Property rights and managerial response to tax policy

It is well known that tax policies alter the allocation and distribution of resources within the economy. In this section I examine some of the theoretical sources of these effects, specifically, how property rights structures in alternative organizations of supply determine managerial response to tax policies. For this purpose I focus mainly on income, profit, and property tax policies and how these affect managerial deci- sion making in the different organizational forms. I consider the rela- tive competitive effects of tax policies in Chapter 10.

1. Tax policy and for-profit firms

There is a vast literature on corporate tax policy. In general, firm response to a new or altered tax policy is predicted to be rational cost (tax) mini- mizing behavior. Such findings are consistent with the neoclassical model of a profit maximizing firm. For example, tax minimization is a basis for some mergers and consolidations. Implicit in these findings are full legal and economic property rights vested in the firm, where owner and man- ager are identical or where the manager is a perfect agent on behalf of shareholder interests.

What is the predicted response to tax policy in the managerial model? In this model shareholders have legal residual rights and utility maxi- mizing models have control rights, and in the position to expropriate some part of shareholders’ residual. The corporate manager’s utility is derived from income, prestige, authority, and discretionary profit. The tax on income reduces managerial income directly. The tax on profits and the property tax, which increases cost, both have the direct effect of reducing discretionary profit, also lowering managerial utility. The rational utility maximizing manager with economic property rights will respond to income or property tax by reallocating resources to promote those inputs that increase managerial prestige and authority, such as additional staff and amenities of office that are not taxed (Williamson, 1963). The high cost of detecting these inefficiencies limits the moni- toring effect of the capital and managerial markets. The increased weight on prestige and authority in the managerial utility function also provides an alternative rationale for mergers, whereby the span of con- trol of the manager is increased.

Tax policies also may reduce firm costs. As an inducement to move to (or remain in) a given location, states and/or local governments may propose tax relief or tax credit policies. Relocation in response to these tax policies is clearly consistent with the full property rights assumed in the neoclassical model of the firm. This response would be inconsistent with the managerial model if shareholders fully comprehend the impli- cations of the tax effect for their profitability and are able to monitor the manager effectively. The premise of the managerial model suggests that this is not likely, however, and that shareholders either do not fully comprehend the extent or implications of the tax effect on their expected return or are unable to monitor sufficiently to ensure that the obtain the full return associated with the tax benefit. The managerial model predicts that resource allocation decisions are made that increase managerial utility at the expense of (at least some) shareholder profit. The manager’s location choice for the firm in this case would not be the location most profitable to shareholders but the location that provides greatest utility through prestige or income subject to some share of tax benefit accruing to shareholder returns. Thus, for the same tax policy the neoclassical model and the managerial model could predict differ- ent decisions on firm location.

2. Tax policy and nonprofit organizations

With respect to nonprofit organizations tax policy primarily consists of tax exemptions and tax deductibility. These policies play a number of roles. These include (1) supporting the existence of nonprofit organiza- tions, (2) expanding equity or fairness in the allocation and distribution of resources, and (3) monitoring nonprofit behavior both with respect to the types of services provided and in its competitive relationships with firms and public sector organizations. Simon (1987) summarizes the US tax system vis-à-vis nonprofit organizations and examines these roles in depth.1 He concludes that tax policy does not ‘intervene into the substantive decisions of nonprofit institutions and their donors’ (p. 95). Alternatively, in their analysis of the tax treatment of nonprofit organizations Brody and Cordes (1999) conclude that US tax policy affects the range and scope of nonprofit activities. Here I ask: do prop- erty rights implications for decision making in nonprofit organizations support the claim of Simon or of Brody and Cordes?

To answer this question I examine tax policies in the context of the neoclassical and managerial models of nonprofit organizations. In either context, eligibility of a nonprofit organization for tax exemption requires the nonprofit to meet the definition of providing a charitable or social service. This definition is relatively broad and includes a vari- ety of services such as education, health care services, cultural activities, and other social services.2 The point here is that tax exemption is not permitted for any commercial operation of organizations that are osten- sibly nonprofit. In general, then, tax exemption has the effect of reduc- ing costs of nonprofit provision of charitable and social services.

Consider first the neoclassical model of a nonprofit organization which does not distinguish the manager from the organization itself, and which has as its assumed objective for the nonprofit pure revenue maximization. The neoclassical nonprofit organization, with no defined legal ownership, has economic property rights through its control rights. Tax exemption, having a cost reducing effect, would have no effect on nonprofit output in the case where the nonprofit is maximizing revenue. The revenue maximizing nonprofit organization chooses its output level where marginal revenue is zero, regardless of cost level, that is, with or without the tax exemption. The tax exemption has the effect of creating or increasing profit, which, by law, may not be distributed to any individual or group. The profit must be either saved or reinvested into the organization. If it is saved, there is no output effect. If it is rein- vested into the organization, it can be used to offset costs of increasing quality or other aspects of the services the nonprofit supplies, but the output level would be predicted to remain unchanged. The implications of a breakeven constraint imposed on a revenue maximizing nonprofit organization are considered below.

Alternatively consider the neoclassical model of a nonprofit organi- zation with the objective of output maximization instead of revenue maximization.3 The output maximizing nonprofit organization will expand the level of services to the point where revenue equals cost. In this case, for a given revenue function, tax exemption, by lowering costs, results in a larger output of services. Even for a fixed amount of revenue, the reduction in cost associated with the tax exemption allows greater output to be provided. As revenue becomes more limited, the output maximizing nonprofit would be willing to add a commercial (non-tax exempt) service as a way to fund provision or expansion of its charitable service (tax exempt) output. If maximizing total output is its sole objective, the nonprofit organization may expand output by changing the composition of its output (that is, increasing commercial services relative to charitable services as defined for tax exemption pur- poses). The nonprofit organization would do this as long as the value of the increased revenue from the commercial service exceeds the value of the foregone tax exemption, and the nonprofit stays within its per- ceived mission. This was the case with the YMCA in Portland, Oregon, USA, that lost its property tax exempt status as a result of providing membership racquet club services that were classed as commercial by the local tax assessor in addition to its more traditional services such as child and family care (Simon, 1987, p. 92).

The managerial model of a nonprofit organization assumes utility maximization as the objective of the nonprofit manager. The manager’s satisfaction is derived from prestige, authority, income, and revenue, and is subject to a breakeven constraint for the nonprofit organization. Managerial prestige, authority and income are positively related to staff size, quality of service, and quantity of service provided. Revenue is positively related to quality and quantity of service.

If monitoring costs are high, the nonprofit manager has full eco- nomic property rights. The manager would be expected to allocate the savings from tax exemption on any profit  earned  by  the  nonprofit and on nonprofit property to attributes of nonprofit operations that increase managerial utility. Larger discretionary profit can be allocated to inputs that increase the quality of nonprofit services and increase staff size, implying overinvestment in these attributes relative to what would occur under conditions of the neoclassical model. To increase prestige or income or revenue the nonprofit manager may be willing to trade off tax exemption and in the limit, nonprofit status for commer- cial activities if this raises the profile of the organization. This behavior has been observed in the recent hearings on the proposed conversion of CareFirst, a nonprofit health care services provider in Maryland, Delaware, and Virginia that is affiliated with Blue Cross/Blue Shield, to a for-profit status (see, for example, Salganik, 2003).

The ability to engage in such a tradeoff is limited when monitoring of the nonprofit exists. In the US, the Internal Revenue Service (IRS) and other  government  regulators,  as  well  as  nonprofit  board  members, may act as monitors in this way (Wolf, 1999, pp. 28–31). As noted in Chapter 7, however, there is some controversy as to the effectiveness of monitoring of managerial decision behavior by nonprofit board members. At times government regulators can be highly effective monitors. In the CareFirst case cited above, the Maryland State Insurance Commission as the relevant regulator considered the  amount  of  managerial  bonuses that were incorporated into the conversion  (from  nonprofit  to  for- profit) plan. It found these to be excessive with respect to the public interest. The conversion was denied. In addition, the Maryland State Insurance Commission and the Maryland State Legislature imposed the additional requirement on the nonprofit that the membership and composition of the CareFirst board of directors must be altered to per- mit more effective monitoring of the management by the board (Community Catalyst, 2003).

3. Implications of property rights for tax policy

Tax policies alter the allocation of resources through corporations and nonprofit organizations differently than in ways predicted by the neo- classical model of the firm. As is usually predicted, corporate managers who maximize utility will likely allocate corporate resources to avoid the tax. However, utility maximizing managers with economic property rights will apply any potential tax savings to their most preferred inputs, such as larger staff or office amenities.

Tax exemption policies for nonprofit may or may not affect nonprofit output levels, depending on whether the organization and/or manager maximizes revenue or output. The strict revenue maximizing neoclassi- cal nonprofit organization will not change output whether taxed or not. This is the only case that is consistent with the prediction made by Simon (1987). Even in this case, however, tax exemption could have the effect of permitting higher quality of that same output, thus altering the nature of the services provided as a response to tax policy. In general, therefore, the property rights implications of tax policy provide support for the Brody and Cordes (1999) contention that the range and scope of nonprofit activities are altered by tax policies. A neoclassical nonprofit organization that maximizes revenue subject to a binding breakeven constraint or maximizes output will use the tax savings to increase the quantity of services provided. A nonprofit utility maximizing manager will channel tax savings into preferred attributes that contribute to his or her prestige, income, or discretionary budget. This would have the most likely effect of increasing quality of services through larger or better qualified staff.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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