Big firms, ‘fat cats’ and social inequality

Unofficially, the 4th January this year was dubbed ‘Fat Cat Thursday’. Granted, it’s not a well-known day, but it was introduced for a sobering reason.

It highlights the fact that by 4th January, only a few days into the new year, some of the world’s highest-paid CEOs had already earned more than an average employee can expect to pocket in an entire working year.

Rising income inequality is getting increasing attention in the developed world and the eye-watering salaries of some corporate CEOs have received regular flak from academics and researchers.

In Capital in the Twenty-First Century, French economist and author Thomas Piketty argues that the top one per cent of earners now include more CEOs receiving salaries than people who inherited wealth. Professor Piketty concluded that income inequality is primarily caused by the unprecedented salaries earned by ‘super managers.’

Governments have attempted to bring in measures to curb these high executive salaries, such as levying a surcharge on companies whose CEO-to-worker pay ratios go above a certain threshold and giving preferential treatment to companies whose CEO-to-worker pay ratios sit below that threshold.

Although an awareness is important, this singular focus on CEO salaries diverts attention from other equally important ways in which corporations contribute to income inequality in society. To better understand this, we need to understand how firms create value, and appropriate it and distribute it to various contributors.

Appropriating Value

Firms create value by producing new or improved goods or services that a consumer is willing to buy. They do this by mobilising and deploying a range of financial and non-financial, as well as tangible and intangible, resources.

Resources can include land, raw materials, equipment, human capital, intellectual capital, machinery, and finances. They also include public infrastructure, community knowledge, business intermediaries, social license to operate and regulatory institutions.

In other words, contributions to create value are made by various stakeholders including employees, executives, shareholders, government, and the society at large.

How value is created has little effect on inequality at a societal level, but how firms then appropriate the value that is created does. Value appropriation is the process by which firms produce goods and services at the lowest possible cost and sell at the highest possible price the consumer is willing to pay.

In other words, it’s about minimising production costs, like wages, in order to maximise revenues.

Firms can minimise costs through various strategies, all of which can indirectly contribute to income inequality. For example, they can outsource and offshore business operations, reducing the bargaining power of workers.

Research by Dr Adam Cobb and colleagues has shown that when large firms reduce direct employment, income inequality increases. When workers have less bargaining power, their wages decrease and they will have reduced benefits such as pension and healthcare – both of which contribute to rising income inequality.

But firms contribute most to income inequality through their value distribution function – this is the allocation of retained earnings to those who contributed resources to value creation and appropriation. Put simply, it is allocation of the money made to those who helped in making the money.

This allocation depends on bargaining power. Depending on the balance of bargaining power, it can enable a few to extract the most and leave the least for the many, increasing income inequality.

How firms contribute to income equality

Firms contribute to income inequality via four value distribution mechanisms.

First and most visible of all is the compensation paid to employees, managers and top executives. The bargaining power of the top executives is the highest and, not surprisingly, they receive a substantial share of the value created and appropriated.

Second, organisations distribute the retained earnings in the form of dividends to shareholders. For a few decades now, the principle of ‘shareholder wealth maximisation’ has had a considerable sway over management theory and practice, and placed shareholders above all other claimants.

The rise of shareholders, particularly the institutional investors, has shifted the focus of corporations away from ‘retain and reinvest’ to ‘downsize and distribute’. So dividends as a percentage of corporate profits have risen in the US, UK, and elsewhere.

Third, paying income tax is one of the means by which organisations can distribute value to society and government. But, firms are able to avoid paying taxes through techniques including treaty shopping, transfer pricing and shell companies in tax havens such as the Netherlands, Bermuda, Luxembourg, Ireland, Singapore, and Switzerland. An estimated amount equivalent to eight percent of global financial wealth of households is held in global tax havens.

Tax avoidance like this increases alongside rises in institutional ownership and ownership concentration. Even when tax cuts are offered, the repatriated money is not reinvested but is distributed to shareholders and executives. Following the recent tax cuts in the US, American companies are expected to spend US$2.5 trillion on share repurchases, dividends, and mergers and acquisitions.

Fourth, corporations can distribute the retained earnings through corporate social responsibility (CSR) and philanthropy. However, even when they engage in CSR, firms often use it to enhance reputation and visibility – often engaging in projects that reinforce the privilege of the few rather than creating opportunities for the many.

A swanky art museum or an elite business school building commonly attracts corporate money, rather than a housing project for the homeless.

Firms can influence and contribute to inequality through so many avenues. Focussing only on CEOs and ‘fat cat’ salaries is unlikely to help identify ways in which businesses and business leaders can make a real contribution to reducing inequalities in society – but if we look at the big picture of income inequality, it may provide avenues to address it.

This article was published by Pursuit.  A version of this article also appears in an editorial essay for a special issue on economic inequality, business and society that Dr Hari Bapuji co-authored with Professor Bryan Husted, Professor Jane Lu, and Professor Raza Mir.