Sunday, December 29, 2013

Andrew Smithers on Labor, Capital and Taxes

This is almost a year old but I wanted it on the blog as a reference.

I haven't seen anyone post a 120-125-year study of the fraction of corporate profitability used to pay wages and salaries; fringe benefits such as corporate pension contributions, health care, vacation time etc; corporate taxes; plant, property and equipment; dividends-pretty much the whole schmear.
I'll probably have to commission something to get what I want but here's a start.

Some of the dates to watch for: The 1870's for the rise of the trades/crafts/labor unions;1913 when the 16th amendment passed, marking the start of income taxation; the use of medical coverage as an inducement to employees under WWII's wage and price controls; the big shift during the 1980's from defined benefit to defined contribution retirement plans and a few others that readers know better than I.

From the PBS NewsHour's Business Desk:
Today we welcome once again our friend and monetary minstrel Jon Shayne, aka Merle Hazard, a Nashville investment manager. Shayne has written and sung such classics as "H-E-D-G-E," "In the Hamptons," "The Greek Debt Crisis" and "Inflation or Deflation?" He shared one of his latest hits, "Fiscal Cliff," with us on Making Sense. You can access his entire oeuvre here.

Today, he conducts an interview with Andrew Smithers, a British economist. We'll let him take it from here.

Jon Shayne: Late last year, Andrew Smithers answered questions on this page about how labor's share of output in the U.S. has declined over the past thirty years. Judging from the comments received and other reader reaction, many of you would like to hear more about the topic. Andrew was kind enough to agree to answer another round of questions.

This graph of his, which we also used in the first interview, shows how much labor's share has declined, in favor of capital's:
Andrew Smithers chart 
U.S. Department of Commerce, Bureau of Economic Analysis.
Andrew formerly ran the asset management business of S.G. Warburg, and now heads up his own consulting firm, Smithers & Co., in London. In our last interview, he explained his view that the movement toward a "bonus culture," in which business managers get paid for short-term rather than long-term profits, is responsible for the diminishment in output going to labor.

Jon Shayne: Andrew, a reader asked whether the problem of labor's lower share can be solved by higher income tax rates, at least on those with very high incomes. Can it?
Andrew Smithers: Yes, it would, I think, fix the problem, but it would probably cause a great deal of other damage -- for example many of the best U.S. managers and entrepreneurs might choose to emigrate, as French ones are doing in response to high threatened French taxes. We need a solution to the perverse incentives of the modern bonus system, but a better one than very high marginal tax rates.

Jon Shayne: In our prior piece, you said that the respective shares of labor and capital are mean-reverting. In other words, you are saying that labor's share will, in time, go back up to its average level, and capital's share will go down. Why? Is the mechanism of reversion political, or more purely economic?
Andrew Smithers: It's economic. Companies can increase output either by using more capital, more labor, or both. They will choose what's best for them. Adding more labor without adding more capital, or adding more capital without adding more labor, will be less efficient than adding both. With this simple assumption economists have shown that profit margins are in theory mean-reverting.

This is one of those all-too-rare economic theories which is supported by the evidence. Professor James Mitchell, of the University of Warwick, has done a statistical analysis of the US data from 1929-2011 that confirms the US profit margins are mean-reverting. I will put be putting some of the details of his research into the appendix of an upcoming book of mine.

Note from JS: In the background of Andrew's answer is the idea that as technology, i.e. capital, improves, it produces more output per hour of labor. This actually makes workers more valuable to employers. All else equal, employers then bid up the price of labor. This is an economic explanation of why living standards have risen over time.
Jon Shayne: Paul Krugman has raised the possibility that labor's current lower share could be a result of technological advances or looser antitrust enforcement. Or a combination of the two. You gave evidence in the prior interview that technology is not the real issue here, but what do you think about looser antitrust enforcement, which seems to have begun during Ronald Reagan's presidency, as an explanation? All else equal, if a business gains some degree of monopoly power, it can make prices and profits go up, without raising wages.
Andrew Smithers: The argument for increased monopoly power is, next to the perverse impact of the bonus culture, the best available explanation that I have seen of the level of profit margins and cash flow surpluses of the business sector in the UK and U.S. In fact the two explanations have much in common.
Companies have a great deal of monopoly power in the short term. Unless spare capacity is massive, buyers cannot shift easily to new sources of supply. Managements are thus always making judgments when they make pricing decisions. The risk they take in keeping up margins is that they will increasingly lose market share over time. The risk they take if they allow margins to narrow is that they will make lower profits in the short term. They have to judge between similar risks when taking decisions on investment. The long-term risk of not investing is that they will have higher production costs than their competitors over time, and the risk of investing is that it will lower profits and, in addition, profits per share. (In the latter case because money spent on new investment cannot be used to buy back shares.)

The bonus system encourages management to play down the longer-term risks in order to maximize short term profits per share. It is in effect an encouragement to exploit short-term monopoly power more aggressively than before.

The effect of the bonus system and a rise in monopoly power are thus very similar in many ways. In both cases, profit margins will rise and investment will not rise proportionately, as the rise in monopoly will probably affect the return on existing capital rather than new.

There are, however, some points which make the bonus culture the better of the two explanations.
1) The evidence for an increase in monopoly power is, as far as I am aware, limited to the evidence that profit margins are unusually high and business cash flow unusually strong. But the evidence for the change in business incentives is independent. We don't therefore need to assume that monopoly power has changed and the principle of parsimony (Ockham's razor) suggests that the bonus culture should be the preferred explanation unless other evidence for rising monopoly is produced for both UK and the U.S.
2)The bonus culture encourages companies to report highly volatile profits, but this does not apply to an increase in monopoly. US reported profits have become much more volatile than the profits shown in the NIPA, as I show in the Chart below. (NIPA is the National Income Products Account series, published by a division of the US Dept. of Commerce.)
Note from JS: Even if domestic competition has lessened, it is also possible, or likely, that international competition has intensified. EPS is Earnings per Share
Jon Shayne: You disagree, then, with the conventional wisdom, at least the old conventional wisdom, that public companies use accounting techniques, some might say tricks, to smooth their earnings?
Andrew Smithers: They may have smoothed earnings a bit in the past. Up to 1990, the volatility of published profits was a bit less than the volatility of NIPA profits, but management now wants volatile earnings and, as the chart shows, what management wants, management gits....MORE