FM Washington

by Toronto Public Library Special Collections

Five Scenarios Depicting Government Policies As a Two-Edged Sword

In that article, I also elucidated on the hidden disparity between international trade and national security, nationalization and de-nationalization. In this segment (part 2) of the article, I would like to discuss the scenario regarding the impact of government policies on investor protection and innovation as a double-edged sword. Also in this segment investor protection and consumer protection will be contrasted with innovation. Other issues to be discussed are the effect of corporate tax reduction and why corporate tax reduction may not be the solution for investment stimulation in a country. The following provides the deliberations on this scenario and perspectives.

Scenario 3: Investors and Consumer Protection Vrs Innovation - Most analysts will agree with me that technological innovation in the financial sector can be impaired or enhanced by government regulations. In my article titled “World Financial Systems in Limbo- What to expect”, I expatiated on this issue and how it is affecting the world economy. I will not want to go back to that. However, I would like to discuss three other notable cases of financial innovation that came about because of government policies. They are the emergence of the Eurobond, Asset-backed securities and the Sarbanes Oxley Act of 2002 (SOX). The third case which is the SOX Act could not be classified purely as an innovation but it emergence brought sanity into the accounting besides adding transparency.

Now, let’s consider the facts of the issues. The interest equalization tax which was instituted by the United States government in 1963 to dissuade U.S investors from investing in foreign securities led to the creation of the Eurobond market. Here, American investors had no option but to invest in these bonds and this caused the bond to gain popularity stimulating other governments and institutions to trade in this market. Strangely, in spite of the default risk associated with the Eurobond and inappropriate documentation governing its transactions, Eurobond market has become a source of financing for governments, banks, global investors, underwriters, traders among others. So, it can be deciphered here that government regulation led to the emergence of this bond which is a sort of financial innovation.

Another causal effect of government regulation in financial innovation is the creation of the risk management tool called Asset-backed Security management. It encompasses the securitization of some underlying assets of banks making it possible for banks to have clean balance sheets as the risk associated with their bad assets can be transferred to a third party in return for cash. For example payments for underlying assets such as mortgage loans, auto loans, and credit cards e.t.c as they become bad debts are sold to a third party by the bank in exchange for cash. In this way, the risk is transferred to the third party who works to liquidate such illiquid assets and use that to pay the bank. Having attained clean balance sheets, banks are then able to invest in new assets and loans. This concept of asset-backed security management was officially instituted by the United States Security Exchange Commission (SEC) on January 18, 2005. It was also the presence of this concept that paves the way for the U.S government in 2008 to buy all the bank bad debts and save them from collapse. As mater of fact, asset-backed security management regulation is a mixed blessing. On one hand, it has provided a debt cleansing insurance methodology for banks but on the other hand it has put tax-payers money at risk indirectly affecting the deficit. Remember the financial input from the government was predominantly the tax payer’s money.

Next on the list of government regulations is the Sarbanes Oxley Act of 2002 (SOX) and the Corporate Fraud Task Force which was instituted by SEC to bring sanity, ethicalness in the sector and obviate corporate accounting scandals inadvertently reinforcing the financial accounting sector. As is widely known, the Act was of three objectives; First, to increase accuracy and transparency in Financial Accounting reporting. Second, to buttress corporate or management accountability and probity in the sector. Third, to promote independent auditing procedures so as to curtail fraudulent reporting, conspiracy and deception. Again, though this Act has no direct correlation with innovation yet it reinforced and transformed the accounting sector setting the pace for ethical creativity in the sector. In fact, the presence of this Act has boosted transparency, accountability and probity in the accounting sector in the United States. Interestingly, opponents of this Act argue that this regulation has made the U.S less competitive in terms of financial resource attraction from global investors because of some stringent components of this Act driving away investors. They also contend that the country’s share of international Initial Public Offerings (IPOs) has gone down from 50% in 2000 to single digits recently because of this Act. They predict the country will gradually loose its competitive edge in the financial market and that Wall Street is negatively impacted by this regulation. No matter the sentiments of opponents, one thing is needful and that is investors must be protected. The Act offers this protection to some degree even though complete protection is impossible. For example investors can be protected from fraud but they cannot be insulated from huge bonuses and other immense fringe benefits given to CEOs of financial institutions and Wall Street. Also, complete protection is not desirable in today’s economy for two (2) apparent reasons: First, it can inhibit innovation with regards to the development of human capital in a firm. Second, there is an inherent increased cost of regulation. In totality the manager’s ability to be innovative will be impaired and also the government will incur high cost due to the running of extensive stringent corporate governance regulations. This also presents another scenario of the association between financial capital and human capital. Financial capital should be complemented by human capital for profitability of a firm. It is the human capital that manages the financial capital to ensure profitability.

In my opinion, every regulation or policy (fiscal or monetary) must be assessed from a cost-benefit perspective. A categorical assessment of the regulation will help in its classification as being under-regulation, over-regulation with regards to its expected impact on the market. That means advocates and opponents of the SOX Act must assess it from a cost-benefit analysis. It is undisputable that the presence of similar regulations prevailing in the United States has brought the products and operations of the Auto makers GM, Toyota and the rest under the microscope. Toyota has been scolded by congress for the massive recall of over $ 8 million defective products worldwide and misleading information to the public about these products in spite of thousands of complaints. Obviously, the company faces tough times ahead in terms of regaining confidence of its customers and maintaining its competitive edge in the Auto industry.

Regrettably, despite the presence of the SOX Act and other financial regulations, it is absurd that huge bonuses were declared recently for CEOs of some banks and institutions. The move actually incurred the displeasure of the government and most Americans as well. In fact, this revealed the limitations of the SOX Act and the existing financial regulations and set the pace for future revision of them to take care of such recurring contingencies. Again, it provides some justification for the push by the current administration with regards to the augmentation and overhauling of the existing financial regulations. As a matter of fact, regulations that will seek for reinforcement of accountability, probity and forestall unethical gestures such as huge unwarranted bonuses in the financial sector whilst at the same time promoting creativity or innovation in the sector is commendable.

Also, currently in the pipeline is the issue of government policy of tax breaks or incentives for companies that employ Americans or companies that do not outsource jobs. The dipolar nature of tax breaks suggests tax increases for firms that outsource jobs and tax decreases for companies that do not. Judiciously, giving tax breaks to some employers and denying others is obviously an incentive to increasing investment inflow and reducing outflows. Again, a reduction in corporate tax can stimulate investment and job growth in the green sector including but not limited to the renewable energy sector, biotechnology and healthcare. However, the issue becomes precarious when such tax breaks or incentives are predominantly corporate tax oriented. There are two issues that of concern here namely

• The influence of shareholders interest on companies as against stakeholders, and

• The economics of corporate tax reduction from the dimensions of ease of doing business and cost of doing business .

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 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. 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 corporate tax reduction by government may not reduce its 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 because of the inherent high cost of capital and an expected increase rate of return. Also, 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 and 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.

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 business friendliness, simplicity of its regulations and also protection of property rights. Seriously, there is a contention 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. Strangely, 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 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, taxes or whether it will be compelled to increase taxes and interest rates in the coming months so as to prevent the economy from falling off the cliff again. 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 retaining 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.

Watch out for part 3 of this article which will discuss the dogmatism of monetary and fiscal policies as opposed to the politics of managing an economy.

Source: Charles Horace Ampong [MSc(Eng), MBA]
Blog: http://www.charliepee.blogspot.com

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Tags: depicting, Five, Government, Policies, Scenarios, Sword, TwoEdged