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The Real Reason for Income Inequality

  September 15, 2022  |    #Make Money

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The reason for income inequality no one’s talking about

The rules changed in 1993 and exacerbated the already growing income inequality in America. Here’s why that must stop and how it can be stopped. Do your part. Get your free copy of the 7-Step Credit Card Debt Slasher here.

Companies turned their backs on workers

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’ve 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 floor 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 aren’t equal, though. The same “free-market” that justifies an average household annual wage increase of 0.84% from 1982 through 2012 for most workers justifies an average annual wage increase of 10.20% over the same 30-year period for corporate executives.

A 2010 study found that “companies with [committed employees] outperformed the total stock market index and posted shareholder returns 19% higher than average. Companies with [uncommitted] employees had a total shareholder return that was 44% 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’s 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% 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 interests 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 that increased income inequality.

The sweetest boss on Earth

When I was in grade school, I was assigned a paper to write on a leading American figure, either past or present. Partly because I lived near Hershey, PA and partly because I loved chocolate even before knowing the amazingness of pairing chocolate with red wine, I wrote my paper about Milton Hershey, the founder of The Hershey Chocolate Company.

Hershey believed that his employees were his greatest asset and treated them equitably because he felt his employees would reciprocate and do their best work for his company. He created the town of Hershey with schools; a shopping center, theme park and more to ensure his employees had the best work-life balance possible.

Several years after I wrote my paper on Milton Hershey, I went to graduate school for business where it was reinforced in me that a company’s greatest asset is its employees. This is mutually beneficial. Not only does this strategy create a desirable workplace that attracts and retains the best employees, but equitably treated employees create a larger, more satisfied and loyal customer base.

Competing for top talent is one of two ways companies compete in the marketplace. The other way is competing for customers. Viewing employees as a company’s most important asset and treating them equitably is the most efficient way to satisfy and grow the company’s customer base.

The new game’s rigged in the new economy

One of the 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%.

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.”

The unfree market grew

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%, most companies pay less than that. In 2010, large, U.S. corporations paid a federal corporate tax rate between 12.6% and 22.7% 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% of Fortune 500 companies’ profits were spent on share buybacks and dividends. That’s anywhere between $300 billion to $600 billion annually that didn’t 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 isn’t the creation of newer and better products and services. It’s not from new inventions and scientific and technological breakthroughs.

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It’s from creative accounting methods. Janus’ (previously PIMCO’s) Bill Gross called this “balance sheet alchemy and financial wizardry”. It’s 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 an incentive to overweight their focus on shareholder value, thereby increasing income inequality.

It’s time for a [better] strategy

Linking corporate executive compensation to such incentives is dubious at best. Studies suggest that “changes in [company] performance account for only 4% of the variance in corporate executive [compensation].” That means that history shows there’s 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 hasn’t controlled corporate executive compensation as the 103rd Congress hoped it would. It hasn’t proved particularly fruitful for shareholders, either.

In 1970, only 1% of Fortune 500 chief executives’ compensation was in stock options and the average salary was $700,000. As of 2012, stock and stock options accounted for 80% of compensation, which has increased more than 1,800% 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.”

How to reduce income inequality

America’s political and business leaders must stop rigging the game and increasing income inequality. If we’re to remain the world leader in business, we must create an environment that fosters innovation, and 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.

Beware of those who argue firmly for either side. They often know we are more easily conquered when we are divided.

And . . . this is the reason it is so hard for the average American to stay debt free.

What can be done about today’s capitalism?

Get more help to fight income equality

3 responses to “The Real Reason for Income Inequality

  1. 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.

    1. 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.

  2. I ran a union plant. As the top corporate executive of the division my pay was roughly (only) twice that of the experienced union hourly workers at my plant who made six figures (and this was ten years ago), whose jobs did not require education past a high school degree. Without exception when we’d have retirement parties for hourly or salaried employees they expressed gratitude about how good their jobs had been. They made well over twice median wages for our area and had great benefits. The corporate CEO off in another state did make millions, and I was fine with that, he had a very demanding job and no life whatsoever. We had no workers at anywhere near minimum wage, even non-union ones got far more than that. I don’t think our company was that unusual, it was a Fortune 200 corporation.

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