Limited Liability and the Known Unknown

Limited liability is a double-edged sword. On the one hand, limited liability 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 externalization of losses to the public. Limited liability cannot eliminate risk. Limited liability can only transfer the adverse consequences of risk away from those who effectively decide how much risk to take and, in so doing, encourage greater risk taking and externalization of losses.

Although mechanisms such as regulation, mandatory insurance, and minimum capital requirements can help mitigate the externalization problem, risks must be well-understood by policymakers for these mechanisms to function properly. When risks are unknown or unknowable, all of the extant policy levers for addressing risk externalization are incomplete, have potentially undesirable side effects when applied broadly, or perform poorly.

Unknown risks often have a life cycle. In the early stages, risks begin to reveal themselves to those most intimately familiar with an activity. Near misses proliferate and relatively small private losses accumulate, but the magnitude of any loss externalization is too small to capture the attention of the public or policymakers.

Private businesses and their sophisticated investors will typically have better information about industry-specific risks than policymakers. Private market actors who are most attuned to these risks often withhold this information or contest scientific knowledge when public revelation could lead to costly regulations or liability. Over time, as economic activity increases and the cumulative probability of negative outcomes rises, externalized losses grow.

Today we take it for granted that industrial pollution is a health hazard. Many air pollutants cause severe and costly respiratory and cardiovascular problems for individuals who neither earn their livelihoods producing industrial goods nor make use of the responsible products. Pollution is the classic example of an externality. But while industrialization began in Britain in the late 18^th century, links between air pollution and health only began to be researched in the United States in the 1950s after particularly bad incidents of severe pollution in the 1940s and 1950s commanded attention. Air pollution was not regulated at the federal level until the 1970s. (See here and here). Recent research continues to identify new links between health problems and man-made sources of pollution.

It seems likely that individuals directly involved in industry, with greater exposure and greater expertise, would have been cognizant of health risks sooner than the public or policymakers. For example, many tobacco company scientists believed as early as the 1950s that smoking was harmful to health. Yet the tobacco industry publicly maintained as late as 1999 that there was no scientific proof that tobacco causes health problems.

What are the great underappreciated risks of today? Where should limited regulatory resources be focused? We do not know. We should attempt to find out sooner rather than later.

The fact that the precise nature and level of residual risks that might be externalized remains unknown does not mean that nothing can be done to address them. They are known unknowns: we know that these risks exist, that they are greater than zero, and that industry participants often understand them better than regulators or the general public. Even a modest countervailing policy could be an improvement over the status quo.

In Limited Liability and the Known Unknown, I argue that firms that desire limited liability for their investors should have to pay for this protection. When limited liability comes at a cost, those who believe that they are engaged in more risky activities will be more likely to opt into limited liability, while those who believe their actions are comparatively benign will be more likely to forgo it.

If limited liability were priced uniformly relative to scale, then variation in the proportion of similar firms that opted into limited liability would reveal information about private assessments of the relative riskiness of various activities. Regulators could use this information to more closely study and eventually regulate or insure high-risk activities. Regulators could also iteratively reprice limited liability in subsequent periods, charging different prices to different risk-pooled groups of firms based on information revealed in the previous period.

Thus, a risk-uniform group in which relatively few or no firms opted into limited liability in the previous period—thereby signaling relatively low risk for the group—would see the price of limited liability fall in the next period. Because the benefits 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 the group (i.e., competitors within an industry), firms will be unlikely to strategically mislead policymakers through their elections.

The iterative approach to taxing limited liability outlined above requires that similar firms be grouped together. To help form larger groups, it is helpful to scale limited liability tax rates by firms of different size to arrive at different tax liabilities. If two firms are engaged in activities that are similarly risky, but one firm’s activities are more extensive, the more firm engaged in more extensive activities should pay more in tax.

To determine a firm’s activity level, and therefore the appropriate tax base, the greater of revenue or expenditures should be used. Revenue has many advantages as a measure of size and economic activity. Revenue reflects the value that the market is willing to pay for the total output of a firm on an annual basis. Unlike profit and income, revenue does not depend on capital structure—regardless of the mix of debt or equity, revenue remains constant. Revenue is more difficult than income to alter through accounting manipulations.

However, firms will only have revenue if they have customers. Firms might undertake risky investment activities in early stages when they have no revenue. For such firms, cost may be a better measure of size of economic activity. Therefore, the greater of revenue or cost may be the best available tax base.

When limited liability prices are set such that similar firms are close to equally likely to choose limited liability or forgo it, we can infer that the cost of limited liability is priced roughly at its value. At this point, differences in the price of limited liability for different categories of firms would be a good indicator of differences in residual risk that was known or suspected by industry participants, but unknown to regulators or the public.

Charging firms for limited liability will lead private firms to sort themselves by riskiness and reveal information to policymakers. Policymakers will then be able to focus their attention on the industries that have collectively self-identified as high risk and develop more finely tailored regulatory responses. By helping to reveal private information and focus regulators’ attention, a limited liability tax could accelerate the pace at which policymakers learn and therefore the pace at which regulations improve.

The limited liability tax is more efficient than taxes that fall equally on activities regardless of their balance of positive and negative externalities. Any negative impact of a limited liability tax on economic growth or innovation could be offset with increases in public investment or reductions in other, less efficient taxes.

The complete article is available here.