There has been some hullabaloo about governments worldwide taking equity stakes in troubled banks1 and car companies.2 The surprised and at times outraged tone of the hullabaloo reveals a broadly shared and incorrect belief that governments do not already have equity stakes in enterprise. Governments, including our own, regularly take equity stakes in distressed corporations.3 In fact, governments have a substantial equity stake in each corporation, distressed or not, via the tax authority's claim on a fraction of corporate income. Some degree of government ownership and control of enterprise is an inevitable consequence of a functional income tax.4 This observation not only challenges popular notions that recent direct investments by the government in public corporations5 represent adventurous departures from the status quo6 but also prompts a puzzle: If the government's economic interest resembles that of a shareholder, why is it denied the control rights shareholders typically enjoy?
The traditional taxonomy of participants in a firm's capital structure divides them between debtholders and shareholders.7 The former sit atop the capital structure, removed by bankruptcy priority and contractually fixed interest payments from the risks and returns the latter face below.8 Differences between debtholders' and shareholders' economic interests lead to conflicts over business strategy. Control rights paired to debtholders' and shareholders' economic interests are designed to resolve these potential conflicts without hindering productive efforts of the firm. The primary puzzle prompting this Article is how-in the absence of control rights traditionally afforded to shareholders-the tax authority protects its interests.9
The tax authority stands in two distinct positions vis-à-vis each firm.10 First, the tax authority promotes the government's interest as regulator. It does so by imposing relatively lower rates on congressionally favored forms of enterprise. Second, the tax authority serves a revenue raising function, which is accomplished through a right to share in firms' revenues.11 That right to share in firms' revenues is similar to that possessed by the firms' shareholders. Specifically, both share in the residual of a firm's earnings after expenses have been paid.12 But while the economic rights of shareholders and the tax authority show profound similarities, the control rights afforded to the latter take a drastically different form from those afforded to the former. Unlike a shareholder, the tax authority cannot vote for representatives on the board of directors, cannot threaten management with a transfer of its interest to those more able to impose discipline, and cannot align management's interests with its own by sharing a portion of tax receipts with them. Thus, it lacks three basic tools shareholders use to focus management on the interests of equity: corporate democracy, the market for control, and the market for management.13 Moreover, directors and officers do not owe the tax authority fiduciary duties that protect other interest holders from their disfavor. Having identified that shareholders and the tax authority have similar economic interests in a firm, but that the latter lacks control rights possessed by the former, Part II considers three questions.
First, does the tax authority need distinct control rights? If taxes served solely the goal of generating revenues, the tax authority could simply be granted nonvoting common shares in every corporation and rely on assertive shareholders to safeguard its interest.14 As is, however, taxes are designed to do more than raise revenues-they are also used to encourage congressionally favored behavior.15 In other words, the tax authority as interest holder does not only care about how much the taxpayer earns but also about how the taxpayer earns it. As a result, the interests of shareholders and the tax authority are not …