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. The externalization problem can be mitigated imperfectly through existing mechanisms such as regulation, mandatory insurance, and minimum capital requirements. These mechanisms could be more effective if information asymmetries between industry and policymakers could be reduced. Private businesses will typically have better information 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 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. 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 industries, firms will be unlikely to strategically mislead policymakers in their elections. 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.
Antitrust and Trade Regulation | Business Organizations Law | Law | Law and Economics | Law and Society | Organizations Law
Date of this Version
Michael Simkovic, "Limited Liability and the Known Unknown" (February 2018). University of Southern California Legal Studies Working Paper Series. Working Paper 260.