Limited Liability and the Known Unknown

by Michael Simkovic

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Abstract

Limited liability is a double-edged sword. On the one hand, limited lia-bility may help overcome investors’ risk aversion and facilitate capital formation and economic growth. On the other hand, limited liability is widely believed to contribute to excessive risk-taking and externaliza-tion of losses to the public. The externalization problem can be mitigated imperfectly through existing mechanisms such as regulation, mandatory insurance, and minimum capital requirements. These mechanisms would be more effective if information asymmetries between industry and poli-cymakers were reduced. Private businesses typically have better infor-mation about industry-specific risks than policymakers.

A charge for limited liability entities—resembling a corporate income tax but calibrated to risk levels—could have two salutary effects. First, a well-calibrated limited liability tax could help compensate the public fisc for risks and reduce externalization. Second, a limited liability tax could force private industry actors to reveal information to policymakers and regulators, thereby dynamically improving the public response to externalization risk.

Charging firms for limited liability at initially similar rates will lead relatively low-risk firms to forgo limited liability, while relatively high-risk firms will pay for limited liability. Policymakers will then be able to focus on the industries whose firms have self-identified as high risk, and thus develop more finely tailored regulatory responses. Because the ben-efits of making the proper election are fully internalized by individual firms, whereas the costs of future regulation or limited liability tax changes will be borne collectively by industries, firms will be unlikely to strategically mislead policymakers in electing limited or unlimited lia-bility. By helping to reveal private information and focus regulators’ at-tention, a limited liability tax could accelerate the pace at which poli-cymakers learn, and therefore, the pace at which regulations improve.

Limited Liability and the Known Unknown

by Michael Simkovic

Click here for a PDF file of this article

Abstract

Limited liability is a double-edged sword. On the one hand, limited lia-bility may help overcome investors’ risk aversion and facilitate capital formation and economic growth. On the other hand, limited liability is widely believed to contribute to excessive risk-taking and externaliza-tion of losses to the public. The externalization problem can be mitigated imperfectly through existing mechanisms such as regulation, mandatory insurance, and minimum capital requirements. These mechanisms would be more effective if information asymmetries between industry and poli-cymakers were reduced. Private businesses typically have better infor-mation about industry-specific risks than policymakers.

A charge for limited liability entities—resembling a corporate income tax but calibrated to risk levels—could have two salutary effects. First, a well-calibrated limited liability tax could help compensate the public fisc for risks and reduce externalization. Second, a limited liability tax could force private industry actors to reveal information to policymakers and regulators, thereby dynamically improving the public response to externalization risk.

Charging firms for limited liability at initially similar rates will lead relatively low-risk firms to forgo limited liability, while relatively high-risk firms will pay for limited liability. Policymakers will then be able to focus on the industries whose firms have self-identified as high risk, and thus develop more finely tailored regulatory responses. Because the ben-efits of making the proper election are fully internalized by individual firms, whereas the costs of future regulation or limited liability tax changes will be borne collectively by industries, firms will be unlikely to strategically mislead policymakers in electing limited or unlimited lia-bility. By helping to reveal private information and focus regulators’ at-tention, a limited liability tax could accelerate the pace at which poli-cymakers learn, and therefore, the pace at which regulations improve.