Institutions and Innovation

Abstract

We study the design of institutions as a framework for regulating innovative activity in the private sector given the informational constraints faced by the social planner. Innovation in the private sector by financial institutions and manufacturing firms imposes important positive and negative externalities; the social impact of these private firms depends on the sharing rule between their owners and the society at large, which in turn, is governed by laws, regulations, and institutions in place. We propose a framework where the social planner puts in place a system of laws, organizational forms, and taxation within which firms optimize without invasive regulation. Since the legal regime affects the extent to which the owners of firms are held responsible for the negative externalities they impose, unlimited liability may discourage innovation in strong legal regimes. Limited liability, however, might be accompanied by excessive innovation. In this framework we consider an optimally designed structure of taxation, a menu of organizational forms, and the legal system. In this structure, firms choose their organizational forms and level of innovation consistent with private optimality, and we show that these private choices are aligned with social optimality. Optimally designed corporate tax rates are a decreasing function of legal effectiveness in the embedding economy. We highlight some stylized facts from cross-country data that support our results.