Social Priorities, Institutional Quality, and Investment

We examine the role of corporate taxation and institutional quality in aligning privately optimal investments with those that are socially optimal. We develop a theoretical framework to characterize how limited liability and non-monetized social benefits give rise to corporate investments to deviate from the socially optimal levels. Our model predicts that, while taxes bridge the wedge between the private objectives of firms and that of the society at large, the level of corporate tax required to achieve social optimality is attenuated in the presence of high-quality institutions. We provide empirical evidence in support of these predictions. Exploiting the staggered designation of strategically important industries by the Chinese government in its Five-Year Plans (FYPs) and leveraging a regulatory event that affected the corporate tax rate, we show that the government lowers taxes to spur corporate investment to a lesser extent if there is a strong local legal regime or a well-developed market-based system. The results are driven by the FYP industries which adhere to the social priorities that generate larger non-monetized benefits. Both corporate taxation and institutional quality also affect the likelihood of firms expanding into FYP industries. Importantly, the investment misalignment decreases in these FYP industries, as previously underinvested (overinvested) firms speed up (slow down) their investment to a greater extent compared to peer firms in the same industry. Our findings highlight taxes as an alternative self-enforcing implicit contract in aligning private and public interests while also demonstrating the moderating effects of quality institutions.