Law, Institutions and Taxes: Optimal Regulation and the Financial Crisis


Calls for tighter regulation of financial innovations are gathering momentum in the wake of the financial crisis. In a setting where corporate innovation imposes positive and negative externalities, the social impact of corporations depends on the sharing rule between the owners of a corporation and the non-financial claimants. We examine the role of law, regulation and institutions in altering this sharing rule. We propose a framework where the social planner puts in place an umbrella of laws, organizational form choice and taxation within which private firms optimize without invasive regulation. Since the legal regime affects the extent to which corporate owners are held responsible for the negative externalities they impose, unlimited liability may discourage innovation in strong legal regimes. Limited liability, however, might be accompanied by excessive innovation. We highlight the role of the government in altering the sharing rule due to its claim through corporate taxation and investigate the relation between law and corporate taxation. We show that the equilibrium corporate tax rates are a decreasing function of legal effectiveness of the embedding economy. Finally, we present some supporting evidence using cross-country data on corporate tax rates and measures of legal effectiveness. * John is from the Stern School of Business, New York University; Nair is from Ada Investment Management and Senbet is from the University of Maryland. The authors thank William Allen, Mihir Desai, Stavros Panageas, Ravi Jagannathan and Bilge Yilmaz for comments and/or discussions. Please address correspondence to Kose John, Stern School of Business, New York University, 44 West 4 Street, New York, NY 10012. Phone: (212)998-0337 Fax: (212)995-4233. E-mail:

Cite this paper

@inproceedings{John2009LawIA, title={Law, Institutions and Taxes: Optimal Regulation and the Financial Crisis}, author={Kose John and Vinay Nair and Mihir A. Desai and Stavros Panageas and Ravi Jagannathan}, year={2009} }