Christian Debt Recovery

Debt Capital Markets Jobs Singapore

February 4th, 2010 |

Author: Gavin

Evolution Of Government Regulations And Its Impact On Investor Protection And Innovation! (Part 2)

In segment one (1) of this article, I discussed the genesis and chronology of government regulations and the mixed blessings associated with its impact on investors-consumers protection and innovation. In segment two(2) of this article, I would like to discuss some conflicts of interest that exist between government and investor-consumer proclivities and why corporate tax reduction may not always be the answer to creating jobs or stimulating the investment climate.

Shareholders interests and Government regulations impact on company investment

Shareholders for medium and large sized corporations do influence corporate governance in spite of their limited liability. They are interested in pursuits of projects that will increase their earnings and wealth. Consequently, management of companies may be under obligations to pursue projects in a foreign country if cost is low compared to the cost of doing business in the U.S. That means no matter the magnitude of the tax breaks or corporate tax reduction, if the cost of doing business at home is high compared to the cost of doing business in foreign land such as India, China, Brazil or South Africa, American firms will continue to outsource jobs. In fact, shareholders may be more interested in management outsourcing jobs if that will increase their returns and equity as against a cut in corporate tax which will give marginal returns domestically. Unfortunately, there is the possibility of unsystematic risk (for example political interference, social unrest, government take over among others) which could increase the cost of doing business in foreign lands.

Analysts will bear with me that corporate tax has some degree of direct proportionality with cost of capital which is the determinant for investor’s rate of return ceteris paribus. Nevertheless, financial mathematics hypothesizes the inverse relationship between cost of capital and debt ratio for decreased corporate tax under some given conditions. The hypotheses is that cost of capital decreases with increased debt ratio for decreased corporate tax until a point where a firm’s ratio of debt to capital becomes so huge that the tendency for default or bankruptcy is highly probable. In that situation, any significant reduction in corporate tax may not reduce the cost of capital. The simple reason being that the interest on debt (which is tax deductible) becomes large and any level of corporate tax reduction by government may not reduce company cost of capital. Ultimately, large companies in America with high debt ratios stemming from the recession may not benefit much from the government’s corporate tax reduction or tax breaks because of the inherent high cost of capital and an expected increase rate of return. In fact there is a trade-off between the rate of return and the cost of capital for these companies. On a positive note, companies with smaller debt ratio may benefit as cost of capital will reduce even with increased debt ratio for decrease corporate tax. For these reasons, the government recent announcement to give tax breaks or incentives may favor companies with favorable cost of capital to debt ratio. What is not clear now is whether such situations will result in massive job creation that will reduce the unemployment rate drastically (halving it from the current rate of 9.7% to about 4.7%).

From another dimension, the situation again becomes precarious because of corporate tax differential between United States and other countries. United States currently has comparatively high corporate tax of 39% which makes it one of the western countries with a higher corporate tax. The following are some corporate tax statistics: China has had to cut its corporate income tax from 33% to 25% in the last few years. South Africa also did cut its already low corporate tax from 12.5% to 10% to further stimulate investment inflow. Hong Kong did cut its corporate tax from 17.5% to 16.5% in order to remain competitive for Direct Foreign Investment inflow in Asia. In 2008, Germany cuts its corporate tax by a whooping 8.7% (from 38.9% to 30.18%). The comparatively low corporate tax of these countries puts United States in a disadvantage position when the positive effect of corporate tax reduction on business increase is considered ceteris paribus. United States may have advantage with regards to the ease of doing business but high corporate tax differential may knock that off.

Economics of Corporate Tax with respect to ease and cost of doing business

Now, considering the economics of corporate tax contrast and its impact on the ease of doing business and the cost of doing business, there is much at stake. According to the World Bank Ease of Doing Business Index, a country’s ranking with regards to the ease of doing business is a quantitative measure of its business environment in terms of business friendliness, simplicity of its regulations and also protection of property rights. Seriously, there is a paradox here when the ease of doing business is compared with the cost of doing business. I must emphasize that the ease of doing business and cost of doing business are not the same for a given business environment. From the definition of ease of doing business, it presupposes that the measure is a partial quantification of systematic risk (that is risk due to interest rate, inflation, exchange rate, taxes e.t.c) and unsystematic risk (that is risk due to terrorism, takeover, unrest e.t.c). This means the measure is devoid of the impact of macroeconomic factors (namely interest rate, inflation, exchange rate, economic conditions e.t.c) and security (predominantly terrorism threat). Cost of doing business provides a broader measure of risk (systematic and unsystematic) and that is more non-trivial. Ironically, it is possible for a country to be ranked very well on the ease of doing business scale but the cost of doing business may produce a retardation effect on the progress of its business environment.

Most countries that high ranked on the ease of doing business index rating may be low ranked on the cost of doing business index if it were to exist. Investors will not only consider the ease of doing business but also the cost of doing business in their investment proclivities. United States is currently ranked third on the ease of doing business after New Zealand (2nd) and Singapore (1st). And does it mean that the U.S will be ranked well with regards to the cost of doing business so as to attract more investors to create more jobs? Certainly, much will depend on whether the Fed can maintain the current macro-stability of low inflation and interest rates, low taxes or whether it will be compelled to increase taxes and interest rates in the coming months so as to prevent the economy from climbing the inflation hill. As a matter of fact, the momentum for influx of investments does not depend only on giving tax breaks or incentives but also on maintenance of macro-stability and security in the nation. Remember, terrorism poses an unsystematic risk and threat which increases the cost of doing business. What a country needs to promote a sustainable prosperity are policies that are not only geared towards the ease of doing business but also the cost of doing business. Reconciling the ease of doing business and the cost of doing business provides conducive environment for attraction and retainment of investors. Ultimately, reconciliation of the ease of doing business and the cost of doing business should be the objective of every government. That is what the world and the United States needs.

Conclusion

Government regulation or policies indeed has a ripple effect on investor protection and innovations. It is also a double-edged sword because it provides some form of protection to the market in terms of unscrupulous and unethical transactions and on the other hand infringes on freedom in the market. These regulations have also led to the emergence of financial innovative platforms such as Eurobond, Assets-Backed Security Management and the SOX Act. Unfortunately, In spite of these positive developments, government regulations regarding corporate tax could have a marginal effect when shareholders interest is taken into consideration. Additionally, the effect becomes more complex and precarious when the ease of doing business and the cost of doing business are also incorporated in the analysis.

Author: Charles Horace Ampong [MSc(Eng), MBA]

Blog: http://www.charliepee.blogspot.com/

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