The Real Reason for Income Inequality

Income Inequality

In 2012, the Center for Economic Policy Research issued findings from a study that highlighted the growing disparity of income inequality. The study showed that if the minimum wage kept up with the pace of productivity from 1968 through 2012, the same as it did from 1945 through 1968; the minimum wage would have been $22 an hour. If the minimum wage kept up with the pace of corporate executive income increases from 1968 through 2012, the minimum wage would have been $33 an hour.

If even $22 an hour was the baseline for wages, it would decrease income inequality and increase the power of Americans to buy more of the products and services their employers sell, infuse more real money into the economy, and improve the average American’s quality of life – your life.

All employees, though, are not equal. The same “free-market” that justifies an average household annual wage increase of 0.84 percent from 1982 through 2012 for most workers justifies an average annual wage increase of 10.20 percent over the same thirty year period for corporate executives.

People First Became Anti-Capitalism

A 2010 study found that “companies with [committed employees] outperformed the total stock market index and posted shareholder returns 19 percent higher than average. Companies with [uncommitted] employees had a total shareholder return that was 44 percent lower than average.” Therefore, employee commitment can drive the performance of a company’s stock price. Employees stay committed, in part, when they feel they are being treated equitably.

Not only does it drain the company purse through shareholder value to not keep employees committed, it affects the company’s bottom line. Studies show that replacing a “key person” can cost a company anywhere from 70 to 200 percent of that key person’s total compensation. This cost includes scouting, hiring and training for that key person’s replacement.

Throughout history corporate executives have known that the heart and soul of companies are employees. Indeed, this now abstract philosophy was familiar as recently as 1971 when Thomas J. Watson, Jr., then President of IBM, spoke about the need to balance a company’s interest with the country’s interests.

During the past 20 to 30 years, a shift in thinking occurred putting shareholder value above all else and increasing income inequality. This shift began when profits became the top priority in September 1970, when the economist and University of Chicago professor Milton Friedman published “The Social Responsibility of Business is to Increase Profits” in New York Times Magazine.

Friedman argued, and Ronald Reagan embraced, the philosophy that “a corporate executive is the employee of the owners of the business.” Therefore, the corporate executive will inherently put their employees and shareholders at the top of the list of competing assets. While that is logical in the free-market system of which Friedman wrote, the rules changed in 1993.

The Rigged Game

One of numerous attempts to decrease income inequality and rein in corporate executive pay took place in 1993, the same year NAFTA passed, when the 103rd Congress, controlled by Democrats, passed and President Bill Clinton signed into law U.S. tax Code 162 to require companies to link corporate executive pay to performance (i.e. shareholder value).

For sentient humans outside The Beltway, the code basically says that any person in the top five highest paid positions of a publicly traded company is limited to a $1 million annual cash salary, but stock compensation is unlimited. Because stock performance is tied to company performance, the theory is that this rule ties corporate executive performance to company performance. This is supposed to be mutually beneficial, making corporate executives accountable to both company shareholders and employees.

Since 1993, the Securities & Exchange Commission (SEC) has adopted more rules to make corporate executives even more accountable to company shareholders. No longer is business an entity in a “free-market” system. The Government, as is too often the case, meddled where it shouldn’t have and opened a Pandora’s Box of income inequality for the 99 Percent.

Because of these changes, corporate executives no longer view employees as assets, let alone their most important asset. Employees are a liability. Labor is a commodity. “There’s never been less pressure on employers to give raises at the same time there’s so much pressure to control costs,” says Dave Van De Vort, a principal with Buck Consultants. “Employers have learned they can squeeze more and more out of their workforce.”

Not-So-Free Markets

Employers are hiring fewer employees. Employee-wages are stagnant and real-unemployment rate is so high that employees have no leverage to demand more equitable compensation relative to corporate executive compensation. This trifecta is perfect for increasing shareholder value in the short-term and handicapping real growth in the long-term.

Steven Pearlstein eloquently stated the problem in his September 2013 Washington Post article, “How the Cult of Shareholder Value Wrecked American Business“:

Indeed, you could argue that much of what Americans perceive to be wrong with the economy these days — the slow growth and rising inequality; the recurring scandals; the wild swings from boom to bust; the inadequate investment in R&D [research and development], worker training and public goods — has its roots in this ideology.

Take, for example, taxes. While the federal corporate tax rate is 35 percent, most companies pay less than that. In 2010, the most recent year for which data is available, large, U.S. corporations paid a federal corporate tax rate between 12.6 percent and 22.7 percent according to the Government Accountability Office.

Until recently companies reduced R&D spending and let the government cover the tab with your money through tax funding. Companies are reducing the workforce and keeping wages stagnant, while the government increasingly spends more on government assistance programs such as SNAP, WIC, Medicaid, and others.

Reduced corporate taxes and expenses mean larger profits for companies. Larger profits increase shareholder value and are used to increase share buyback and dividend distributions. Over the previous decade, about 94 percent of Fortune 500 company’s profits were spent on share buybacks and dividends. That is anywhere between $300 billion to $600 billion annually that did not go to employees or investments for future corporate growth. Nor did this money go to the government to cover the cost of doing business.

The main capital generation for U.S. companies these days is from retained earnings, and credit and debt financing. The leading cause of capital generation is not from the creation of newer and better products and services. It is not from new inventions and scientific and technological breakthroughs. It is from creative accounting methods. Janus’ (previously PIMCO’s) Bill Gross called this “balance sheet alchemy and financial wizardry”. It is not business management.

This is how the rules changed in 1993. A corporate executive is no longer just the employee of the owners of a company serving multiple stakeholders that include shareholders, customers and employees. A corporate executive is now the employee and owner of the business with incentive to overweight their focus on shareholder value, thereby increasing income inequality.

Short-Term-ism

Linking corporate executive compensation to such incentives is dubious at best. Studies suggest that “changes in [company] performance account for only 4 percent of the variance in corporate executive [compensation].” That means that history shows there is minimal causation between how well a company performs and how much corporate executives get paid.

Adding insult to injury, Roger Martin and Lynn Stout’s research on the benefits of linking corporate executive performance to shareholder value has not controlled corporate executive compensation as the 103rd Congress hoped it would. It has not proved particularly fruitful for shareholders, either.

In 1970, only 1 percent of Fortune 500 chief executives’ compensation was in stock options and the average salary was $700,000. Today stock and stock options account for 80% of compensation, which has increased more than 1,800 percent to $12.9 million.

Martin and Stout go on to say that with average corporate executive tenure being four and a half years and stock ownership tenure being four months, corporate executives have no incentive to maximize a company’s long-term growth.

The long-term success of any company depends more on innovation, quality products and services, a good business strategy and not simply meeting quarterly earnings. As Keld Jensen says, “Maximizing returns is an outcome, not a strategy.”

Real Change

America’s political and business leaders must stop rigging the game and increasing income inequality. If we are to remain the world leader in business, we must create an environment that fosters innovation, advancements in technology, science and engineering and allows all citizens to reap the financial rewards of their blood, sweat and tears.

This will reduce income inequality, increase the buying power of average Americans and infuse money into the economy.

Liberals will claim we’re advocating unmitigated capitalism and conservatives will say we’re socialists. We’re advocating that all employees participate in the rewards of a prosperous company just as all employees participate in the negative consequences.

Comment List

  • Frank Facts 18 / 04 / 2016 Reply

    Declines in unionism are probably another contributing factor to growing income inequality. I like your de-emphasis on liberal/conservative viewpoints, and your ability to strike something somewhere in between. I feel similarly about unions: at some level, though conservatives tend to dislike unions, they’re the ultimate free market tool. If labor is itself a market commodity, then unions serve the purpose of negotiating with an employer about the value of labor, and they help facilitate finding the right price. Minimum wages, on the other hand, have replaced that function. In the past, an employer would give their employees more money in exchange for something (maybe more productivity, more hours, etc.), but now they have to unilaterally give them slightly more when the minimum wage increases, without receiving anything in return. The market mechanism is thrown off.

    • David Auten 21 / 04 / 2016 Reply

      Thanks for the comment Frank Facts. We try to stay away from siding politically since we often find they are different sides of the same coin depending the issue, the week and the opinion of the general public. I think one of our concerns today too, is that we no longer live in a society that allows workers to just maintain a job. If you are not constantly increasing your value to your employer, they will find no value in keeping you.

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