Senator Bernie Sanders recently remarked this in his comments on the crisis:
This country can no longer afford companies that are too big to fail. If a company is so large that its failure would cause systemic harm to our economy, if it is too big to fail, then it is too big to exist. If it is too big to fail, it is too big to exist. We need, as a Congress, to assess which companies fall in this category. Bank of America is certainly one of them. Those companies need to be broken apart. We cannot have companies so huge that if they go under they take the world economy with them.
I most certainly agree. There is a tendency these days for companies to grow beyond any economically substantiable limit. Corporations grow for the entirely wrong reasons.

First and foremost, it is necessary to understand that corporations don't grow because this makes them economically more efficient. Hugeness does not equal efficiency. A huge corporation is, in effect, a small centrally commanded economy. Being centrally commanded economies, the structure of large corporations has more to do with Soviet-era communism than it has to do with capitalist efficiency. (There is a small but important exception: corporations can choose their employees.)

I believe the following are two of the fundamental reasons why corporations grow and grow.
  • Double taxation of dividends. Any dividends that corporations pay to their shareholders are double-taxed. First, the government takes some 20-40% (depending on which government) on the amount of corporate profits. Then, those profits are distributed as dividends to shareholders, and the government takes an additional 20-50% of that, depending on the incomes of shareholders. Effectively, dividends are taxed at something like 50%.

    It is not only that it's double taxation. It's more than that - by paying dividends, a corporation first has to recognize that portion of revenue as profit in the first place. If the revenue is not recognized as profit, it cannot be used for dividends, but the corporation can use "creative accounting" to avoid paying corporate income tax.

    The consequence of this tax system is that shareholders are encouraged not to take dividends, but instead, to reinvest the money into corporate growth. This avoids the corporate and income tax, while shareholders get their due through an increased value of their shares.

    Most importantly, because dividend taxation is so huge, money is invested into corporate growth, even when it would be better used elsewhere. The investment opportunities elsewhere would have to be more than 100% better for dividend payments to make sense.

    This distortion should cause excess organic corporate growth.

  • Conflicts of interest between shareholders and corporate leadership. Directors and CEOs do not own the corporations they run; but they sure do run them. The bigger the company you run, the more power you wield, the more money you make, and the greater you are. Even when it isn't good for the shareholders, directors are motivated to pursue opportunities to buy other companies or merge with them, so that their company can grow even larger, so that they can earn and control even more.

    This distortion should cause excess growth through mergers and acquisitions.

So what is to be done?

Senator Sanders is certainly right that companies that are too large to fail are a liability, and are too large to exist in the first place. His proposal to solve this by threatening a breakup of corporations that grow too large, makes sense. Companies approaching a clearly defined breakup limit would be motivated to split themselves before the courts do. But the trend for companies to grow until they approach this limit would continue.

I think that the least that can be done to fix this trend is to at least remove the corporate income tax. Losses would be tolerable because corporations are avoiding paying this in the first place, and increasing inefficiencies and systemic risk through that.

However, it would be better still to remove both the corporate and personal income tax altogether, and replace them with a federal sales tax.

Among many other advantages, replacing income taxation with FairTax would remove the shareholder incentive to keep growing their companies when it makes no economic sense, and would leave only the agency problem of mergers & acquisitions. And to solve the problem of companies that grow "too large to fail" in that way, a threat of breakup as proposed by Senator Sanders would be a good way to avoid systemic risk.