Arnold Kling  

The 1990's Bubble Economy

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Long-term Growth Forecasts... Phelps on Dynamism...

William Nordhaus reviews two books on the economy of the 1990's. One of the books, by Janet Yellen and Alan Blinder, apparently finds little evidence that economic policy was a major factor in the rapid economic growth of that era. Instead,


Their basic finding is that a series of unexpected and favorable developments were responsible for the extraordinary performance. Among the favorable developments were declining health care costs, a fall in oil prices, a rise in the exchange rate of the dollar, and changes in the way the consumer price index (CPI) was measured. The most important single development was the upturn in productivity growth. This directly lowered production cost and inflation, led to higher growth in real (or inflation-adjusted) wages, and reduced the demand of workers for higher money wages.

The Internet Bubble and financial scandals figure prominently in any history of the past decade. Nordhaus says that even though Internet commerce may have been a productive innovation,

innovation does not automatically lead to profits. Economic history teaches us that when a wondrous new product is invented, its price generally falls as other firms enter and imitate the product, rapidly eating away at the profits. In fact, with a few exceptions, companies producing innovations on average earn no more than a normal return on their investments.

On the topic of financial scandals, Nordhaus suggests,

One important reform that would illuminate the true state of corporate finances would be to require corporations to publish their tax returns. This would allow investors to assess profits by a standard yardstick.

For Discussion. What might be the unintended consequences of forcing corporations to disclose their tax returns to investors?


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COMMENTS (14 to date)
Witchfinder General writes:

On the topic of publishing IRS data and the costs/benefits thereof, BusinessWeek has come out as a proponent,(1) while Greenspan has acknowledged the superiority of tax reports over shareholder reports in some respects.(2)

For me, I don't see why there should be two sets of books, and while I understand the need for corporate privacy/secrecy (esp. for privately held companies), it seems there's room for compromise, and as such it should be feasible.

Certainly we can all agree that greater transparency is an unalloyed Good Thing, as it leads us further down the road to the economic nirvana of perfect information...

As for unintended consequences, assuming ceteris paribus no major revelations, I would think more scrutiny would not only affect management behaviour, but investor behaviour as well, towards being more risk-averse.
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(1) http://www.businessweek.com/magazine/content/02_32/b3795039.htm "The IRS data has several advantages. First, manipulating tax return data is harder than distorting earnings statements, since there is no such thing as a pro forma tax return. Second, the tax data for profits, unlike the financial reports for investors, treat the cost of exercised stock options as an expense. Finally, tax return data includes all companies, from money-losing startups to the biggest multinationals."

(2) http://www.federalreserve.gov/boarddocs/hh/2002/july/testimony.htm "[T]he measure of profits calculated by the Department of Commerce for the National Income and Product Accounts is designed to gauge the economic profitability of current operations. It excludes a number of one-time charges that appear in shareholder reports, and, importantly, records options as an expense, albeit at the time of exercise. Although this treatment of the cost of options is not ideal, it is arguably superior to their treatment in shareholder reports, where options are generally not expensed at all. NIPA profits closely approximate those obtained from reports submitted for tax purposes, and, for obvious reasons, corporations tend not to inflate taxable earnings. Consequently, NIPA profits have been far less subject to the spin evident in reports to shareholders in recent years."

Steve writes:

Witchfinder--

Remeber: WorldCon and Enron BOTH sent in "updated" tax forms in the past year lowering their "earnings" and requesting tax refunds. (The IRS decided that they would not allow such a thing).

Sure, it's harder to manipulate tax returns, when "manipulation" means HIDING earnings. When it comes to inflating earnings, why would the IRS care? They'd get more money! The IRS is simply not equipped to ferret out income overstatements, only understatements.

Aaron writes:

There is no requirement to maintain two separate "sets of books." The obvious reason it is done is because some companies do not wish all information to be known to all parties. This is not necessarily a bad thing, although misleading investors and/or tax collectors is, admittedly, one of the purposes of doing so.

If tax information is required to be published, then I suspect corporations would lobby to changed what is published, and some would inevitably become more evasive in their tax reporting. What then is the solution?

None is needed.

Investors are entitled to loan their money to whomever they wish. I think the few visible scandals have induced not just corporations to be more honest and forthcoming with financial statements, but that they will hopefully induce investors to demand more accurate and straightforward reporting from their creditors.

However, I see no need to legislate the requirement. If there is a demand, the information will be forthcoming, or the investment will be made elsewhere.

If there is no demand, well, a fool and his money are soon parted, and if he intends to go where others fear to tread, who am I to stand in his way?

Lawrance George Lux writes:

The unintended consequence would be a vast replacement of Corporate Boards and Executives, and a vast increase in Dividend payments. Stockholders currently do not know the total cost of Stock Options, Executive compensations, the cost of internal financing of Production and Consumer credit, the withholding size of delayed Dividend payments for Investment purchases, the lineal cost of Stock issuances to maintain Stock prices, and the Consulting fees paid for practically everything, with a backish systems of interlocking receipt(some Board members and Executives triple their total gain through consulting firms, trading consulting fees with other Corporations). The last may not seem relevant, but some Corporations pay more in Consulting fees, than they do in Production operations. lgl

Eric Krieg writes:

What about the Asian crisis? I think that the currency crisis and the resulting economic implosion in Asia helped to supercharge the US economy. For one thing, oil prices plunged. I remember paying 89 cents per gallon back in early 1998! It also freed up a lot of capital that was looking for safe returns. A lot of it got invested in the US.

Yes, it decimated US exporters. But exports are a small part of the US economy. The cheap gas and cheap capital more than offset those losses.

Boonton writes:

Two sets of books are kept because Congress has permitted accounting methods that violate GAAP to be used to compute taxable income. For example, depreceation is faster under the tax law because Congress wants to reward 'investment'. Would it be simplier to just adopt GAAP and adjust the rates to raise the desired revenue? Sure.

"Sure, it's harder to manipulate tax returns, when "manipulation" means HIDING earnings. When it comes to inflating earnings, why would the IRS care? They'd get more money! The IRS is simply not equipped to ferret out income overstatements, only understatements."

But overstating revenue to the IRS has the undesirable consquence of requiring the company to fork over more cash to the IRS. While companies may play liberal with income as reported by GAAP they would want to be as conservative as possible to the IRS. If both GAAP and IRS statements were available to investors, they could scrutinize any company whose income statements are very different.

Monte writes:

“What might be the unintended consequences of forcing corporations to disclose their tax returns to investors?”

Disclosure has been tried several times in the past unsuccessfully, beginning with the publicity feature of Taft’s 1909 Corporate Excise Tax. Corporations argue, among other things, that this provision would compromise their position by forcing them to release proprietary information to competitors. I’m not persuaded the consequences of such a policy would be counterproductive, assuming across-the-board compliance by all players. However, U.S. firms could obviously be harmed by foreign competitors leveraging this information (nature, sources, and character of revenue) to their advantage who are not held to the same requirement.

Also, tax and financial reporting have vastly different objectives. Comparing a company’s financials to its tax returns is not meaningful in the sense that it would reveal vital information for making sound investment decisions. In fact, it would complicate matters for investors who must now reconcile pre-tax income with taxable income. Absent a detailed understanding of the sources of divergence between the two, comparison of a corporation’s federal tax return liability with its reported income tax liabilities for financial reporting purposes is a potentially misleading exercise.

Finally, taxpayer privacy is not a right we should take too lightly. If we allow lawmakers to strip corporations of that right as a deterrent to criminal activity, how long before individuals will be subjected to the same fate?

Boonton writes:

There are many measures that can be misleading to an investor...for example the P/E ratio. If the information was useless then it would be ignored. If the information was useful then it would pay for investment firms, mutual funds, etc. to hire analysts who understood the difference between pre and post tax income.

Taxpayer privacy is not a small issue but corporations are not the same thing as individuals. If the disclosure was limited to publically traded corporations then the privacy issue becomes moot IMO. Public corporations are already required to disclose their financial condition to anyone who wants to know.

I'm also skeptical of the competitiveness argument. I think the transparancy of the US market is a huge competitive advantage and this policy would boost that by providing shareholders (and potential shareholders)...who after all actually own the corporation...with more information that they can use as they see fit.

Monte writes:

“If the information was useful then it would pay for investment firms, mutual funds, etc. to hire analysts who understood the difference between pre and post tax income.”

Professionals may understand the differences, but where’s the value-added? Including tax return information complicates the investment decision, it doesn’t simplify it. Financial accounting allows for estimates, probabilities, and reasonable certainties where tax accounting does not. It’s entirely possible that investment decisions would cancel each other out in this scenario, leaving both amateur and professional at square one.

“Taxpayer privacy is not a small issue but corporations are not the same thing as individuals.”

In the strictest sense, you’re correct. But corporations have many of the legal characteristics of a natural person. It is given life, personality, and existence by the law. It can sue, be sued, own property, invest, make or lose money, and go bankrupt. We currently accord the same rights of privacy to corporations as we do individuals respecting taxable income. If corporations lose that right in the interest of protecting investors, why not impose the same requirement on individuals in the interest of protecting creditors?

A corporation’s financial position, fully and fairly stated, serves the investment decision process very well, IMO. If fraud and malfeasance is proven, it should be severely prosecuted. And if current laws and penalties don’t sufficiently deter this type of behavior, enhance them. I just think it’s imprudent to sacrifice the right to privacy at the altar of investor confidence.

“I think the transparency of the US market is a huge competitive advantage and this policy would boost that by providing shareholders (and potential shareholders)...who after all actually own the corporation...with more information that they can use as they see fit.”

Transparency of US markets benefits corporations and shareholders alike. But you can’t say that domestic enterprise wouldn’t be hurt by foreign competitors who are exempt from any disclosure requirements. If we were to hold foreign firms to the same standards of business practice as US firms, your point becomes a more valid one.

Boonton writes:

"If corporations lose that right in the interest of protecting investors, why not impose the same requirement on individuals in the interest of protecting creditors?"

Because corporations are only given some of the rights of individuals only because it is useful for society to do so. No one thinks corporations are entitled to vote, for example. If changing the rights of the corporation improves society then gov't has every right to do it. This doesn't hold for individuals. For example, if I could prove to you that a tax on speech advocating protectionism would lead to better policies and improved GDP the gov't still could not implement such a policy because it would violate free speech.

Tomorrow gov't could abolish the law that permits corporations. It couldn't vote to abolish individuals.

"A corporation’s financial position, fully and fairly stated, serves the investment decision process very well, IMO."

It is the investors decision to decide what information is necessary to make the investment. It is quite common for investors to demand tax returns, audits by their own agents and more. Go to a bank and see if they will give you a business loan solely on audited financial statements?!

"Transparency of US markets benefits corporations and shareholders alike. But you can’t say that domestic enterprise wouldn’t be hurt by foreign competitors who are exempt from any disclosure requirements. If we were to hold foreign firms to the same standards of business practice as US firms, your point becomes a more valid one."

I'm not convinced that tax returns disclose any information that would give a competitor a significant advantage. Nevertheless, foreign firms would be under the same burden if they wanted to access US capital markets by listing their shares for sale. Likewise, corporations that are privately owned would be exempt from the burden. Going public, by definition, is a loss of privacy for a corporation. It is up to the corporation's owners to determine if the advantages outweigh the disadvantages.

Monte writes:

“No one thinks corporations are entitled to vote, for example. If changing the rights of the corporation improves society then gov't has every right to do it. This doesn't hold for individuals.”

But most people believe corporations are entitled to certain rights. What’s more, government can change individual rights for the good of society whether we want them to or not. I would disagree that it has the right to do that. Ask the average taxpayer if he or she thinks the level of taxes we must pay is fair.

By the way, corporations vote through campaign contributions, which exercise more political influence than any constituency.

“For example, if I could prove to you that a tax on speech advocating protectionism would lead to better policies and improved GDP the gov't still could not implement such a policy because it would violate free speech.”

The government can, and does, implement such policies all the time. Why do you think case loads involving infringement of constitutional rights by the government are so heavy at the Supreme Court level? Judicial activism is a direct assault on our constitutional rights and happens all too frequently today, IMO.

“Tomorrow gov't could abolish the law that permits corporations. It couldn't vote to abolish individuals.”

But it could certainly vote to abolish individual rights, which is something we could all stand to be more vigilant about.

“It is the investors decision to decide what information is necessary to make the investment. It is quite common for investors to demand tax returns, audits by their own agents and more. Go to a bank and see if they will give you a business loan solely on audited financial statements?!"

Banks make loans to individuals and businesses all the time without requiring tax return information. I can go to virtually any bank in the U.S. and qualify for a loan based on my credit history and current income alone. As an investor, I’m perfectly content with financial statements in making a decision to buy or hold a particular stock. If that information is misrepresented, I would like the think our current set of laws would provide legal recourse. If making a case on that score requires a corporation to turn over tax return information, so be it. But I prefer to err on the side of preserving both the corporations and individuals right to confidentiality rather than eliminating them.

Boonton writes:

"The government can, and does, implement such policies all the time. Why do you think case loads involving infringement of constitutional rights by the government are so heavy at the Supreme Court level? Judicial activism is a direct assault on our constitutional rights and happens all too frequently today, IMO."

You're not being very clear here. To my knowledge there is no policy anything like a tax on undesirable speech. The above argument is also incoherent. If you feel there are loads of cases where the gov't infringed on our rights, then what is the complaint about judicial activism? Certainly you would want such laws struck down!

To simplify the issue. Corporations exist solely at the pleasure of the government. Individual rights exist independent of the government. This is reflected in the US Constitution where certain rights are held outside the gov'ts ability to influence.

"But it could certainly vote to abolish individual rights, which is something we could all stand to be more vigilant about."

Not it could not. First of all the Constitution would make such laws invalid. Second the understanding behind American law makes it clear that individual rights are inherent in human beigns (i.e. 'endowed by their creator'...with unalienable rights). The founding documents of the US clearly state that a gov't that attempted to abolish individual rights would become illegitimate.

Finally you are comingling two different ideas. There is no corporate right to privacy except as such a right would be useful to society as represented by its elected gov't. It is fine that banks sometimes will make loans without looking through tax returns. That does not mean that such information is useless to potential investors. I'm sure there may be times where a company's financial statements may be of no use to an investor. That doesn't mean it is wrong to require audited financial statements as a condition of going public.

Monte writes:

“You're not being very clear here. To my knowledge there is no policy anything like a tax on undesirable speech.”

I never claimed there was a tax on undesirable speech (although some might argue that campaign finance laws come dangerously close). I simply pointed out that our government infringes on our constitutional rights, including free speech, quite frequently, as evidenced by the number of Supreme Court cases involving the violation of such rights. It’s clearly evident that many of our constitutional rights have been eroded, re-defined, or watered down by all branches of government (including the judicial branch), particularly over the course of the last century.

“The above argument is also incoherent. If you feel there are loads of cases where the gov't infringed on our rights, then what is the complaint about judicial activism? Certainly you would want such laws struck down!”

Judicial activism isn’t about courts striking down laws that are found to be unconstitutional. It’s about “Supreme Court justices (and other lower-ranking judges) creatively re-interpreting the texts of the Constitution and laws in order to serve the judges' own considered estimates of the vital needs of contemporary society when the elected "political" branches of the Federal government and/or the various state governments seem to them to be failing to meet these needs.” In other words, judges should not hesitate to go beyond their traditional role as interpreters of the Constitution and laws given to them by others in order to assume a role as independent policy makers or independent "trustees" on behalf of society.

“To simplify the issue. Corporations exist solely at the pleasure of the government. Individual rights exist independent of the government. This is reflected in the US Constitution where certain rights are held outside the gov'ts ability to influence.”

Check your sources. Corporations gained title to the first 10 amendments of the constitution (the Bill of Rights) starting in 1976 when the U.S. Supreme Court ruled in two separate cases that corporations have a First Amendment right to speak through unlimited contributions to political parties and that commercial speech is protected under the First Amendment. Corporations, like individuals, aren’t endowed with these rights solely at the discretion of government to serve the larger interests of society (or, at least, they shouldn’t be).

Me: But it could certainly vote to abolish individual rights, which is something we could all stand to be more vigilant about.

You: Not it could not. First of all the Constitution would make such laws invalid. Second the understanding behind American law makes it clear that individual rights are inherent in human beigns (i.e. 'endowed by their creator'...with unalienable rights). The founding documents of the US clearly state that a gov't that attempted to abolish individual rights would become illegitimate.

The Supreme Court has held on numerous occasions that rights are granted by society and can therefore be revoked whenever this would serve some social purpose. Freedom has been significantly eroded as our government has expanded its powers at the expense of individual rights. The result has predictably been pressure-group warfare, economic decline, political chaos, and widespread national disunity. Many contemporary intellectuals and politicians have obscured the meaning of individual rights and its foundation in reason and rational self-interest in favor of the collective good.

For instance, many of our most basic individual rights have been compromised to facilitate improvements to the environment, promote national security, and ensure taxpayer compliance. All three branches of government (at both the federal and state level) have seriously eroded important protections, including the Fourth Amendment guarantee against unreasonable searches and seizures, the constitutional bar on double prosecutions, and the Fifth Amendment privilege against self-incrimination.

With regard to eminent domain, a serious problem is growing across the country in jurisdictions both large and small. The problem is the forcible taking of private property for private use. Asset forfeiture is a glaring example of the state superceding individual rights by seizing property if it’s suspected to have been used in a crime, whether or not the owner is charged with, let alone convicted of, anything. Asset forfeiture is a grave problem in America today, often used to persecute the poor, politically disfavored, and racial minorities.

“It is fine that banks sometimes will make loans without looking through tax returns. That does not mean that such information is useless to potential investors. I'm sure there may be times where a company's financial statements may be of no use to an investor. That doesn't mean it is wrong to require audited financial statements as a condition of going public.”

I’m not opposed to granting shareholders access to certain aspects of corporate tax returns for investment purposes, but I think full disclosure goes too far. We need to be careful about introducing more regulations and restrictions as a cure for business malfeasance. Legislation is a problematic way to achieve normative behavior, IMO.

Prof. Heskett of the Harvard Business school recently commented that “investors can have too much accounting transparency” and asks whether “our current approach to greater accounting transparency through legislation and regulation attack[s] the symptoms and not the disease.?”

Here, here…

Boonton writes:

The problem is that your position actually is in favor of gov't regulation. Without access to information, it will fall upon gov't regulators to investigate and decide if a corporation has been deceptive in its financial statements. Considering how many public corporations there are this is a huge undertaking.

With valid information in hand, though, investors can take up this job. If a companies books appear too good to be true they will lower its value accordingly. What makes tax returns unique is that companies have high incentives to be both extremely conservative (understate income to avoid taxes) and honest (to avoid audits).

It seems that a knowledge investor may be able to use such information to better value a company. If asset markets are more efficient at finding the correct value of corporations then capital accross the economy is allocated more efficiently.

Regarding privacy, tax returns do not contain a corporations general journal. They do not report every transaction the company has engaged in. They summarize transactions in a manner similar to a GAAP income statement.

Regarding Constitutional freedoms. You'll have to be a bit more specific. Clearly individuals have a greater degree of freedom of speech than in older days. Emminent domain is a valid issue that I'm concerned about too, however it appears to be an area of gov't abuse...not the tip of a larger movement to void the Bill of Rights.

Even so, the domain issue isn't about the judicial branch but the executive and legislative. One would desire a strong judicial branch to protect onesself against gov't taking.

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