How high profits and low investment by business in R&D and workers lead to income inequality. Why the current situation is unsustainable and what can be done about it.
In this episode you’ll learn:
- Why isn’t productivity improving as quickly as in prior decades.
- Why are profits too high.
- How does CEO compensation compare to what employee make.
- Why public shareholders don’t actually own the company.
- What is the level of income inequality in the U.S. and what can be done about it.
Welcome to Money For the Rest of Us. This is a personal finance podcast, it’s on money – how it works, how to invest it and how to live without worrying about it.
I’m your host, David Stein. Today’s episode is #177 and it’s titled “How Business Contributes to Income Inequality.”
I’m recording this episode in Japan. I’m in the Yamagata region and I’ve formed a recording studio out of tatami mats and futons. It’s been about four years since I’ve been to Japan. I first went seven years ago with my oldest son, and that’s who’s accompanying me on this trip. The biggest difference is he can speak Japanese now, whereas seven years ago we were completely lost as we tried to navigate with really no language skills at all.
Service and Productivity
Episode #72 was titled “Will a Robot Take Over Your Job?” and I talked about how in Tokyo at many commuter train stops there were white-gloved attendants who quietly motioned people with their hands not to fall off the edge of the platform. I mentioned they’re not there to increase productivity; it’s a nicety. The Japanese have perfected the art of the personal transaction. They’re very service-oriented, so they have – or did have – platform workers that just kind of guided people. I didn’t see that on this trip. On many of the stops there were automated gates that would open and close, allowing the people to get onto the train.
We did something different on this trip – we’ve rented a car. Before, we always just took the train. We paid $90 to go 445 kilometers from Utsunomiya up to Obuke in Northern Japan. It’s about 20 cents/kilometer, 33 cents/mile, but very well-maintained roads, and just beautiful scenery.
An example of something else that wasn’t particularly productive – they have hedges on a part of this main highway, that divides the two sides, but the hedges are trimmed into square boxes. Somebody’s out there trimming, but I didn’t see anybody… Well, at the toll booths, in the U.S. and in many other countries, and including in Japan, they have some automated toll booths; it’s called ETC. You can just go through if you have a card. We didn’t have a card, so we’re going through toll booths… Some have change; you put in your money and you go through with no individual there, but some still have attendants, and they’re just so nice.
They said “Hello, may I have your ticket? Thank you very much.” They explain exactly what they’re doing as they process your ticket, and say “Here’s your charge.” They take your card or your money, they count your change, but they very politely explain everything that’s going on, and when they’re done, they hand you your card or your change after they’ve counted it in front of you with two hands. They say “Have a nice day and drive safely!” It’s not fast, but it’s very, very polite, and the Japanese do a lot of things like that.
When you get stopped for road construction, if there’s a man or a woman, a flag person, they’ll actually bow as a way to express their apology that we’re being delayed. And yet at other stops, there isn’t a flag person, there’s a mannequin/robot that automatically waves a flag. More productive, not as nice.
Dieter F. Uchtdorf – he’s a member of the First Presidency of The Church of Jesus Christ of Latter-day Saints – told a story of an elderly man who is standing in line at the Post Office to buy stamps at the counter. A young woman noticed he just walked with difficulty, and wanted to show him how to buy stamps from a machine, to save time. The elderly gentleman said “Thank you, but I prefer waiting. The machine won’t ask me about my arthritis.”
Amazon – in the New York Times there was an article describing Nissa Scott, who works at an Amazon warehouse. Her job was to stack plastic bins. It was really grueling work. These bins weighed 25 pounds each; she worked 10-hour shifts. She’s 21 years old. Now she babysits robots – these giant, bright yellow mechanical arms stack these bins, and she minds/monitors these robots to make sure they’re doing their job. That’s an example of a productivity increase, some robot taking over a job where the worker is being replaced, but has a different job, a more advanced job.
That’s what productivity improvement is – companies making investments in their business and in their workers, so they become more efficient at producing things, and create new things, become innovative and creative. Then that helps the company better compete, become more efficient, more profitable, and then the workers get a share of those profits, as do the owners of the private company, or the shareholders. That’s capitalism.
But there’s a problem with it now – it’s not working the way it used to. It starts with productivity. The IMF did a recent study that I’ll link to in the show notes where they show that productivity is slowing; it’s not improving as fast as it used to since the Great Recession. And why? What’s changed? Well, they give a number of reasons. One is that the impact of the technology, communication, information systems – they had a huge impact in the productivity in the ’90s and early 2000s; they have less of an impact today.
Another factor is workers. Workers are aging, and as they get old, their skills — if they don’t invest in new skills and the businesses aren’t investing in their workers, then their skills start to degrade, and the companies become less efficient.
The companies are investing less than they used to, both in terms of R&D, as well as in their workers. They’ve changed their focus, and it shows up in lower productivity numbers, it shows up in income inequality, and it shows up in higher corporate profits.
When Profits are Too High
In March 2016 The Economist did an article/report titled “Profits are too high.” They write:
“Profits have risen in most rich countries over the past ten years, but the increase has been biggest for American firms. Coupled with an increasing concentration of ownership, this means the fruits of economic growth are being hoarded. Profits are an essential part of capitalism. They give investors a return, encourage innovation, and signal where resources should be invested. Their accumulation allows investments in bold, new ventures.”
That’s what we’ve talked about – the profits reinvested in the company, invested in their employees, their workers, to inspire creativity, innovation, invested in R&D. The economist goes on:
“The high profits across the whole economy can be a sign of sickness. They can signal the existence of firms more adept at siphoning wealth off, than creating it afresh… Such as those that exploit monopolies. If companies capture more profits than they can spend, it can lead to a shortfall in demand.”
How has that happened? Well, if they’re not reinvesting it, cash balances just start climbing, and get higher and higher, and we have that – trillions of dollars held by corporations, not invested, and often held overseas to avoid paying taxes… Just sitting there, not reinvested.
The economist continues:
“High profits can deepen inequality in various ways. The pool of income to be split among employees could be squeezed.”
Workers are fighting over a smaller and smaller pie in terms of their income, and consumers might pay too much for goods.
“In a market the size of America, prices should be lower than in other industrialized economies. By and large, they are not. Though American companies now make a fifth of their profits abroad, their naughty secret is that their return-on-equity is 40% higher at home.”
There should be business dynamism where if there’s an opportunity and too high of profits, that another business can come in and take over and take advantage, and you’re not seeing that often times. The profit can be too high.
Falls in the share of output going to workers over the past decade is equivalent to about 60% (60%!) of the rise of domestic pre-tax profits. Profits are rising because workers are getting less, and shareholders and company’s senior management is getting more. Why is that? The economist talks about technology is replacing workers with machines and software. That’s a good thing, that’s normal; that’s automation, that’s productivity improvements. But if the spoils of those improvements aren’t’ going to workers and it’s just falling into the bottom line, then that contributes to income inequality.
Certainly, globalization has had an impact as manufacturing moves overseas to where workers are paid less. Declines in trade union membership has an impact, where employees have less clout and ability to negotiate fair wages, but the economist says none of these accounts though for the most troubling aspect of America’s profit problem. It’s persistence.
Business theory holds that firms can at best enjoy only temporary periods of competitive advantage, during which they can rake in cash. After that, new companies inspired by these rich pickings will pile in to compete away those fat margins. Bringing down price is increasing both employment and investment. It’s the mechanism behind Adam Smith’s invisible hand in this book, The Wealth of Nations, written hundreds of years ago.
In America, that hand seems oddly idle, writes The Economist.
An American firm that was very profitable in 2003, one with post-tax returns on capital of 15%-20% had an 83% chance of still being very profitable in 2013. That’s a study done by McKinsey. But it is the way that they stay profitable that isn’t sustainable.
In 2014 William Lazonick published a piece in Harvard Business Review called “Profits Without Prosperity”, and he talked about – from the end of World War II into the late 1970’s, corporations did “retain and reinvest”. That was their approach to resource allocation. They had retained earnings, and then they reinvested those earnings in increasing their capabilities, and becoming more competitive by rewarding and investing in their employees. They provided workers with higher incomes and greater job security. That is sustainable prosperity, because the workers then could go out and buy stuff and afford to do so.
He goes on and talks about the pattern broke down in the late ’70s, giving way to what he calls “downside and distribute regime.” A regime of reducing costs, and then distributing the freed up cash to financial interests, particularly the shareholders. That’s what we’re seeing… Stock buybacks. He reports that from 2003 to 2012 during a period where companies used 54% of their earnings, 2.4 trillion dollars, to buy back their own stock, and another 37% of their earnings for dividends. So 54% to buy back stock, 37% for dividends, leaving 9% to reinvest in R&D and increasing their investment in their employees. That isn’t sustainable.
Another way that businesses contribute to income inequality is the pay, the compensation of CEOs. From 1978 to 2015, U.S. CEO compensation increased 940%, versus 543% for the S&P 500. The increases, according to Fortune – they’re increasing the pay of CEOs faster than the stock market is increasing, and the idea is they do that to provide incentives for the CEO to boost their stock price… But they’re actually getting paid more than the stock price is increasing.
In 1965, according to Payscale.com (a study they did) the CEO-to-worker compensation ratio in the U.S. was 20 to 1. The CEO made 20 times what the median worker made, and that was according to the Economic Policy Institute. The Payscale.com study looked at what is it today – 70 to 1. So the typical, average CEO is making 70 times what the median worker is making, versus 20 times back in 1965. Some of them are making 300 times more their median worker. That contributes to income inequality.
Now, we talked about this last week – we have to reward the shareholders. The shareholders are the owners, we’ve got to maximize shareholder wealth. Peter Georgescu in Capitalists, Arise! points out:
“Part of the justification for this philosophy – paying a CEO more is increasing profits – is that shareholders are viewed as the equivalent of owners in a private company. The prevailing myth is that shareholders own the corporation.”
Lynn Stout, a Cornell Law School professor pointed out “This isn’t legally the case.” She writes, “Shareholders don’t legally own a company. They simply own shares of stock. The corporation itself owns its assets. The shareholders have rights, but so do other stakeholders. If the shareholders were the true owners, they would be liable in a court of law for a corporation’s mistakes and crimes, and they’re not.” They have limited liability. There are other stakeholders – we talked a little bit about that last week.
In September 1982 Peter Georgescu was in a meeting; he was a young analyst at Young&Rubicam. He was there with the CEO in this meeting at Johnson & Johnson’s headquarters. They were represented by their CEO, Jim Burke, and other senior management. Why were they there? That was the month that a number of bottles of Tylenol had been poisoned by potassium cyanide and there were deaths. Johnson & Johnson needed to decide “What do we do?” Jim Burke opened his desk and pulled out a piece of paper. It was the company’s mission statement, and it starts with “We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services.” That’s about high-quality. That’s their first responsibility, their first stakeholder.
He went on, “We are responsible to our employees, the man and women who work with us throughout the world. We are responsible to the communities in which we live and work, and to the world community as well. And our final responsibility, just one of them, our final is to our stockholders. Businesses must make a sound profit. We must experiment with new ideas, research must be carried on, innovative programs developed and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched.
Reserves must be created to provide for adverse times. When we operate according to these principles, the stockholder should realize a fair return.”
Notice there were multiple stakeholders: the customers, the community, the employers and the shareholders. But there needed to be investment in their workers and in R&D, so that long-term profits can be there, so that workers have the resources collectively around the community to buy the products.
The Unequal Outcomes
If the profits are going more and more to the wealthiest decile in the U.S. and the lower deciles are not getting the income they need, they’re not. You look at the 2016 consumer expenditure survey – half the country has negative cashflow. They’re spending more than they’re receiving in income, and we talked about this a little bit last week. We’re looking at what percent is insolvent, what percent has debts greater than their assets. Georgescu said it was 40% to 60%. At the end of that episode I said it was 25%.
Listener George pointed out, I don’t even think it’s that, because I was referencing a Congressional Budget Office study, and he’s right; I said it was 25%, because the study said the average wealth of the 25th percentile and below is negative, that they are insolvent. That’s the average of that quartile. If you look at the numbers, 12% are insolvent, have assets worth less than their debt, but half is actually running negative cashflow.
If you look at that consumer expenditure survey – and this is a survey, so they’re reporting it; they’re reporting their after-tax income, and they’re reporting what they spent and what they spent it on, and half are reporting spending more than they’re taking in in income… How can that be? Well, you read the footnote, and the Census Bureau that puts the study together – they answer it:
“Consumer units (people, households) can experience spells] of unemployment, so they may draw up on their savings if they become unemployed. Self-employed consumers might experience business losses. If you’re retired, you’re pulling from your savings, so you could spend more. Or if you’re a student, you’re getting by with loans.”
So there’s flux in these deciles. Sometimes you go through periods of unemployment, then you get a job, but it shouldn’t be half… And I compare this to 1972. I pulled out – where was it then? In 1972 seven out of ten deciles were making more in income than they were expending. Three deciles weren’t, but the third decile, the shortfall was only about $400. That today is roughly in inflation-adjusted about $2,300. So in today’s dollars, the third decile was spending $2,300 more than they were taking in in income. Today, that third decile (the lowest decile) is running an $8,800 shortfall in 2016 dollars. So income inequality is real. The fact that more and more of the spoils are falling to the bottom line in terms of profits, and being used to buy back shares, and not invested in workers and employees – that shows up in the numbers, it shows up in shortfalls, it shows up in income inequality.
From 1979 to 2013 average tax income grew at significantly different rates. Households in the top 1% – again, this is a CBO study; I’ll link to it in the show notes – had 192% higher inflation-adjusted, after-tax income in 2013 than they did in 1979. 3% increase per year.
Those in the bottom quintile only increased 46%, so about 1% a year.
The top 20% in the U.S. gets over 50% of household pre-tax income. The top 1% gets close to 10%. The bottom 20% only gets about 5%. We have income inequality, and businesses contribute to it, because they’re no longer taking their earnings and reinvesting it in the employees. They’re buying back their stock, they’re rewarding their CEO’s and they’re not investing in R&D, and ultimately, it’s not sustainable. You can only cut costs so much. You can only buy so much stock back. At some point you need customers to buy your products, and if your customers are running ongoing negative cashflow, they’re spending more than they’re taking in in income, increasing their debt loads, they’re not going to be able to keep buying.
Now, there’s a reason why businesses do that. Business is hard. Very, very competitive. We have a surplus of stuff, it’s so easy now to make things, to make anything. So if you’re going to invest in your workers and in innovation, R&D, you’ve gotta create something new that people want to buy, and it’s hard to know what people want to buy. It’s very competitive. We can’t compete on price. We have all of these website to figure out who’s got the cheapest price; it’s a race to the bottom. It’s those that have something new and different; it could be a differentiated experience, it’s the niceties like we seen in Japan that people are willing to pay for… But business is hard; it’s easier to cut costs, it’s easier to buy back stock… And it’s worked. Profits are up, the stock market has done very, very well, and if CEO’s don’t perform in that way – that’s what their incentives are in terms of their compensation – then you have activists, shareholders, hedge funds demanding that they make those changes. It’s such a short-term focus. Georgescu writes:
“If inequality is not addressed, the income gap will most likely be resolved in one of two ways – by major social unrest, or through oppressive taxes.”
We don’t want that. I’d rather see businesses invest in their workers and their employees and in R&D. That’s what’s sustainable, even if it is hard and difficult… But that is what will allow for capitalism to continue, because it can’t continue in its current form.
I recently saw a promotion for Walmart. They said “We’re investing $2.7 billion in training, education and higher wages, because it’s our humanity that drives our creativity, powers our competitive spirit, and keeps us out in front.”
Now, if Walmart can do it, other businesses could do it. I don’t know the extent Walmart has, but at least they’re recognizing it, the importance of investing in their workers, the importance of R&D… Because that is what drives our creativity.
You can get show notes at moneyfortherestofus.com. While you’re there, go ahead and sign up for my Insider’s Guide. I’ll send you those show notes weekly; it’s free. I’ll send you a weekly essay with some of the best writing I write each week, not published anywhere else; it just goes to those members – Insider’s Guide. It’s free. Go ahead, sign up at moneyfortherestofus.com. If you’re a U.S.-based listener, you can text the word “insider” to the number 44222.
Everything I’ve shared with you in this episode is just general education. I don’t give investment advice here. This is about the economy, we’re talking about money and investing. I hope you have a great week. We’ll be in Japan a few more days, and next week back in Idaho.