7.4  Growth impacts from present policy implied by an information asymmetry framework

The various tax distortions described here appear, on the margin, to bias investment toward larger, less risky firms and away from financial intermediaries. Because the capacity for arbitrage is high in financial systems and elasticities of response can be significant there is reason to believe that distortions such as these “can have unanticipatedly large and damaging effects” (Honohan 2003). The impact of an incentive to invest in firms with poor return on investment but which were sensible from a tax position illustrates this point. It is no surprise that the financial services industry has expressed unease with the operation of the capital-revenue boundary, and it has been noted as a barrier to the development of the venture capital industry (Lewis 1999 and Chairman’s address at the NZVCA Conference 2002).[44]

Quantitatively evaluating the effects of the particular biases specific to the New Zealand tax system would be a difficult exercise that has not been undertaken to date.[45] In the absence of such quantitative data, the information asymmetry framework developed in this paper provides a way to gauge the scope, the relative importance and the interconnections amongst the distortions arising from the current capital-revenue boundary. This in turn provides a better ability to track shortcomings in New Zealand’s tax policy to potential solutions and to evaluate the likely effectiveness of those solutions. This paper has discussed relevant quantitative work overseas that is also useful in forming any conclusion.

Financial systems contribute to economic growth by overcoming an information asymmetry between borrowers and lenders, the existence of which creates a crucial impediment to free flow of capital (Mishkin 1997). The development of financial systems represents the key market response to such impediments. Financial intermediaries play a particular role as they have a comparative advantage over financial markets in overcoming information asymmetries associated with smaller and younger firms, particularly those which are novel. A bias against the use of intermediaries would be expected to reduce their use and may result in investment projects not being funded that would otherwise be financed.

An analysis of investment channels in New Zealand highlights the potential effect of these tax distortions and the types of firm likely to be affected. New Zealand is a small open economy that uses international capital to fund part of its current level of investment. In tax policy, this often leads to the conclusion that only the taxation of international investors has the potential to influence investment. This conclusion is based on the assumption that all investment is interchangeable, that the international investor is the marginal investor from the perspective of New Zealand as a whole and that the supply of international funds is infinitely elastic. Following such a line of reasoning, the tax treatment of domestic investment through intermediaries would not be seen as critical. This line of reasoning ignores a fundamental point of the information asymmetry literature, that the channel of transmission of funds is more important for many firms in determining their cost and access to capital than measures of the aggregate cost of capital (Bernanke and Gertler 1995 and Gertler and Gilchrist 1994b) . This point is underscored by empirical evidence which demonstrates that information asymmetry affects which firms are likely to receive foreign investment (Kang and Stulz 1997).

An evaluation of investment channels shows that New Zealand’s largest firms are able to access international debt and equity markets directly. New Zealand has in place an Approved Issuer Levy (AIL) regime which allows New Zealand borrowers able to access international debt markets to pay a trivial tax rate for debt finance at world prices. In practice, it is New Zealand’s larger banks that transmit offshore debt finance to smaller New Zealand firms while larger firms access offshore portfolio debt directly. Many firms will be unable to obtain finance, or attain their desired leverage ratios by directly borrowing from offshore. This is because debt contracts have a limited ability to overcome information asymmetry for firms in some situations. Some of these firms may be able to access international equity financing as an equity stake in a firm increases investors’ ability to limit ex post information asymmetries.

New Zealand firms that are unable to access offshore external financing directly, by issuing debt or equity or by raising funds from individual lenders, will primarily benefit from capital flows into New Zealand through bank borrowing (intermediated debt). Bank borrowing is the most common type of capital available through intermediaries for firms that can not access arms length debt or equity through financial markets.

However, not all firms will be able to access bank lending. Another form of intermediated external financing is provided through private equity investment such as that from venture capitalists and angel investors. The nature of the information asymmetry associated with a particular firm will affect the work that an intermediary has to undertake to reduce that asymmetry and the type of contract that is needed to generate effective monitoring. Banks are large and general purpose financial intermediaries. In some cases they resort to credit rationing rather than to price increases in determining their optimal supply of lending. As a result, particular types of firm are likely to be affected. Smaller and younger firms have been mentioned in this category. Other affected firms include novel firms which lack easy comparison to existing lending relationships, firms that are expanding beyond their ability to collateralise (usually against a personal home) – perhaps for the purpose of export, or firms with assets that are difficult to value or liquidate such as intellectual property. Firms with these characteristics, if they require external finance, may be unable to obtain debt finance through banks and may instead have to turn to private equity investors.

The work of Gertler and Gilchrist (1994b), Bernanke and Gertler (1995), Denis and Mihov (2003), Petersen and Rajan (1994) and Faulkender and Petersen (2003) demonstrates that firms with increased information asymmetries are often constrained in their access to certain sources of finance. As a result they may have to pay higher costs of finance or they may not receive finance. The empirical work cited in this paper provides evidence for the theoretical proposition that the level of financial constraint to some firms has the potential to be significant and as a result, the market response to information asymmetry has an important economic benefit. By extension, resolving the tax distortions against investment through intermediaries because they are the actors with the ability to overcome these asymmetries is necessary to allow the economic value of intermediaries to be realised. The economic benefit could potentially be substantial if resolving the distortions would increase firms’ ability to obtain finance in the future.

Because the tax distortion against the use of intermediaries applies to capital gains, and thus to equity investment, these distortions will disproportionately affect investment to the types of firm that rely on such forms of external finance. These firms will bear much of the cost of current distortions.

There are several types of firm and reasons why firms, in particular circumstances, might choose to obtain equity investment via financial intermediaries. Small or fast growing firms may find that typically available debt contracts are not ideal due to volatilities in their cash flow that make servicing debt obligations a poor choice compared with other uses of retained earnings. Another reason that firms may seek equity through financial intermediaries is to obtain the expertise that investors often bring along with their investment capital. Firms may also wish to avoid debt at a certain stage of development in order to preserve their ability to access such finance at a later stage, perhaps to finance a future project where other types of finance might not be as forthcoming.[46]

The ability of firms to obtain equity finance from intermediaries may increase access to additional finance or lower their cost of finance in the future, providing an additional benefit to the information discovery provided by the equity financier. In addition to funding otherwise foregone projects, finance by financial intermediaries has value in providing efficient and effective monitoring (Denis and Mihov 2003). As a relationship deepens with a financial intermediary, and if that intermediary obtains positive information about a firm that is durable and not easily transferred (assuming scale economies in information production) then the cost of capital extended to that firm may decrease over time. This effect of relationship building has been shown in the case of bank lending relationships (Faulkender and Petersen 2003 and Petersen and Rajan 1994), and it may exist to some degree for firms developing relationships with other financial intermediaries. Evidence from overseas banks that participate in venture capital suggests that making an investment as a venture capitalist increases a bank’s likelihood of providing a loan to a firm (Hellman, Lindsey and Puri 2004).[47]

Firms’ ability to access external financing may be further enhanced if firms’ net worth and cash flow improve as a result. Cash flow and net worth (firms’ market value) are important signals for lenders who are attempting to assess agency costs and they are thus good predictors of the availability of finance to a firm (Bernanke, Gertler and Gilchrist 1999, Petersen and Rajan 1994 and Walsh 1998). Equity investment that improves these measures for a particular firm would affect well established mechanisms by which banks determine the credit risk associated with a firm. Essentially, private equity investment in a firm would act as a signal reducing information asymmetry associated with that firm, increasing the market value of the firm and thus strengthening the firm’s balance sheet. These measures flow back to the ability to obtain debt finance. This result in particular has potential significance in the presence of AIL, which results in low tax rates on debt investments to New Zealand from abroad. This type of investment represents much of the foreign capital imported into New Zealand through financial intermediaries. An enhancement in the discovery of information through private equity investment, if it improves the subsequent ability of banks to provide debt finance could provide reinforcing increases in access to capital and reductions in the cost borrowing.

The tax distortion that affects intermediaries also has an impact on the functioning of financial markets. This is because investors in financial markets rely to some degree on other investors to discover information about firms and to perform the costly monitoring required to promote good governance of listed firms. New Zealand tax policy may undermine this function by biasing investors to hold direct investments for longer periods of time. A passive index tracking fund that deviates from that practice to act on information revealed may result in the taxation of the broader investments of the particular investment fund in addition to investments directly affected by any information obtained. A bias against the use of intermediaries will increase the costs of acting on information obtained for a class of decision makers that is likely to uncover information about listed companies.[48] As a result, there is likely to be a decrease in the check on firm governance provided by financial markets and a decrease in the confidence regarding firms on those markets.