If corporate investors, in aggregate, are going to eat an ever-growing portion of the American economic pie, some other group will have to settle for a smaller portion. That would justifiably raise political problems.
Marc Faber
The data is unequivocal. The income share of the national economic pie going to labour has been shrinking for around three decades (see Figure 3.1 overleaf).
This phenomenon should not be confused with rising inequality in the distribution of that income among working people. Neither does one imply the other. You could have a more equal distribution of income from wages (from CEOs down to the lowest employee) even if the total take from wages fell as a percentage of national income. However, they are linked historically and the effects of each on consumption and growth is similar. Other things being equal, each has a depressing effect on the incomes – and so purchasing power – of the less well-off, whose propensity to consume out of income is greater.
Clearly, a decline in labour’s share of national income means that, even in a growing economy, growth in consumption will be weaker, unless households spend more as a proportion of income. In other words, in order to keep up, households will need to either save less or borrow more. Similarly, an increasingly unequal distribution of income within the labour market has well-known depressing consequences for consumption. We will look at the latter in more detail in Chapter 4.
Figure 3.1: Changes in labour share in G20 countries plus Spain 1970–2014
How and why has this retreat by labour taken place and what does it mean for the developed economies and investments in the future? And crucially, how does it link to globalisation, technological change, rising inequality and the erosion of trust in mainstream politicians and the democratic process?
Looking at the relationship between labour and capital another way, in the 1960s it took American workers about 30 hours of work to buy the value of the S&P 500 stock market index.
Figure 3.2. Hours of work to buy the S&P 500
This ratio fell to about half that during the 1970s, when the market fell and workers had the upper hand in wage bargaining, before rising to around 74 at the market peak in 2007 (S&P 500 at 1,565/$21.05 average private-sector hourly wage). The GFC brought the ratio back down to about 30 in March 2009. Fast-forward to end of July 2019, and it has soared to 106, underscoring how well capital has done relative to labour in the aftermath of the crisis.1 A related factor is that company earnings have been so strong partly because wage growth has been so weak. The bulk of growth is being captured by corporate earnings and shareholders.
According to a McKinsey Global Institute report, global corporate net income rose fivefold between 1980 and 2013, compared to world GDP growth of a mere 70 per cent.2 Profits as a share of GDP rose to 11.6 per cent in the US, which is the highest level since 1929 and double the rate of the more egalitarian 1990s. In the UK a similar trend is clearly visible.3
The McKinsey Institute is not alarmed because it believes that the share of corporate profits globally will revert towards the mean as growth becomes concentrated in emerging markets. Because of the preponderance of family-owned or controlling-shareholder companies in these markets, companies are less driven to pursue short-term profits or squeeze their employees, and are more inclined to take a long-term view and reinvest profits to build position in the market and pursue growth. According to the institute, emerging-market companies only returned 39 per cent of earnings to shareholders between 1999 and 2008 compared to 80 per cent for developed-market companies. Even if developed-market companies eventually lose the long-distance race, they have certainly made out like bandits over the last thirty years, scant consolation for their workers.
If sales and revenues don’t grow much, the only way to grow corporate earnings more impressively is to expand margins by cutting costs. This drives up share prices, which benefits owners and managers of capital. Since labour often represents a major part of costs, company managements have been busy ‘improving efficiency’ by shedding expensive labour in the US, UK, Germany and France, either moving production to cheaper locations abroad or through automation. The result is that the interests of corporations and their employees are no longer aligned.
The corollary to the squeeze by companies on labour costs has been the dwindling slice of the pie paid to labour. Again, US data graphically charts the deteriorating trend (Figure 3.3).
A similar trend is clear in the UK, following the change in economic policy which transformed the balance of power between organised labour and employers after 1979’s so-called winter of discontent and the election of Margaret Thatcher (Figure 3.4).
Figure 3.3: Share of labour compensation in GDP in the US 1950–2015
Figure 3.4: Share of labour compensation in GDP in the UK 1856–2006
This decline holds, with some variation, pretty much across the developed countries, and has been well documented by economists such at Thomas Piketty.4
Under the economic system in force until the 1980s gains from increases in productivity were shared out between profits and wages, thus providing employees with the purchasing power to buy the fruits of their production. This created a virtuous circle of rising revenues begetting further wage and profit growth (see Minsky). Rising profits were also partly recycled into new investments that would in turn generate demand in the economy and increase productivity in a second virtuous circle.
In contrast, during the ‘recovery’ since the GFC of 2008 company chiefs have grown corporate earnings in spite of lacklustre revenue growth by cutting all costs. This has meant not only labour costs, but also skimping on reinvestment in productive capacity – capital expenditure. In what has now turned into a vicious circle, every round of labour cost-cutting undermines the purchasing power of consumers. This weakening demand has prompted management to engage in further cuts and dissuaded them from capital expenditure, given the visibly weak demand trend. This is partly responsible for what has become an entrenched deflationary pressure in major developed countries, in stark contrast to the great industrialist Henry Ford’s benign paternalism: ‘I will build a motor car for the great multitude … constructed of the best materials, by the best men to be hired, after the simplest designs that modern engineering can devise … so low in price that no man making a good salary will be unable to own one and enjoy with his family the blessing of hours of pleasure in God’s great open spaces.’ The millennial generation’s questioning of the need for car ownership is a poignant reminder of the principle that you reap what you sow.
In a more modern version of the story, a company executive proudly showed off to visitors his newly automated factory. The visitors politely enquired how the robots would buy the product.
This tacit recognition by companies of the need to pay workers enough so they can buy their own output both constrained the profit-seeking behaviour of companies and was consistent with acting as good corporate citizens. It also made economic sense. As we saw in Chapter 1, any single company can improve its profits by cutting its own labour costs and so it is ‘rational’ for it to do so on its own. But this ceases to be the case if this corporate behaviour becomes generalised, since the aggregate cut in purchasing power of labour will (unless workers find ways to supplement their purchasing power in the form of government handouts, loans or reduced savings) eventually hit that company’s revenues, placing those temporarily enhanced profits under pressure.
This is sometimes referred to in ethics as the generalisation principle. A simple example of this is questioning whether to vote as a single vote will apparently make no difference to the outcome of an election; instead, you might as well save your valuable time. But if this reasoning is generalised, and no one votes, then the democratic process will implode. Likewise, squeezing wages to protect profits shows that Adam Smith’s invisible hand can lead to perverse consequences if that hand is so blind as to completely miss the aggregate consequences of individuals acting only according to their narrow short-term interests.
Nor is it the case that lower wages can still maintain demand growth if it means more workers being priced into jobs. The fact is, the declining slice of wages in the national cake has occurred over a long period of time, during which there have been many economic cycles, including low and high unemployment. Fluctuating employment levels have not prevented the total take of wages from shrinking as a proportion of the whole, causing a continuing downward pressure on demand.
Classical economics does recognise some special cases where, from an aggregated point of view, the price mechanism on its own leads to sub-optimal results. Pollution and the protection of the environment is a topical case, where it is clearly of benefit to everyone to tax individual polluters for the societal consequences of their selfish actions and in order to encourage socially optimal outcomes. The only issue here is the technical one of how high to set the taxes. While it might be acceptable for a single economic entity to pollute if it gains from doing so and is too small to have a noticeable impact on the planet, it is not acceptable if this behaviour is replicated by a myriad of economic agents.
Curiously, while there is a whole body of economics that addresses the conundrum of the consequences of the rational decisions of individual economic agents in the case of pollution, there is, with some notable exceptions, much less discussion of this conundrum when it comes to the sharing out of the economic pie between profits and wages. This is probably because it is a more directly political issue which raises awkward questions for free-market ideologists.
Since the short-term, profit-maximising behaviour of companies is in conflict with the concomitant growth of wages, it is equally fair to say that there has been a breakdown in the social contract. Not only is this new model of growth not sustainable, it is clearly leading to disaffection among Western populations that threatens to challenge the economic and political status quo. Henry Ford was aware of this danger when he said, ‘Profits made out of the distress of the people are always much smaller than profits made out of the most lavish service of the people at the lowest prices that competent management can make possible.’5
The collapse of the Soviet Union and the discrediting of the communist system opened the way for a capitalist system that has turned its back on balancing the interests of business, the managerial class, shareholders, workers and consumers to an almost unbridled anything goes – as long as it’s the result of the market operating without constraint. The market may not be perfect, but, like its twin, democracy, it’s the best we have. Those within government who believe they can successfully second-guess the market are doomed to failure, as demonstrated by the collapse, under its own weight of inefficiency, of the seven-decade communist experiment of social and economic organisation starved of the vital price signals generated by the free interplay of supply and demand. The counterexample of the successful Chinese state-capitalist model was not yet evident in the 1980s and 90s when the unconstrained free-market ideology rippled out from the Anglo-Saxon countries across the globe under the political leadership of Ronald Reagan, Margaret Thatcher and their successors.
If the free market was the undisputed champion of the world, then its consequences could be justified by its economic efficiency and the invocation of supporting mantras. Companies are major players in markets; they allocate scarce resources through the signals of the price mechanism. The least efficient go out of business or are eaten up by their more efficient competitors in a Darwinian struggle for survival. The share price of a company reflects its perceived success or failure and acts as currency for takeovers and mergers. A company’s share price being expensive or cheap determines whether it is able to stalk the corporate jungle as a predator or struggle to avoid becoming prey.
Shareholders in a company are rewarded by owning a part share in the earnings growth of the company and through payouts such as dividends or buy-backs of shares. No wonder the exhortation that the goal of business is to maximise earnings per share over time, encapsulated in the mantra of ‘shareholder value’, was an easy sell.
Of course, the goals of the professional managers hired by the owning shareholders of limited-liability companies to realise this objective are not necessarily aligned with those of their owners. Unlike in the time of the high priest of the market, Adam Smith, when business was arranged around partnerships constituted by active partners, today’s free market has separated ownership from management. The potential for conflict of interests, sometimes referred to as the agency problem, manifests itself most blatantly in the realm of pay.
Faced with thousands if not millions of shareholders who subcontract the stewardship of their ownership interests to professional investment managers (who in turn have their own commercial interests to defend), there is little to deter corporate managers from seeking to game the system. There are many ways in which this can be done, but perhaps the most effective has been to tie top company management’s compensation most heavily to the simple metric of earnings per share, either in the form of the granting of options related to this number, or bonuses contingent on reaching some pre-determined earnings per share target within a set time period.
Earnings per share are the result of three factors: revenue, costs (the difference between these two being earnings) and the number of shares outstanding (being the denominator). Management can influence all three, but to different degrees. Revenue growth is a function not only of a company’s products and services, but also the general economic environment, demographics and technological change. It’s easier for management to control costs. This can be achieved in a number of ways, including moving production to cheaper locations, increasing automation and granting wage rises below the rate of increase of productivity.
Another strategy to flatter profitability, at least in the short term, is to minimise reinvestment in the business, for example by reducing capital expenditure. Instead of reinvesting to promote the company’s profitability and survival, management often prefers to spend cash on buying back the company’s own shares. This mechanically increases the key metric of earnings per share, to which is tied top management’s variable remuneration, typically many multiples of fixed salary. We shall return to the subject of market manipulation by senior managers in order to game the system in Chapter 8, as it does not directly affect the overall share of labour in the national pie. Cost reduction, on the other hand, by whatever means, is a direct cause of the falling share of labour in national income.
Some might argue that stock-owning households have seen their wealth increase as a result of this focus on share price, offsetting the effects of wage stagnation. However, according to the Federal Reserve Board, only 30 per cent of the lowest paid in the USA invest in stocks, compared to 92 per cent of the richest families. In other words, it is scant consolation for many that investment portfolios have done well; all they have are stagnant incomes. And while it is true that the ageing baby boom generation, with generous pension plans, may enjoy a comfortable retirement thanks to high growth in their stock investments, it is highly unlikely younger generations will enjoy the same stock returns or generous gold-plated defined-benefit pension plans.
The inflation-adjusted annual rate of return from US stocks (with dividends reinvested) since 1946 to July 2019 was a whopping 7.1 per cent,6 far higher than the rate of growth in real wages, a theme which also features in Thomas Piketty’s work. The extraordinary asset price inflation, including property, since the early 1980s has also contributed to a huge increase in wealth inequality.
Figure 3.5 graphically illustrates the increasing gap in the US between the growth in output per head and how much each head in the middle of the income distribution scale is paid.
Part of the explanation is that some components that make up the consumer price index – such as energy, medical and housing costs – started to rise quite sharply from the 1970s onwards. This effectively increased GDP while holding back the purchasing power of labour. But, on its own, this cannot entirely explain the growth of the gap.
In contrast to median wage levels, average wages did somewhat better because the average is skewed upwards by the outsize gains of those at the top end of the income distribution. The median (the individual in the middle of the pack) is a fairer measure of change because it is not affected by the change in the distribution of income within the labour force. If those at the top reap almost all the gains from growth, the purchasing power of the majority of the workforce stagnates.
Figure 3.5: The productivity–wage gap
Table 3.1 shows this phenomenon with the changes in real household incomes skewed in favour of those at the top. The average household has seen modest gains, slowing sharply since 1980, and partly emanating from the increased participation of women in the labour market.
Table 3.1: Changes in real incomes per household by distributional shares, US 1945–2012
|
1947–80 |
1980–2012 |
Bottom 90% = |
+87% |
-6% |
Average = |
+87% |
+24% |
Top 10% = |
+89% |
+80% |
Top 1% = |
+57% |
+178% |
Top 0.1% = |
+63% |
+312% |
Top 0.01% = |
+83% |
+431% |
The picture appears slightly different in other developed countries such as the UK. While real median wages in the UK seem to have progressed until the GFC struck, they fell back during the ‘recovery’ and are still below the pre-crisis peak.7 Note that weekly earnings are not the same as median wages, since they are the combination of average wage rates and changes in hours worked such as overtime.
Even though UK real earnings have slowly recovered since 2015 to 101.7 in July 2018 (taking 2015 as 100), they are still substantially below the pre-crisis peak of 108.2.8 Stephen Machin, however, believes that the stagnation of the wages of typical British workers predates this post-GFC downturn but has been masked by the gap between median wages and average wage growth inflated by faster wage growth among top earners: ‘The opening of the gap between mean and median wages is because of rising wage inequality. As top earners had faster wage growth, that pulled the average (mean) wages up at a faster rate than the median wages (of the middle or typical worker).’9
Figure 3.6: Median wages lag behind average wages and productivity in the UK between 1988 and 2013
Figure 3.7: Real and nominal median wages lag in the US between 1980 and 2013
Figure 3.8: Real productivity, compensation and wage growth in Germany between 1980 and 2010
He also points out that similarities can be seen in other developed countries (Figures 3.7 and 3.8).10
In fact, in many OECD countries wage growth is lagging behind GDP growth, slowing the progress of real median incomes. With some exceptions, such as Portugal and Spain, the story is generally consistent in developed countries: workers in the middle of the income distribution scale have seen miserly income growth compared to their economies’ growth per person.
There must be consequences to this phenomenon. In fact, the decoupling of wages from GDP has coincided with the unprecedented accumulation of cash by corporations over these same decades. This represents a greater share of retained profits in the economy, caused by two factors: a failure by company managers, as we’ve seen, to increase investment at a corresponding rate, and decreasing corporate tax rates tied to the effects of globalisation.
As companies have gained the freedom to divert production to low-cost, higher-growth countries, so their ‘home’ countries have felt the need to offer greater incentives in the form of reduced tax rates. This naturally leads to a race to the bottom, with tax authorities in the developed world leapfrogging each other to offer the best tax deals. While individual governments may reason that a lower corporate tax take is better than no tax take at all if companies were to move elsewhere, the long-term effects are pernicious, a negative-sum game between countries, with the only winners being the corporate sector. This is yet another example of the generalisation principle: what is rational for one economic unit, in this case a country, may cease to be so if it is generalised by its peers. In fact, it becomes counter-productive.
As a result, companies have built up cash mountains, often in lower-tax jurisdictions, sometimes referred to – without the slightest hint of irony – as the ‘savings glut’ responsible for the slow growth and deflationary pressure in the industrialised world. But company cash piles are in fact the consequence of a rising share of less taxed profits, not the cause of low growth.
The same mechanism is responsible for the growing indebtedness of governments in industrialised countries, as they are faced with the stark choice of making up for the loss of corporate tax revenue by either raising personal taxes (not exactly a vote winner) or borrowing to plug the gap.
President Obama, among others, verbally took aim at the more than $2 trillion in corporate cash parked abroad to avoid paying federal taxes of 35 per cent. However, this does not seem to have deterred companies from seeking to escape Uncle Sam’s tax rates by moving their tax domicile to less onerous jurisdictions.
President Trump’s Tax Cuts and Jobs Act cut federal corporate tax rates from 35 per cent to 21 per cent in December 2017, with a one-time 15.5 per cent tax on repatriated liquid assets, payable over eight years, to encourage some of that cash to return onshore. It did partially succeed in that objective, since the cash piles of the largest companies (much of it held overseas) did fall from $1.99 trillion in 2017 to $1.69 trillion at the end of 2018.11 However, this was largely used to boost returns to shareholders in the form of share buy-backs and dividends. In 2018 share buy-backs almost doubled from 2017 to $467 billion. The tax changes overall served only to reduce the tax take over the medium term and boost the government budget deficit.
The UK has slashed taxes on companies over the years to 19 per cent (2019 rate), well below the average for developed countries of around 25 per cent, but still much higher than the Irish world-beating bargain rate of 12 per cent.
In the US in the 1950s, corporate tax represented just under 6 per cent of GDP. By 2013, this had shrunk to 1.6 per cent. In the EU, the average top corporate tax rate has fallen from 35 per cent in 1995 to 22.4 per cent in 2019. Free-market ideologists, aided and abetted by increasingly powerful and effective company lobbyists, have argued that the smaller the take of the state the better, subject to a minimum required to maintain the legal and defence infrastructure. Taxes, they say, distort the signals of the price mechanism and the efficient allocation of resources, as well as blunting the incentive to create, innovate and take productive business risks.
We will return to this in Part Three when discussing how political systems have become an accomplice to the transfer of income and revenue from households and governments to the corporate sector, causing long-term low growth and deflation. In the meantime, we will explore the twin to labour’s diminishing share of the pie: the egregious increase in income and wealth inequality over recent decades.