Might High Taxes and Weak Shareholders Increase Real Investment?

Like everyone else in the economics blogging sphere, I have been impressed by the new Mason-Konczal project at the Roosevelt Institute. The headline argument, which was previewed by Mason at The New Inquiry a short time ago, is that the shareholder revolution has not delivered on its basic promise, but instead has put corporate managers under severe pressure to disgorge cash to shareholders rather than use it to make investments in production and jobs.

The crux of this argument, as I see it, is about how the surplus (in the Marxist sense) gets allocated. When shareholders have more power, Mason-Konczal maintain, firms are more likely to disgorge the surplus out to shareholders in the form of dividends and buybacks. When managers have more power, however, firms are more likely to put the surplus into actual investment.

This argument got me thinking of a related point about the top marginal tax rate that has been floating about since Piketty's book. The conventional take on having a high top rate is that it will reduce labor supply as high-earners refuse to work after a certain point because it's not worth it. But Piketty suggests that at least one effect of high top tax rates is that firms simply become less willing to pay executives as much. When 70% of a pay increase is going to be taxed away, a firm has a hard time justifying allocating more of its money towards executive pay, and will instead allocate it towards investment or maybe increasing pay lower down in the firm.

If we were to combine this top rate tax theory with the shareholder power theory of Mason and Konczal, four possibilities of how firms allocate surplus emerge.

1. Strong Shareholders, High Top Tax Rate

Under this power mix, there will be a heavy inclination to disgorge the surplus out to the shareholders. The executives have very little interest in competing for the surplus because so much of it will be taxed away.

2. Strong Shareholders, Low Top Tax Rate (What We Actually Have)

Under this power mix, the shareholders will fight hard to disgorge the surplus while executives will fight hard to have it directed towards their compensation. Accordingly, dividends and buybacks will increase at the same time as executive compensation increases. Redirecting the surplus into real investment will be the lowest under this regime.

3. Weak Shareholders, High Top Tax Rate (What We Used To Have)

Under this power mix, executives will have little incentive to fight for increased compensation. They will also face little pressure from shareholders to pay out the surplus as dividends. The combination of the high top tax rate and weak shareholders therefore causes the surplus to be bottled up in the firm. With nowhere else to put it, managers will end up using the surplus to reinvest, fund exploratory research and development that they get a kick out of, or perhaps pay their workers more.

4. Weak Shareholders, Low Top Tax Rate

Under this power mix, executives will fight hard to direct the surplus towards their compensation and shareholders will have little power to restrain them. The surplus will thus find itself in executive compensation more so than any of the other scenarios.

I am not saying this is for sure what happens and obviously things are altogether more complicated than this. But the idea that corporate governance and tax laws create power dynamics that affect the way firms allocate their surplus is one that should be taken seriously. After all, firms are small centrally-planned economies with owners that often have no control over day-to-day operations. Their weird nature leaves a lot of room for sociological forces and power relations to affect their actual functioning.

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