Race to the Bottom

A Times story illustrates a peril that is a virtue to some

The New York Times gave this piece as big a play as you’ll see a non-news story get yesterday, going with a four-line, two-column headline atop page one. That’s newspaper for This Story Is Important.

The Times reports on how states are letting the insurance industry set up so-called captive companies whose sole purpose is to insure the parent insurance company. Why is this a potential problem?

This has given rise to concern that a shadow insurance industry is emerging, with less regulation and more potential debt than policyholders know, raising the possibility that some companies will find themselves without enough money to pay future claims. Critics say this is much like the shadow banking system that contributed to the financial crisis.

To carry the analogy forward, the Times is saying basically that insurers are going regulator-shopping just like banks did in the years leading up to the Crash. The banks pitted the Office of the Comptroller of the Currency against, say, the Office of Thrift Supervision, making the regulators, whose budgets depended on having banks to regulate, try to get their “business.” That led the regulators to compete on who would be the most impotent and to defend banks from bothersome consumers and state regulators who actually wanted to regulate them.

That’s known as regulatory arbitrage, and it’s a key reason why we ended up with the biggest financial crisis in eighty years. It’s nuts that we ever allowed it, and the Dodd-Frank financial reform law changed the rules to prevent it, at least on the federal level.

Another way to think of all this arbitrage is as a race to the bottom. It’s what we mean when we talk about how free-trade fundamentalists are really engaging in labor and environmental arbitrage—pitting the U.S. with its relatively high wages and strong safeguards against third-world countries that have neither. Or when a $90-billion corporation like Amazon blackmails states like Texas and South Carolina that want it to collect sales taxes like everyone else in the state does. Or when a governor famous for his budget cutting gives a Japanese firm $102 million so it won’t move out of the state. Or when companies transfer sales overseas to take advantage of lowball corporate-income shelters. Or when David Stern sends a warning shot to NBA fans and taxpayers by sending the Seattle SuperSonics to Oklahoma City after voters decline to foot the bill for a new arena. Or when Texas Governor Rick Perry tries to take advantage of California cracking down on egregious municipal corruption to poach businesses.

But of course, not everybody thinks the idea of a race to the bottom—an obvious downside to the benefits of free trade and federalism—is a bad thing. Some people actually think the race itself is not only good, but the point.

You might have guessed the Wall Street Journal editorial page would be one of these somebodies, and you’d be correct. Here it is last month arguing that states shouldn’t try to tax the sales of Amazon and other Web retailers:

One virtue of the U.S. federal system is that it allows states to compete on tax policies.

In other words, it’s a virtue to allow big companies like Amazon (and it’s almost always big companies) to pit one state or city against another to give it an unfair advantage.

(And wait a minute. Isn’t this the same WSJ editorial page that argued strenuously, over and over, for a federal-only system when states were clamoring to regulate predatory lending? I thought so. So, let’s see: it’s for federalism when it favors big business, and Big Government centralization when it favors, um, big business. Got it.)

Here’s the Washington Post’s George Will last month making it even more explicit:

Federalism — which serves the ability of businesses to move to greener pastures — puts state and local politicians under pressure, but that is where they should be, lest they treat businesses as hostages that can be abused.

In this case, the “abuse” would be having Internet merchants like Amazon collect taxes like mom and pop in Peoria do. And the flipside, of course, is that businesses—again, the big ones, who have the money to buy influence—treat cities and states as hostages that can be abused.

Presumably, Will’s and the Journal’s logic extends to states racing the Caymans to the bottom for insurance-industry scraps. Neither likes taxes or regulation, especially on business.

The Times reports that these captive-insurance deals let insurance companies hide details that would normally be public, like where they’ve invested their reserves.

Liberal Vermont and its former governor and presidential candidate Howard Dean, ironically enough, led the federalist charge here, according to the NYT, beginning in 2002. And now the race to the bottom is on for real with dozens of states horning in on the action. Not only has the competition between states reduced regulation and public information while allowing insurers to raid their reserves meant to cushion against catastrophe, but it also means Vermont, which now depends on the business for 2 percent of its budget, is going to see its cottage industry go away:

Other states took note of Vermont’s success. Hawaii charged lower taxes than Vermont on the revenue that captives took in on premiums, leading Vermont to reconsider its rates. Delaware gave its insurance commissioner the power to exempt a captive from provisions of state insurance law; the number of captives in the state doubled last year.

New Jersey, the latest entrant, offered to cap its tax on such subsidiaries at $200,000 a year. Michigan decided not to tax them at all, but charged a modest fee. Nevada passed a law allowing captives to be formed with as little as $200,000 in capital.

Insurance companies and their executives will be left with higher profits (at least in the short-term) and fatter bonuses. What taxpayers will be left with: Chump change in tax revenue and a weakened insurance system more vulnerable to collapse.

In which case, of course, taxpayers will be on the hook to bail out the insurance companies.

Meantime, Governor Perry has seen the downside of the race to the bottom after the state’s comptroller (a Republican like Perry) tried to collect hundreds of millions of dollars from, yes, Amazon. The company bolted Texas, citing, incredibly, the state’s “unfavorable regulatory climate.”

“We don’t want to be onerous on tax policy where businesses and I would say I’m having a hard time getting my hands around this one,” Perry continued. “The good news is that the legislature is in town for our biannual session. Hopefully someone will be able to craft some legislation — and actually do it — before Amazon walks out the door. Texas should be a bastion for businesses not one where they’re sitting there going ‘we’d rather go over to go to Oklahoma where we could get a better deal.’”

“Texas doesn’t need to make itself less competitive with its tax decisions.”

And so on and so forth.

Next time you wonder why we get ourselves in these positions, remember that there are powerful folks who think this is a good thing.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum. Tags: , , , ,