the world economy is to make a healthy recovery, it will need both more consumption (that is, less saving) and less dependence on debt. This elusive combination can be achieved only if consumers have a larger share of world income, enabling them to spend more from their income rather than from borrowing.
Where does limited liability affect this? You can look at it as a damaging incentive for companies to retain too much income. That is, when they make profits, they keep them, rather than investing them internally, making acquisitions, paying dividends to shareholders and pension funds or paying them to employees in wages. They keep hold of cash that, if it made its way to households by one route or another, would lead to more spending. In China, Japan and South Korea, retention of large swathes of corporate income, well beyond the needs of profitable investment, seems to reflect an ingrained culture.
If the world economy is to make a healthy recovery, it will need both more consumption (that is, less saving) and less dependence on debtBut in the west, retention of income is at least partly the result of companies building up cash in tax havens and being unable to take it out without incurring tax. For example, US net saving in 2013 was just over $400bn, 2.5 per cent of Gross Domestic Product. This $400bn was made up of $670bn in retained corporate profits, $600bn of personal saving, and minus $870bn of public-sector dis-saving. And these figures exclude the profits nominally earned abroad in subsidiaries of US companies, retained there to avoid a tax charge, and therefore not repatriated and distributed.
The shortcomings of limited liability have been there for years. The new element is its role in causing the financial crisis and in undermining the recovery. In the run-up to the crisis, it gave bankers distorted incentives to take on risk. Not that many realised they were delusional; most sincerely believed nothing could go wrong. But by giving them the reward up front, in pay and huge bonuses, well before actual returns had materialised, limited liability contributed mightily to the carnival of folly.
The savings glut contributed to the build up of too much debt in the deficit countries, the US, United Kingdom, Ireland, Italy, Spain, Greece and Portugal. Since the crisis, it has also contributed to the feebleness of the recovery, where lack of demand is a central problem. Estimates of the damage vary, but they are all large. The International Monetary Fund reckons that world GDP in 2014 was $107 trillion, measuring all countries at prices comparable to the US, with $46 trillion in advanced economies and $61 trillion in emerging markets. Its estimate of the slack in the advanced economies is 2.5 per cent, implying a current loss of income, compared to potential, of $1.2 trillion. This is probably the lowest estimate of the current annual cost of inadequate demand.
But if you use a different method—projecting the growth rates before the 2008 crisis, and seeing how far the actual outcome now has fallen short—you end up with an annual GDP deficiency of more than 7 per cent. And these calculations are for advanced economies only. On this second method, the world economy overall is “missing” 6 per cent, or $6.4 trillion. Of that, $3 trillion would be in developing countries, and $3.4 trillion in advanced ones, nearly three times the loss estimated above.
This calculation has immense implications. If inadequate demand is responsible for an annual loss of world income measured in trillions of dollars, and if companies’ propensity to hold on to their profits is one cause of it, then we need urgent reforms to the incentives that cause companies to do this.
However, for all these drawbacks of the limited liability model, is it practical to abolish it? Unfortunately, no. A radical proposal from Laurence Kotlikoff, a professor at Boston University, for the reform of banking goes a long way to explaining why this is so.
Kotlikoff’s idea, in outline, was to turn “banks” into mutual funds, with what are now depositors becoming shareholders in a loan-holding company. This would, he argued, ensure that losses from bad loans (and other mistaken activities) would fall on the savers that financed them, not the government. In effect, it would be banking without limited liability: loans not repaid would simply cost depositors part of their savings.
A moment’s thought reveals the snag in this scheme, however. People depositing their money in a bank don’t regard themselves as taking on this kind of risk; they want assurance that their deposit is safe. And in a more general sense, getting rid of limited liability would cause a huge contraction of commercial activity, dwarfing the problems of a weak recovery that we already have. Indeed, the whole network of financial markets and international financial relations depends on limited liability. There is no going back on that. Like the bank depositors referred to above, investors everywhere depend on globalised ownership patterns that have limited liability “baked in” to their structure and behaviour.
So what could be done? The natural way forward is incremental. One suggestion has been to crack down on corporate tax avoidance, such as companies’ ability to shift profits to jurisdictions with low tax rates. David Cameron made this a centrepiece of the UK’s presidency of the G8 in 2013, and he has had some limited success in prompting others to join in. Tax havens are gradually lifting some of their veil of privacy. The US is best placed to take the lead on this.
But it would be wrong to expect this to go far. For a start, the US Supreme Court ruled in 2010 (in Citizens United vs the Federal Election Commission) that no restraint can be placed on corporate contributions to election expenses. Those are now huge and mounting alarmingly. With many members of Congress dependent on such funding, it would be naive to expect Congress to pass tough curbs on corporate tax avoidance. While there is more appetite in parts of the European Union for this quest, the passion for rooting out tax avoidance may have been muted by the decision to install Jean-Claude Juncker, formerly Prime Minister of Luxembourg for 18 years, as the President of the European Commission. Challenged last year on whether Luxembourg had built its wealth out of its appeal as a regime of very low taxes, he said that companies that benefited from rulings offering very low or no taxes were taking advantage of “the interaction between divergent national” laws, which was not Luxembourg’s fault. If those differences in tax regimes between countries were “leading to a situation of non-taxation, then I would regret that,” he added.
Our alternatives boil down to two approaches. The first is incremental—trying nonetheless on various fronts to improve tax collection. The second is radical: accepting that corporation tax itself is a lost cause. These are not mutually exclusive, as individual countries may adopt different approaches—corporation tax is unlikely to be the vehicle by which world government ever arrived.
The incremental approach is not hopeless, even if success will be limited. It must start with much tougher enforcement of proper transfer pricing—that is, working out which profits a company should be deemed to have made in each country. That task will have to start with national governments—no doubt led by those countries losing most at the moment. It should, though, be a responsibility of all. However, greater awareness of the scale of the damage, followed by more cooperation, ought to stiffen the backbones of those governments daunted by taking on multinational companies. The US has some clout to insist on curbing abuses in both countries like Switzerland and Ireland (where the corporation tax rates are currently 18 per cent and 12.5 per cent respectively), and in established havens such as the Cayman Islands. If it does so, others could follow in its wake. It does not require world government for countries to cooperate in reducing artificial tax shelters. But it is hard for some to forge ahead alone, or they will lose out while others benefit.
There are a few other possible steps. To discourage banks from taking undue risks, it would be reasonable to insist that the capital pertaining to any subsidiary’s type and scale of business should be lodged in that subsidiary. The relevant profit would necessarily occur there and be taxable in that country—an added benefit from the reform of bank regulation which is needed anyway.
Another might be to draw on the US concept of a minimum tax, and try to apply it to companies. This strand of the US tax code applies to people in principle liable for US tax, who would in practice otherwise largely or entirely avoid it. But such a tax would almost inevitably (for companies) look a lot like a turnover or VAT. And that brings us to the second alternative—accepting that corporation tax is a lost cause because it is impossible to enforce well, and gives international companies an unfair and undesirable advantage over domestic ones.
The logical conclusion is to phase it out. In its place, we could have a higher VAT, that is, a tax paid by consumers on the price of goods and services. This might seem a significant disadvantage, having started with the argument that the old bargain has broken down. Yet consider the studies suggesting that in the long run, corporation tax does not affect companies’ return on capital after tax—that is, how much profit they make on their capital after they have settled their tax bills. Instead, it is eventually passed on to consumers in the price of goods and services (although as already discussed, international firms are better at wriggling away from paying much tax at all).
This reform would remove the bias in favour of international companies. Nor would there be an incentive to hoard cash in tax havens. We would, of course, be left with one central disadvantage—that shareholders would still not be paying anything for the immense privilege of limited liability. It is true, too, that the asymmetrical incentives embedded in the notion of limited liability would still be there. But the bargain that was originally conceived has in any case been vitiated by companies skill in passing the tax on to consumers in higher prices. Scrapping corporation tax would acknowledge that the bargain has broken down and the tax has failed. It would rid the world of the other malignant effects both of the tax and of the efforts to avoid it. That would, to say the least, be of immense benefit.
