Institution and economic growth

Small firms are subcontractors either in their direct or indirect relation against large firms. They develop new technologies if doing so is incentive compatible, i.e. if entitled to the rents they generate by putting an extra effort to innovate. Therefore, in the program in which large firms decide the level of small firms’ effort to contract for, they must ensure that small firms enjoy a part of the rents and they remain incentivized to develop new technologies. To the extent that technologies help raise profits, it is rational for managers to do so. They often don’t, however, in reality. Such myopic behavior undermines large-firms’ long-term profits. As a result, both large and small firms are worse off. It is therefore necessary that lawmakers and regulators jump in and restrict large firms’ behavior by legislation (e.g. punitive damages) and enforcement. In so doing, a ground is maintained over which small businesses continue to innovate, grow to hire people and spawn skilled labor and entrepreneurs, and eventually let the economy grow. The contractual relationship between small and large firms highlights why and how the institutional devices of legislation and enforcement are critical for economic growth. Their quality are particularly important for developed economies, which are little aided by population inflation, the strongest booster for growth, and among the main features that distinguish developed economies that continue growing against those that don’t.

Corporate tax subsidy and investment

Corporate tax policy in Korea lacks, if doesn’t ignore, basic understanding of the nature of firms. In corporate finance theory, large firms are characterized by low investment opportunities and high cash flow and small firms are characterized by high investment opportunities and low cash flow. What is needed to foster investment and thus growth is then to tax large firms more to reduce over-investment cost and small firms less to reduce under-investment cost. If done reversely, the obvious consequence is an increase in cash reserve, perquisites, and tunneling through related-party transactions (in case of family firms), as large firms are short of investment opportunities to exploit. If the government forces them to increase investment, things will get worse. The tax subsidy to large firms will flow to increase their pies within industry, stifling small firms – which are primary sources of growth and employment in the economy – rather than increase the size of pies to share. Even so, the previous and current administrations have continued to cut (effective) tax rates more for large firms – which already have cash in hand but nowhere to invest – and now turn to blame the large firms for not making investment and lay the current economic distress to their charge. Is this a lie or a joke?