Matt Levine writes the Money Stuff daily column covering finance at Bloomberg. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz, and a clerk for the U.S. Court of Appeals for the 3rd Circuit. Subscribe to his Money Stuff daily column here.
Should index funds be illegal?
Why not. Here is an argument from Danielle Chaim that, when public companies are all owned by the same small group of big institutional shareholders, they evade taxes more. “A few recent empirical studies have … found a significant positive correlation between tax avoidance and institutional ownership.” Chaim’s theory is basically that if one company evades taxes, it will get in trouble, because the tax authorities will notice. But if every company evades taxes, none of them will get in trouble, because the tax authorities will be so overwhelmed by all the evasion that they won’t be able to do anything about it:
In my paper, “The Perils of Common Ownership: The Flooding Phenomenon,” I argue that the observed increase in corporate tax avoidance triggers a phenomenon that I call “flooding.” The term is apt because, under this phenomenon, institutional investors push their portfolio firms towards higher levels of tax avoidance. Without adequate measures in place to stem the flow, abnormal levels of tax noncompliance by many public corporations gather the force of a flood, leaving the tax agency floundering. The effectiveness of at least one of the audit stages – commencement, case development, or deficiency collection – is compromised. This, in turn, reduces the probability that such behavior will be detected and adequately penalized.
This has the same sort of solving-the-prisoners’-dilemma form as the more usual, antitrust-related worries about index funds that we talk about around here:
- If one company in an industry does a thing (raise prices, evade taxes), it will be worse off (lose market share, get in trouble).
- If every company in the industry does the thing, they will all be better off (have higher profits, pay lower taxes).
- There are impediments (antitrust law, awkwardness around illegal conspiracies) to getting them all in a room to make a binding agreement to all do the thing.
- Common ownership of all the companies by the same group of institutional investors somehow has the same effect as getting them all in a room to agree to do the thing.
I don’t know. Point 4 often seems sort of vague and abstract; it’s not like the big index funds generally call up companies to say “hey raise prices” or “hey evade taxes.” “In my paper,” writes Chaim, “I identify various potential mechanisms that link institutional ownership to tax noncompliance, some of which fall short of direct communication between institutional investors and their portfolio firms.” Here’s the paper.
But here I just want to note that the structure of the argument has such wide application. If you believe point 4—if you believe that common ownership of multiple companies by big institutional investors can somehow cause them all to act like they’re on the same team—then you can believe it about anything. You can talk about it in terms of consumer prices, which is what started all of the worrying about common ownership: If all the airlines are owned by the same funds, won’t they raise airfares, etc. You can talk about it in terms of tax evasion, apparently. But really anything that would be hard for a company to do individually, but that would be good for companies collectively, can fit into this story.
Bad things! Here’s one: “Common ownership depresses employee wages: If one company cuts wages it will lose skilled workers to competitors, but if they all agree to cut wages the workers will have no ability to push back, and index funds blah blah blah.” That’s sort of an obvious extension of the antitrust theory. I have not Googled it carefully but I assume that there is already a literature; if there isn’t, though, go write it! That’ll get you tenure! Real wage stagnation over the past few decades has coincided with the rise of index funds and common ownership, so, you know, it feels empirically true. (You’ll probably want to be more careful empirically, for tenure.) And the theory behind it is the same as the theory behind everything else.
Also good things! Here’s one: “Common ownership is good for the environment: If one company spends more to avoid pollution, it will not capture the positive externalities and will underperform, but if they all agree to avoid pollution then they will capture more of the externalities and be better off in the long run, and index funds blah blah blah.” That is more or less explicitly BlackRock Inc.’s argument: Individually, companies have a tendency to pursue their unenlightened short-term self-interest, but BlackRock, with the broader and longer-term perspective that comes from owning all the companies, can pester them into taking better care of the environment.
These are just examples. Any time you think coordinated decision-making by public companies is bad (price setting, wage setting, exercise of political power), and any time you think it is good (environmental, social and governance rules, exercise of political power but in good ways), you could tell a story about how the rise of common ownership of public companies by the same handful of big institutional investors causes more of that coordination. It might even be true! Surely some of the stories are, at least a little bit. Having the same people own all the companies is still a relatively new way of organizing economic activity, and it shouldn’t be too surprising if it has some weird effects.
Matt Levine writes the Money Stuff daily column at Bloomberg. Please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks!