Statistical Methods in Finance 2019

Dec 16 - 21, 2019


Innovation and Institutions

by Kose John, Stern School of Business, New York, USA

We present an international model of the design of institutions for regulating innovative activities of private corporations. Each country is characterized by its own legal system. Informational limitations faced by the social planner precludes complete contracting with private firms and invasive regulation. Corporate innovation creates positive and negative externalities whose societal impact depends on the sharing rule between the firm owners and the society at large. In our framework, the social planner in each country takes into account the legal system in place, and designs a menu of organizational forms and an optimal rate of corporate taxation. Since the legal regime affects the extent to which the owners of firms are held responsible for the negative externalities they impose, unlimited liability may discourage corporate innovation in strong legal regimes. Limited liability, however, might be accompanied by excessive innovation. Firms choose their organizational form and level of innovation consistent with private optimality. With the optimal institutional design for each country, these private choices of innovation levels are aligned with social optimality. Optimally designed corporate tax rate in each country is shown to be a decreasing function of its legal effectiveness. Using archival data from 63 countries over 2003-2018, we document supporting evidence. Tax strategies implemented by multinational companies (MNCs) have the potential to overcome the constraints of the institutional design. We highlight some policy implications of our model for regulating domestic firms and MNCs.