Social Priorities, Institutional Quality, and Investment

We provide a theoretical framework and empirical evidence characterizing positive and negative externalities that lead corporate investments to deviate from socially optimal levels. A limited liability organizational form, combined with the optimally designed corporate taxes and subsidies, can induce socially optimal investments. A novel empirical prediction is that the quality of institutions can play an important moderating role. Our empirical work is based on the setting from China and utilizes its five-year plans, private and state-owned enterprises (SOEs), and provincial level differences in institutional quality. Our evidence shows that the level of corporate tax required to induce socially optimal investments is lower in the presence of high-quality institutions.