1. Complex organizations, tax policy and financial stability by G. Nicodano and Luca Regis Discussion by Elisa Luciano Parma, January 30, 2015

2. Basic set up  An entrepreneur can organize two activities as two stand- alone units, a merged company or a parent-subsidiary  Purely financial synergies, no operational ones (no economies/diseconomies of scale)  Stand Alone: each company raises its own debt at time 0, receives its profits and pays its own taxes at time 1.  Merger: acts as a single stand alone  Parent-subsidiary: the parent raises debt in both units and decides how much equity of the sub it wants to keep (ownership share), how much it wants to commit to rescue. Each unit receives its profits and pays taxes at 1. Obviously, the sub pays dividends to the parent. Dividends may be subject to double taxation (IDT, intercorporate dividend taxation). 2

3. Main assumptions  Default occurs whenever the (exogenous) after-tax cash flow at time 1 is smaller than the face value of debt  What matters is each company’s cash flow in the case of stand alone or parent-subsidiary companies, the pooled cash flow in the merger  Higher debt = higher tax exemption (tax shield) but also higher default probability  Default costs proportional to asset size  Bailouts are possible only in the parent subsidiary. 3

4. Research questions  What is the optimal organization = the one which maximizes value = debt + equity?  How much does it lever?  If it is a parent-subsidiary, who levers up?  What are the optimal levels of ownership and bailout?  How much do policy interventions (IDT or thin capitalization, which is a cap on the sub tax shield) affect the result?  Does this explain the dismantling of parent-subsidiaries in the US in the thirties? 4

5. Background: Luciano and Nicodano (using a picture from Dell’Ariccia);  With bailout prob and ownership rate =100%, Parent-subs > Mergers (for high rho) > Stand alone. Why?  Observe first that, with exogenous debt, stand alone banks cannot rescue each other, so even minimal insolvency leads to large default costs; same for merger, which defaults in full  Because default costs are proportional to assets 5 company 1 AL 9091 D 9 E company 2 AL 9291 D 9 E merger AL 180182 D 18 E

6. Background: Luciano and Nicodano  To explain why Parent-subs > Mergers > Stand alone, observe then that subs can transfer assets (bailout): from  To 6 company 1 AL 9091 D 9 E company 2 AL 9291 D 9 E company 2 AL 9191 D 9 E company 1 AL 9191 D 9 E

7. Background: Luciano and Nicodano  On top of this, they can place debt where they want (debt diversity): optimal is zero-levered parent. From  To 7 company 1 AL 9191 D 9 E company 2 AL 9191 D 9 E company 2 AL 90 D 9 E company 1 AL 91 + 82 91+82 D 9+tax shield E

8. Main results of Nicodano and Regis, before policy interventions  Subs > Stand alone ??  Yes,, if bailout probability is high enough, because same mechanisms as in Luciano and Nicodano are at play (bailout and debt diversity); ownership share does not matter, as intuition commands (no double taxation).  Yes (??), even if bailout probability is low, provided some debt goes in the parent and optimal ownership share =1, which spurs dividends. So, debt + dividends restore the previous case, even when bailout is not very credible. 8

9. Main results of policy intervention  IDT discourages full ownership, all others equal (interaction with rescue not known, but intuitively sound because it is a double taxation)  IDT has no effect on value when parent is optimally unlevered (?)  IDT lowers default costs of the parent and increases value when the tax rate is high and the parent is levered = when thin capitalization rules are present, but constraint is not too high  This explains why IDT was effective in the New Deal (no thin capitalization and levered parents)? 9

10. Clarifications/Comments  Financial stability = low default and low leverage. But here parent-subsidiary may provide high leverage, low default probability (loss not studied). So, I would recommend investigating the different meanings of stability  Not clear the role of commitment to rescue versus ownership: sometimes treated as parameters (th. 2 and 3)  Superiority of the parent-sub does not come as a surprise, because it has many more “degrees of freedom”: how much debt not only as a total, but also in each affiliate, ownership share, bailout prob: can you separate the effects?  Resiliency with respect to the correlation of cash flows is important (based on Luciano and Nicodano, it favours parent-subsidiary) 10

11. Research questions, not addressed so far  Does greater value go together with greater default probability? With greater loss given default?  In the banking sector (see Luciano and Wihlborg), without policy interventions and with 100% ownership, this is the case: parent subsidiaries boost value, but have much greater expected loss (7 to 1), and therefore create systemic risk  Can you justify IDT or thin capitalization rules also based on risk, on top of expected values (private, E+D, or public, D+E+T)?  Empirics: Was this New Deal dismantling motivated by value destruction or risk concerns? Would it be a good policy today? 11

12. References  Luciano, E. and C. Wihlborg, 2013, The Organization of Bank Affiliates; A Theoretical Perspective on Risk and Efficiency, http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=2264713. http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=2264713  Luciano, E. and G. Nicodano, 2014, Intercorporate guarantees, leverage and taxes, Review of Financial Studies, 27 (9), pp. 2736-2772.