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So I'm back from vacation in Tibet/Nepal and just about ready to re-engage with the series on ethics. One encouraging sign while I was gone was the shared Nobel Award for Economics awarded to Elinor Ostrom and Oliver Williamson - encouraging because they are two of the people whose theories I was already planning to cover as part of my blog series.

One thing I haven't noticed in any of the commentaries I've read so far, beyond the general comments from the Nobel committee itself that, "Both scholars have greatly enhanced our understanding of non-market institutions," is people commenting on the similarity between their work. Williamson is primarily known for his work on explaining how corporations (firms) exist in part to help overcome market failure due to monopolies caused by the specific nature of many production processes (i.e. people who make engines that only work in Ford cars can only sell them to the Ford company and vice-versa), while Ostrom is known for her work on how local groups of people can overcome market failure due to shared ownership of limited local resources.

In my Sytems of Survival-coloured view, both Ostrom and Williamson's work represent efforts to understand how people have developed innovative ways of coping with situations where guardian ethics (that deal with monopoly and limited resources) come into conflict with commercial ethics (that deal with trade of goods and resources).

More on both of these folks at some point in the future...

17. Trust: The Social Virtues and the Creation of Prosperity

Note: This post is the seventeenth in a series. Click here for the full listing of the series.

The point of Mancur Olson's 'Logic of Collective Action' was that a group of people - especially a large one - will struggle to work together unless their collaboration produces specific benefits to the group members as opposed to public benefits that will accrue to all group members regardless of what effort they put in.

So I thought that a logical follow-up would be to look at groups where there *is* a specific benefit to group members. Now I could be talking about religion here (where the reward for good religious behaviour is some sort of post death reward/punishment that is specific to each member of the religion) but I'll leave that aside for now and talk instead about companies.

In the Efficient Society, Joseph Heath opened his chapter on big business with a personal anecdote about Quebec's annual St. Jean Baptiste Parade:

"The year I attended, one of the major components of the parade was a series of floats celebrating the 'giants of industry.' All the big corporations in Quebec - Bombardier, Hydro-Quebec, Quebecor - were represented.

The suggestion that people should take pride in the fact that their economy is dominated by large corporations in one that would be quite foreign to most Canadians outside Quebec...

In part, this is because people outside of Quebec take the existence of giant corporations for granted. In Quebec, however, where society has only recently emerged from a long period of relative economic backwardness, these corporations are the symbol of a modern economy. The only way to be a real player on the world stage is to have some big companies that can compete in the major leagues. Thus there is a natural harmony of interest between Quebec nationalists and the various and sundry home-grown tycoons."

Here's a personal anecdote on corporations. A few years back now, I was on a class trip to Mexico and we visited a relatively high tech plastics factory in Guadalajara. The company, which at the time employed hundreds, had been built up from scratch by the founder over the course of a few decades but now that he was getting older, he was trying to decide who should take over the company.

His preferred option was to pass the reins to one of his children, but none of them were interested. The next best option seemed to be to pass it over to his partner of many years, however this was not optimal because, although his partner was willing, and had the skills necessary, and had been a good friend of the founder for decades, he wasn't family.

It was a bit like watching a scene from the Godfather. What was not considered, even as a remote option, was taking the company public and allowing it to be run by professional managers with no personal relationship to the owner and founder.

Given the size of the country and economy, Mexico has one of the world's most undeveloped stock exchanges with less than 200 hundred companies on it, most of which are either former crown corporations or foreign branch operations (e.g. Wal-Mart Mexico).

* * *

OK, enough anecdotes, let's get to the book that is the subject of this post, Francis Fukuyama's, 'Trust: The Social Virtues and the Creation of Prosperity"

The short version of the book is that in cultures where there is a high degree of trust of strangers, there is a greater likelihood of large, professionally managed corporations being created and greater prosperity as a result.

In more detail, 'Trust' contains two interwoven storylines. The first storyline is a relatively empirical and concrete survey of a number of countries which range from those with a high degree of trust and sociability (The United States, Japan, Germany are the focus, with the other Protestant, Central European countries (Holland, Denmark, Sweden, etc.) also placed in this category) to those with a lower degree of trust and sociability (China, Italy, France and Korea are the focus, with Canada, New Zealand and Latin America considered further examples) to those where trust has broken down almost entirely (there is less focus on this group, with some discussion of the South of Italy, and with American inner cities and Russia being other examples).

Starting at the bottom, in areas of very low trust, organizations beyond the state and the family are weak, nonexistent or criminal (mafia, gangs), and even the state and the family are often weak and/or corrupt.

The middle group is one where trust and social virtue is strong enough that the family (often including the extended family) and the state are capable of sustaining economic organization, but the growth of large, successful, professionally managed corporations is rare. Fukuyama notes that these cultures are often just as wealthy, or nearly so, as the high trust cultures that can generate large corporations. He also notes that in cultures such as this where the level of social trust is too low to sustain corporations without assistance, the state can often play a helpful role by stepping into the breach.

Let's go back to the Heath quote above and review the three large Quebec corporations he mentioned: Hydro-Quebec, Quebecor and Bombardier.

Hydro-Quebec is, of course, a fully state create, owned and managed monopoly.

The first line of the Quebecor wikipedia page reads as follows, "Quebecor Inc. is a communications company based in Montreal, Quebec, Canada. It was founded by Pierre Péladeau, and remains run by his family.

Finally, Bomardier. Here are some quotes from an article about the departure of Paul Tellier from the CEO position,

"WHEN PAUL TELLIER took over the reins of BOMBARDIER INC. in January 2003, it appeared the family-controlled aerospace and rail giant was finally going to allow an independent boss to call the shots. Wrong.

...

The reason for Tellier's departure given by Laurent Beaudoin - son-in-law of the company's founder, Bombardier's executive chairman and now the lead player in a newly created three-person Office of the President - was that Tellier hadn't planned on continuing with the company after his three-year term as CEO was over at the end of 2005.

...

Whatever the cause for Tellier's departure, the result is indisputable: the family is back, firmly in charge. And perhaps, observers suggest, that's what was really at issue. In the new president's office with Beaudoin is his son, Pierre, who many think is being groomed to take over. Two independent directors followed Tellier out the door; with the promotion of Beaudoin's son to the board, that leaves the family holding five of the 13 seats, compared to four of 14 before the recent events. Last year, Tellier tried, without success, to revamp the company's ownership, replacing the dual-class share structure that guaranteed family control with a one-share-one-vote system. The existing formula allows the family, which owns 16 per cent of the equity, or less than one-fifth of the business, to call the shots. Which it just did, by showing Tellier the exit."

After the low trust but still functional societies, Fukuyama looks at the high trust cultures. In each of Germany, Japan and the United States he points to unique historical factors that supported the development of trust beyond just the family level (for example, strong, relatively small religious groups in the U.S. such as the Mormons).

If you try coming up with brand names in your head, odds are whatever comes to mind will either be a Japanese, American or German (or Dutch/Swedish/North-Central European) company that you think of. And if there are exceptions that come from other countries, many of them will be state founded or supported companies.


----

The second, more intriguing thread in the book, is a theoretical contrast between individualism and communalism.

Much of the first few chapters are taken up with Fukuyama's repeated assertions that the neoclassical economic model of people as rational self-interested utility maximizers is not 100% accurate. For example:

"it is very questionable whether human beings act as individual utility maximizers rather than seeing themselves as part of larger social groups"

"while contract and self-interest are important sources of association, the most effective organizations are based on communities of shared ethical values"

Nonetheless, it appears as though he fears being considered 'not serious' if he doesn't mostly accept the rational self-interest theory and he hastens to note that,

"The edifice of free market economics is .. about eighty percent right, which is not bad for a social science and substantially better than its rivals as the basis for public policy"

Still, he points out that even this 80% view puts him in opposition with many economists who take after Margaret Thatcher's notion that 'there is no such thing as society' and believe that there is one set of free market economic rules that will work best for every country and every culture.


In chapter 5, 'The social virtues', Fukuyama sets out to define just what virtues we are talking about here when he refers to trust and sociability. He notes that the virtues which make up Max Weber's well known 'Protestant work ethic' are mainly individual in nature, but there are also social virtues as well.

"The capacity for hard work, frugality, rationality, innovativeness, and openness to risk are all entrepreneurial virtues that apply to individuals and could be exercised by Robinson Crusoe on his proverbial desert island. But there is also a set of social virtues, like honesty, reliability, cooperativeness and a sense of duty to others, that are essentially social in nature. (p46)"

He further notes that, "spontaneous sociability is critical to economic life because virtually all economic activity is carried out by groups rather than by individuals. (p47)"

Later on, in his discussion of France, Fukuyama touches on some of the cultural characteristics that don't support economic growth:

"Jesse Pitts ... argued that the successful French bourgeoisie was co-opted by the mores and values of the aristocracy. The latter held capitalism in low esteem and prized the noble, individualistic act of prouesse, or prowess over the process of steady, unremitting rational accumulation. The French bourgeois family did not seek to overturn the status quo through growth and innovation, but rather aspired to the settled, landed, rentier status of the aristocracy (p116)"

...

"The solidarity of the traditional French bourgeois family, with its tendency to look inward and its concern for its status and traditions, has been a staple of French literature and social commentary"

* * *

On page 154, there is an interesting quote from Nathan Rosenberg and L. E. Birdzell on how, as Europe moved out of feudalism, a need developed for a separate set of morals for trade,

"The need for a form of enterprise which could command trust and loyalty on some basis other than kinship was only one facet of a broader need: the rising world of trade needed a moral system. It needed a morality to support reliance on its complex apparatus of representation and promise, credit, representations as to quality, promise to deliver goods, or to buy goods in the future, and agreements to share in the proceeds of voyages.

A moral system was also needed ... to supply the personal loyalties necessary to the development of firms outside the family, as well as to justify reliance on the discretion of agents, ranging from ships' captains to the managers of remote trading posts and including merchant' own partners. The ethical system of feudal society had been built around the same military hierarchy as the rest of feudalism, and it did not meet the needs of merchants. It was out of the turbulence of the Protestant Reformation that there developed a morality of patterns of religious belief compatible the needs and values of capitalism."

It's worth noting the conflict between the desire for "a form of enterprise which could command trust and loyalty on some basis other than kinship" and the desire to move past the "same military hierarchy as the rest of feudalism" - worth noting because the corporations that filled the bill for non-family enterprise all adopted a military style hierarchy.

On the next page, Fukuyama launches into a discussion, pace Olson, of how free rider problems can mean that a society "manifesting a high degree of communal solidarity and shared moral values should be more economically efficient than their more individualistic counterparts"

It's interesting that even though Olson limited his discussion to organizations producing public goods and Fukuyama is discussing corporations that provide specific rewards to workers (i.e. they pay you to work for them) he still sees the same need for a moral code to support communal activity in corporations that Olson saw for non-economic groups that only offer public goods.

He notes that,

"if [workers] strongly identified their own well-being with that of the group, or even put the group's interests ahead, then they would be much less likely to shirk work or responsibilities. This is why family businesses are a natural form of economic organization"

He then points to the limitations of the economic notion of 'allocative efficiency' which fails to differentiate between positive and negative groups,

"...not all groups serve economic ends. Many groups are engaged in redistribution rather than the production of wealth, from the Mafia and the Blackstone Rangers to the United Jewish Appeal and the Catholic Chruch. Their purposes range from sinister to divine, but from an economist's point of view, all of them lead to 'allocative inefficiencies', that is, a mismatching of resources to their most productive uses."

* * *

Starting on page 199, Fukuyama starts to take a more abstract look at the nature of the corporation,

"While capitalism is supposed to be based on free markets and competition, life inside a Western corporation is at once hierarchical and cooperative. As anyone who was worked in one knows, corporations are the last bastion of authoritarianism: the single CEO at the top has, with the leave of the board of directors, more or less total freedom to order his organization around like an army. At the same time, the people working within the hierarchy are supposed to cooperate, and not compete against one another."

This is a strange passage. First of all, corporations are hardly the only remaining hierarchical structure and it's not exactly authoritarian when you are free to leave whenever you want. But more importantly, as far as I'm aware, people are *always* expected to cooperate in a hierarchy - this is not some unique feature of a corporation. Union members within a local are expected to cooperate, soldiers within a unit are expected to cooperate, etc. The manager in a hierarchy is not in competition with his workers, nor is he a referee adjudicating between competitive rivals. The manager is a coach who ensures that his players are playing for the good of the team and working towards the same objective he is.

Fukuyama then moves on to correctly note that the real puzzle here is that if the market is the most efficient way to arrange production, why do corporations exists and why are they so successful. Fukuyama follows the conventional thinking that this is due to Coasian transaction costs, a theory which suggests that many economic endeavours are more efficient when conducted cooperatively in a high trust environment (within a corporation) than when they are organized through interactions between self-interested market players. (more on this theory another time, perhaps, although I covered some aspects of it already, here.

* * *

Later on, Fukuyama comments on some similarities between Japan and Germany,

"The number of similarities between German and Japanese culture, many of which can be traced to the highly developed sense of communal solidarity shared by both, are intriguing, and have been remarked upon by numerous observers. Both countries have reputations for orderliness and discipline, reflected in clean public places and tidy private homes. These are societies whose members enjoy playing by the rules, thereby reinforcing a sense of belonging to a distinct cultural group. ... On the other hand, their communal solidarity within the national community weakens their regard for people who stand outside it; neither country has been known for its friendliness to foreigners, and both became notorious for their brutality to the peoples they conquered and ruled. (p 210)"

He picks up the same thread a few chapters later,

"In the past, both Germany and Japan have been known for authoritarian government and for having sharply hierarchical societies ... And yet, as we have seen, the German and Japanese factory floors are much more egalitarian than their English, French or American counterparts. ... The answer is related to the fact that the egalitarianism in communally oriented societies is often restricted to the homogeneous cultural groups that tend to comprise them and does not extend to other human beings even if they share their society's dominant cultural beliefs. Moral communities have distinct insiders and outsiders; insiders are treated with a respect and equality that is not expected to outsiders. Indeed, there is an inverse proportion between the solidarity of those inside the community and the hostility, indifference or intolerance shown to those on the outside."

I think that Fukuyama's observation about the exclusiveness of groups with strong moral bonds is accurate, but I'm not sure it explains the contradiction between a hierarchical society and an egalitarian workplace that he begins the quote with. After all, the hierarchical, obedient, rule following German or Japanese society is made up exclusively of Japanese or Germans, just as their egalitarian workplaces are.

Later on page 292, Fukuyama makes the point that, aside from being groups within the state, rather than states themselves, many religious groups in the U.S. have a similar strong cohesion within the group, hostility to those outside the group dynamic that Japan and Germany have - with the Mormons being a particularly strong example.

* * *

When Fukuyama starts to discuss the history of trust and sociability in the U.S., he launches into a comparison of an individualistic, Western, rights-based set of morals which can be traced back to monotheism, with a communal, Eastern, duty-based set of morals which is linked to Confucianism.

"The United States has undergone a "rights revolution" in the second half of the twentieth century. This revolution has produced a moral and political basis for the promotion of individualistic behaviour, with the consequent weakening of many earlier tendencies toward group life. ...

In contrast, an Asian ethical system like Confucianism sets forth its moral imperatives as duties rather than rights. That is, an individual is born into the world with a series of obligations to other people: parents, brothers, government officials, the emperor. Being a moral person, or achieving the status of a gentleman-scholar, depends on the extent to which one is able to carry out those duties. Those duties are not derived from prior ethical principles. In this respect, Confucianism is not different from much of the Western philosophical and religious tradition up to the early modern period. Many of the virtues defined in classical political philosophy, such as courage, honour, benevolence or citizenship, were duties. And God's law for both Judaism and Christianity was almost always enjoined in the form of duties.

Western political thought takes a sharply different turn, however, in the writings of Thomas Hobbes ... for Hobbes, man is not born with duties but with rights alone ... Whatever duties to takes on, he acquires as a result of his voluntary entry into civil society. Duties, for Hobbes, are entirely derivative of rights and are undertaken only to secure individual rights. Thus, one has an obligation not to do violence to another human being only because to do so would return one to the state of nature, in which one's own right to life would be jeopardized."

...

"Man in the state of nature for early moden Anglo-Saxon liberal political theorists was the exact counterpart of the economic man of classical economic liberalism. Both were portrayed as isolated individuals, seeking to protect their own basic rights (in the case of political liberalism) or their private "utility" (in the case of economic liberalism)."

To be honest, it wasn't entirely clear what this digression about rights and duties had to do with the rest of the book, but I found it interesting nonetheless.

* * *

Fukuyama finishes up by reiterating his argument that social capital (high levels of trust and sociability) is a driver of both political stability and economic success and then foolishly, in my opinion, trying to make a case that,

"in practice, liberal democracy works because the struggle for recognition that formerly had been carried out on a military, religious or nationalist plane is now pursued on an economic one. Where formerly princes sought to vanquish each other by risking their lives in bloody battles, they now risk their capital thorough the building of industrial empires.

...

...what has happened in the modern world is not simply the embourgeoisement of warrior cultures and the replacement of passions by interests, but also the spiritualization of economic life and the endowment of the latter with the same competitive energies that formerly fueled political life."

Two objections come immediately to (my) mind. First of all, it was only half a book ago that Fukuyama was arguing that French economic activity was stultified by too much influence from 'political' morals, one of many examples in the book where transfering the energies of political life to commerce was considered a bad thing.

Secondly, it's hardly the case that the world has seen an outbreak of peace since Hobbes wrote Leviathan. We haven't seen a World War since all of the major powers obtained nuclear weapons but I'm not sure that it's really reasonable to argue that this is the multi-century delayed flowering of the fruit of liberal democracy allowing people to build commercial empires instead of political ones.

* * *

In the end, Fukuyama covers a remarkable range of territory, but in so doing, I feel that he kind of weakened his point until it was hard to know exactly what point he was trying to make beyond noting that there are more large corporations in parts of the world where there are higher levels of trust and sociability, a point which probably didn't require 360 pages to make. Still, there's lots of interesting bits here and there which I tried to highlight in this post.

To finish off, here's an article from today's Wall Street Journal, the title reads "World Wealth Down 19.5% In '08,Wipes Out Two Year Gains" (deflation, anyone?) but I noted that in the body of the article was the following throwaway line, "While the world's wealth is still concentrated in three areas - U.S., Japan and Germany - the ranks are continuing to shift."

Corporate Taxes

The topic of corporate tax rates has come up a lot here lately so I thought I'd take a look at corporate taxes from a (somewhat) theoretical perspective. Specifically, I want to look at what happens to taxation as a whole when corporate tax rates are cut and think about whether we need corporate taxes at all.

Right now in Canada, the (federal) corporate tax rate is 21% (down from 28% a few years ago). So if a company made a profit of $100 million (and didn't have any previous losses stored up¹) it would owe $21 million in federal taxes. Now, say the tax rate was 15% instead. That would mean a tax bill of $15 million, a savings of $6 million for the company.

What would happen to this $6 million? I see three possibilities: 1) The money could be distributed to shareholders in the form of a dividend, 2) The money could be invested/saved by the company, increasing the value of the company accordingly or 3) the money could be 'wasted' on items like massive stock option grants to senior management, travel costs for corporate meetings in the Bahamas, ego-stroking diversification/expansion plans and so on. I'm not taking the time to do serious research here, so I have no idea what the exact breakdown would be, but for reference, this paper (which is excellent and deserves a post of its own) suggests that about 20% of total corporate profits goes to dividends in Canada (if you know the exact figure, please let me know, I looked for it but couldn't find it).

Money given out in dividends would be taxed at the dividend rate which has been constructed to roughly approximate personal tax rates (that is, when you combine the corporate tax with the tax on dividends the effect is the same as if the money had just been personal income to begin with - for an idea of the theory of how this works, see here).

If we assume that the government wants to maintain this 'neutral' taxation of dividends, then a cut in the corporate tax rate would be matched by an increase in the dividend tax rate so to the extent that lower corporate taxes leads to more dividends, there would be no impact on the federal tax take or it's distribution (progressiveness). Of course if the government cut corporate tax rates and didn't increase the dividend tax rate then the tax rate for dividends would fall below taxes for personal income and the government would suffer a loss in tax revenue.

Money kept by the corporation would, on average, be recovered as a capital gain by shareholders and eventually taxed at 1/2 the personal rate of tax (since income from capital gains is taxed at a 50% of the normal personal income rate).

Money wasted on various bad ideas would go all over the place but seems likely to generally end up in the hands of management and friends.

So to sum up, there are three potential sources of lost tax revenue for the government: dividend tax rates falling below personal income rates, more money going to capital gains which are only taxed at 50% the rate of personal income (likely to be lower than the 21% charged against corporations) and money wasted which never shows up as income at all.

Given that the vast majority of shares are owned by wealthy individuals and that the wealthy would likely be the beneficiaries of most wasteful corporate spending as well, it seems clear that the change would be regressive in that the poor would see very little benefit from this reduction in taxes.


--------------------

OK, let's look at this from another angle. Consider the following from the 1997 Canadian federal budget:

"A key element of a fair tax system is that corporations should pay their fair share of tax. Some have argued that corporations should not pay taxes at all since, sooner or later, corporate income ends up in the hands of individuals and is taxed under personal income tax. This view is inaccurate and corporations should pay tax for three key reasons. First, businesses benefit from public services in many of the same ways that individuals do. Second, in the absence of tax on corporations, it would be possible for individuals to postpone tax on income or capital gains indefinitely by placing income-producing assets in a corporation and thereby having the income or gains accrue within the corporation. Corporate income tax addresses this problem by imposing a tax on profits and capital gains prior to their distribution to individuals in the form of dividends. Third, corporate taxes allow the taxation of income accruing to foreigners and ensure that foreign-based corporations operating in Canada pay tax on income earned in Canada."

Now, the first reason doesn't make a lot of sense to me. OK, businesses benefit from public services, but to the extent that they benefit, this is reflected in the gains made by the owners of the corporation. I don't see how this refutes the argument that we should just tax profits as personal income when they end up in the hands of the owners.

The second reason, avoiding an indefinite delay of taxes, makes more sense to me, although if the owners never get any profit out of the corporation, one wonders why they invest in it.

The third reason, lost government revenue from taxing foreigner's investments in Canada is valid as well, but more of a technical concern which could probably be worked around.

Personally, I have a different concern, which is that by delaying tax until shares change hands or a dividend is paid, the corporation will have more money on hand with which to exert an influence on society. Ideally, any profits a corporation makes would either be invested if deemed necessary by the shareholders (represented by management) or returned to the shareholders. But in reality, corporate profits might well be spent frivolously and, more perniciously, used to lobby the public / government to change the social/legislative framework in their favour.

In this view, corporations are a danger to society which need strong oversight in order to be kept to their beneficial role of providing goods and services efficiently without overstepping into trying to buy legislation/influence to create artificial monopolies, exclude competitors from the market, get subsidies for their operations, etc. etc.

Clearly, taxation of corporations is not a substitute for regulation and citizen vigilance in trying to keep corporations out of politics but it's something to consider when thinking about big changes to corporate taxes.

----

Putting the pieces together, the logical solution, which I personally first saw recommended in David Korten's brilliant, "When Corporations Rule the World²", is to reduce the corporate tax rate to 0, but mandate automatic 100% dividends on all profits.

This would address our earlier concerns about lost tax revenue in that dividends would now be taxed exactly the same as personal income (a nice side effect of this change is the simplification of the tax code) so we don't have to worry about a discrepancy between dividend tax rates and personal tax rates. Furthermore, profits will be taxed as personal income not as capital gains which would only be taxed at half the personal rate. Finally, companies would have to make a case for needing money for investment and being able to spend it wisely to entice shareholders to reinvest their (post-tax) dividends back in the company.

Similarly, this addresses the budget's concern about people indefinitely postponing their taxes by leaving the profits in a corporation. As for foreigners, I'm sure the government could withhold an equivalent amount of taxes to foreign countries as those countries withhold on money which would go to Canadian shareholders.

Another benefit is that this change would remove the perverse incentives which are often created when corporations pursue specific strategies because they are tax-optimal rather than market-optimal. Furthermore, it would shift the balance of power from management to shareholders by leaving the decision of how much of the profit should remain with the organization in the hands of shareholders. This change would also serve to delegitimize corporate interference in our legislatures. Right now, given that they pay tax, it is logical for the corporations to feel they have a right to influence government. Taxing people instead of corporations would be a reminder of where legitimacy and power should reside. It would also act as a brake the growth of corporations where the shareholders themselves don't support that growth explicitly. Finally, the income, now taxed as personal income, would be subject to the same progressive rates of taxation as all other income.

I should note that this change would probably be much less radical in it's impact on corporate finances than you might think at first glance. For one thing it's not that different from the income trust³ model which has spread rapidly in Canada over the last few years. For another, I imagine that most shareholders would sign up with plans to have their post-tax share of the corporate income automatically re-invested in the company.

Anyway, I make no claims to have thought this through fully and there are likely any number of technical details which would be tough to work out - even if there aren't any big theoretical obstacles. I'm really just thinking out loud (so to speaktype) and inviting thoughts from anyone who may see flaws in my thinking. I ran it by a friend who's a tax accountant and we basically had a philosophical difference. He felt that the decision of whether profits should be reinvested or given out as dividends should be left in the hands of management since it was part of managing. I felt that this is an important enough decision that it, like the election of the board of directors, should be left in the hands of the shareholders directly. What do you think?



---------------
¹ The big difference between corporate taxes and personal taxes is that corporations are taxed on profit (net income) whereas people are taxed on revenue (i.e. your tax bill is unaffected by your expenses - except specific expenses which generate tax credits like tuition). So when corporations suffer net losses they can save those losses to offset against a profit made in a future year.

² Don't let the title fool you into thinking this is just some mindless anti-corporate rant. The author lays out his extensive conservative credentials in the prologue and the book is a very fair and well reasoned look at what corporations are and the reasons why and manner in which their influence has grown in our society. It's a good read.

³ For an introduction to income trusts, see here (or here) In a nutshell, an income trust is an extra layer on top of an existing company which focusses on extracting wealth from the company and distributing it to the trust's owners (unitholders). The primary purpose is to avoid corporate taxes and just pay personal income taxes on the received income.

Did Your Pay More Than Double Last Year?

If not, don't worry because your CEO's did.

The Globe's Report on Business figures that the 161 top executives in Canada received average total compensation of $5.5 million each last year, thanks mainly to cashing in some stock options.

So let's do some math. $5.5 million x 161 = $885.5 million. Over 5 years that adds up to a little over $4.4 billion dollars. Hmm, roughly $4.5 billion over 5 years, that rings some kind of bell...

Just to refresh your memory, here's some quotes from a Globe story last week:

"Business leaders roasted the minority Liberal government's decision to boost spending by $4.6-billion and cancel corporate tax cuts [worth $4.6 billion over 5 years] to buy NDP support for its beleaguered budget.

They warned it will cost Canada billions of dollars in lost investment, job gains and tax revenue, and erode the business-friendly reputations of Prime Minister Paul Martin and Finance Minister Ralph Goodale.

"I think it puts Mr. Martin's credibility in doubt and Mr. Goodale's credibility in doubt," said Nancy Hughes Anthony, president of the Canadian Chamber of Commerce."

and more,

"Thomas d'Aquino, president of the Canadian Council of Chief Executives, warned that rolling back corporate tax cuts will discourage the investment needed to generate the future tax revenue needed to "pay for the massive federal commitments to expanding social programs and equalization payments."

Jack Mintz, president of the C.D. Howe Institute, predicted Canada will lose "billions of dollars in investment" as a result of Liberal missteps on corporate taxes."

and my favourite,

"Perrin Beatty, head of the Canadian Manufacturers & Exporters, said Liberals are turning their back on businesses. "The government put those tax cuts in the budget because they recognized that Canadian business faces unprecedented competition"

So forgoing a $4.6 billion future tax cut for Canadian business will cost us billions of dollars in investment, destroy the credibility of the government, make business unable to compete in a tough global environment and is enough to pay for massive federal commitments to social spending and equalization.

But the same amount (probably more if you consider the time value of money) paid to the CEO's of just 161 companies is no doubt a wise and necessary cost of doing business which will more than pay for itself by creating incentives for CEO's to try and do a good job - something which a salary of $700,000 (on average) apparently wouldn't be enough to encourage them to do thus requiring the incentive of cashing in stock options if the share price goes up.

Here are some quotes from the Globe article on executive compensation:

David Beatty, head of the influential Canadian Coalition for Good Governance (CCGG), agreed that some CEOs, such as Power Financial's Mr. Gratton, have created "tons of value" for their shareholders, but others "are just riding on the boat" that has been lifted by overall rising market levels. "They are giving away a lot of the company for nothing. There are other ways to reward people."

...

Bill Mackenzie, head of Institutional Shareholder Services Canada, formerly Fairvest, said it's hard to link huge option gains with individual performance. "It just means there were big grants. Whoever has options has beautiful leverage, and they are making a killing."

...

Claude Lamoureux, CEO of the Ontario Teachers Pension Plan, argues that options do not always reward performance. "It is very random. You could do wonderful work and not be rewarded, and you could do crappy work and make a lot of money with your options."

...

Mr. Hugessen [from Mercer] expects investor groups will pressure boards to be more selective about when they hand out share units, rather than just making grants a given every year for anyone "who fogs a mirror."

"It begins to feel a little like a money machine. People are hankering on to this."

...

Citing the work of Harvard law professor Lucian Bebchuk, he [David Beatty] said many compensation decisions are based not on performance but on a desire for collegiality, a sense of loyalty to the CEO and conflict avoidance. The result, he said, has been "outrageous costs."

Just something to think about next time you hear dire warnings of doom and gloom from our CEO's when the government fails to cut corporate taxes quickly enough for them or when they talk about how we need to keep costs down in order to be competitive.

Corporate Profits

Back on January 20, I analyzed a TD Economics study which was complaining that, despite significant increases in GDP/capita, Canadian's after-tax income hadn't increased much in the last 25 years.

I figured that the GDP growth had to be going somewhere and wrote:

"Anyway, the next question is what about the difference between 25.5% growth in GDP/capita and 9.3% growth in after-tax income. Since GDP is a measure of total income for the country, any growth that didn't go to people would have to either go to corporations or to the government. While the study notes this, it doesn't say anything further about the change in corporate income over this period - which seems pretty odd. Maybe corporations caused some of this gap and maybe they didn't, but if figuring out the source of the gap is the point of your study, wouldn't you want to look into it?"

At the time, I didn't really have any data on corporate profits so I left it at that, but I recently ran across the Feb 12-Feb 18 issue of the Economist which had a couple of articles (subscribers only) on corporate profits as a % of GDP. Here are the relevant quotes:

"UBS, a Swiss Bank, estimates that in the G7 economies as a whole, the share of profits in national income has never been higher. The flip side is that labour's share of the cake has never been lower."

and

"Over the past three years American corporate profits have risen by 60%, wage income by only 10%."

not to mention,

"there is another factor that might have raised the return on capital relative to labour in a lasting way, namely the integration of China and India into the world economy, along with their vast supply of cheap labour. To the extent that this increases the global ratio of labour to capital, it will lift the relative return to capital."

Now to be clear, I have no problem with corporations making profits or even much of a problem with corporate profits increasing as a % of national income (the one drawback being that given the unequal distribution of share ownership, this leads to greater inequality), I'm just putting this out there for the record so when you hear right wing folks blaming high taxes for the low dollar, the high dollar, the lousy weather, the breakdown in family values, the poor quality of television programming and the fact that after tax income hasn't grown at the same rate as GDP growth, you can point out that - at least for that last one - there's more going on than high taxes, and that corporate profits taking a bigger piece of the pie is a big reason why wage growth has been slow in recent years.

As a long term goal going forward, it would be ideal for all members of society to earn income from a mix of wages and share ownership so we could end the artificial divide between owners and workers but that's probably a long way off.

When Competition Goes Bad

Interesting article in the National Post today (that alone is noteworthy!) about corporate welfare.

The article is primarily about a recent court victory by Ralph Nader which argued that state subsidies to lure businesses to set up there were a form of illegal discrimination against other states.

It's a pretty good article and it almost gets right to the heart of the matter when the author (Peter Foster) argues that,

"As Nobel economist James Buchanan noted several years ago, politicians are every bit as self-interested as market actors. The difference is that private actors in free markets do, as Adam Smith pointed out, a "good that is no part of their intention." Political actors invariably do unintentional damage."

Unfortunately, in his haste Foster oversimplifies matters in saying that the private sector always achieves good by following its self-interest while the public sector does the opposite. When private actors dump toxins into our environment for their own benefit, no unintentional good is done. When public actors ensure that police forces are properly trained, staffed and free from corruption this is both in their own self-interest and good for the public as well.

I would argue that private actors achieve an unintentional good not through all their actions, but when they are in competition with each other while public actors do harm when they compete with one another.

Let's look at an example. Suppose Ford wants to open a new auto plant somewhere in North America. Suppose further that whatever state/province the plant moves to will get a total financial benefit (lower unemployment, higher tax revenue etc.) of $100 million. Ford wants to keep its costs as low as possible (which is good for the public) because of its competition with other auto-makers.

Now suppose that Ontario offers Ford $10 million to put the plant there. This is perfectly reasonable since there will be a net benefit to Ontario of $90 million. Seeing this, Alabama offers $50 million, and Ohio then offers $80 million, and so on. In the end, because it can play one jurisdiction against one another, Ford can capture and keep pretty much all of the social benefits of it's new plant.

I am reminded of Jane Jacobs brilliant book, Systems of Survival, in which she builds on Plato's Republic, to argue that humans have two ways of making a living: our traditional one based on control of territory and a somewhat newer one based on trading. Each of these ways of making a living has it's own set of ethics, with ethical trading relying on shunning the use of force, competing, honesty, openness to novelty, invention, collaboration with strangers and a bunch more.

In contrast, ethical territorial activities (such as government) rely on a different set of values including shunning trading, respect for hierarchy and tradition, loyalty and a bunch more.

In Jacobs' view, unethical behavior arises when values which are ethical in one way of making a living are used in the other way. As an example of what happens when governmental organizations adopt commercial tactics she documents a case where a consultant to a police organization recommended introducing market incentives to the force by financially rewarding officers based on how many arrests they made (basically, putting them on commission). As you might expect, the whole thing unravelled amid numerous false and marginal arrests being made. Jacobs could just as well have used governments competing over the location of a new factory as an example of what goes wrong when a commercial value like competition is introduced into a territorial (governmental) system.

In the end, the Post hopes that Nader's actions will end the corporate welfare by appealing directly to the courts to tie the government's hands. Still, I think if they want to provide the subsidies, state and provincial government will find a way to skirt the law (and I'm sure the corporate law troops will only be too happy to help.) The true solution would be to move jurisdiction over subsidies to multinational companies under federal jurisdiction instead of state/provincial. Of course as a global problem (Many companies can build new plants pretty much any where on the globe) it really needs to be dealt with by a global government. A global government wouldn't be in competition with any other jurisdictions and would therefore be able to protect the global public interest, but that may still be a few years off (we're doomed without it, but alas, that's no guarantee it will happen).