Does corporate lobbying benefit society?September 28, 2012: 11:09 AM ET
Lobbying costs money, which hurts investors. It often leads to new regulations, which cost society even more. Can regulation be One Size Fits All?
By Moshe Silver, Hedgeye
FORTUNE -- Henry Friedman, of UCLA, and Mirko Heinle, of the Wharton School, have co-authored a paper titled "The Merits Of One-Size-Fits-All Regulation." They argue that a uniform approach to securities regulation yields greater societal benefit, better investor outcomes, and more market stability than attempts to tailor regulatory approaches to fit individual firms or sub-sectors in the marketplace.
The focus is on the social cost of corporate lobbying, an activity which creates high costs for firms, driving down investor returns, and political liability for regulators who attempt to balance their response to the firms with their investor protection mandate. This not only provides an unsatisfactory outcome for both constituencies, it also spawns more complex regulatory responses, making the regulatory burden more costly to society.
The authors' premise is that, in the absence of effective regulation, managers are motivated to divert assets away from shareholders. The more a manager perceives regulation as likely to be effective, the less likely the manager will be to improperly divert firm revenues or resources from investors, and from society at large.
As a broad example, companies that lobby successfully for changes to the tax code deprive the society of revenues. The added stream of income to the firm is generally moved into the corporate accounts in a way that deprives shareholders of part of the windfall, and an argument can be made that at least some of that tax money is properly due to the society, but is unfairly denied because of the effects of lobbying. President Obama said "you didn't build that," expressing the notion that a successful corporate venture arises from the fecund soil of America's infrastructure, which is not merely electricity, sewers and railroads, but also the legislative and regulatory environment that stimulates creativity and supports free enterprise. Whether Obama misspoke – meaning to say "you succeed in America thanks to all that America brings to your undertaking" – or whether he was articulating a near-socialist view of free enterprise as "belonging to the people," the fact remains that America has an unparalleled history of fostering creativity and enterprise, and many successful businesses grow here that could not flourish anywhere else. Lobbying can create incentives for new undertakings whose complexities are not properly reflected in the tax code, but it increasingly creates an asymmetric situation where firms deprive the nation of just payments.
The massive offshoring of corporate revenues highlights this problem, as does candidate Mitt Romney's latest release of his tax returns, showing that he paid taxes at a 14% rate. Our argument is not with a smart business executive legally minimizing his tax liability, but with a tax code that unreasonably and asymmetrically favors the wealthiest, even if they did not create that wealth themselves. While we do not have statistics at hand, but we daresay the taxpayers among Romney's "47% of Americans" pay taxes at a significantly higher rate than he does. The cynicism of campaign messaging has the Obama team castigating their opponent over how little he paid in taxes – in effect taking Romney to task for obeying the law – while not acknowledging that the tax code is a hopeless mess for which Republicans and Democrats share the blame.
We see articles daily quoting polls that indicate the majority of Americans believe the rich should pay a substantially higher percentage of their income in taxes. Yet the "one percent" retain a grip on Washington as legislators fall over one another to be the first to offer greater tax breaks – the result of the simple fact that the poor can not hire lobbyists.
We constantly hear that small businesses create jobs, and therefore they must be given tax breaks. This is an almost true statement: new small businesses create jobs. In the current downturn, existing small businesses have retrenched significantly – consider the recent announcement by Bank of America that 16,000 jobs will be cut, then ratchet that down several orders of magnitude to the neighborhood dry cleaner or plumbing supply business. Across the nation, businesses have downsized from twenty employees to 16, from 8 to five, have laid off anyone who is not a family member, all in a desperate bid to survive the endless downturn. Each job cut from a small business represents a huge percentage reduction in that firm's employment, and a family in trouble. Yet tax cuts that should incentivize new businesses are asymmetrically applied, so that the CEO of Bain Capital can get the same break on his existing wealth as a start-up family-owned tool and die shop on its meager first-year revenues.
Under "perfect regulation," the paper says "firms' announced performances are perfectly informative about the actual outcomes," while with no regulation, "firms will always announce bad performance" in order to divert revenues from shareholders to managers and to minimize tax payments. Increases in regulation raise the costs to firms, but the authors posit this is fully offset by the reduction in resources available for lobbying. The higher cost of regulation leaves fewer resources to divert away from shareholders, an outcome which, say the authors, leaves no room for additional lobbying under a uniform regulatory regime.
The paper also explores the broader market information effect. Under uniform regulation, information made available by one firm allows investors "to update their beliefs about payments from another firm, leading to a change in the security price of this second firm." In other words, under uniform regulation, firm information is generalizable across firms – even in different industries, since accounting and tax rules are the same for all participants – giving markets greater overall transparency.
The paper posits lower capital constraints under uniform regulation, as firms have less incentive to lobby, as well as less opportunity to divert funds. Thus, they conclude that "one-size-fits-all" regulation frees up more capital to fund projects with higher capital requirements or lower expected payoffs. We read this as implying it also makes it more attractive to pursue riskier investments, as firms will have more cash available for business uses.
Exceptions arise under conditions where uniform regulation leads to market failure. Under unequal regulation, there will be firms that receive funding, or where internal resources are freed up, while other firms go out of business. The authors say that, when all projects are projected at positive net present values, the unequal regulatory model can occasionally create greater social benefit, by permitting at least some firms to succeed.
The authors conclude that one-size-fits-all regulation is superior to individually tailored oversight. Regulators have a political problem of ensuring returns to investors, and the uniform approach does this most consistently while also providing optimal market transparency. Firms faced with the decision to launch lobbying efforts are faced with a "free-rider problem:" successful lobbying by one firm gives their competitors the same breaks, dampening the benefit to the firm that undertakes the expense. In the present case, this "problem" increases social benefit, as it reduces the incentive for firms to spend resources on lobbying. Lobbying, say the authors, is a "socially wasteful" activity, a sentiment only a politician in need of campaign funds could dispute.
Moshe Silver is the Chief Compliance Officer at Hedgeye Risk Management and author of the new book, Fixing A Broken Wall Street --- How It All When Wrong and What To Do Next, available on Amazon Kindle.