FAC­ULTY FO­CUS Lau­rence Booth

Rotman Management Magazine - - CONTENTS - Lau­rence Booth

CHANGES IN WEALTH and in­come in­equal­ity around the world are largely the re­sult of two struc­tural changes in so­ci­ety: The role of gov­ern­ment and the dy­nam­ics of eco­nomic change. Nei­ther have been par­tic­u­larly con­tro­ver­sial un­til the pub­li­ca­tion of Thomas Pick­etty’s Cap­i­tal in the Twenty First Cen­tury (2014).

Pick­etty’s book is an ex­haus­tive analysis of changes in wealth and eco­nomic growth over time. Unto it­self, the analysis is not that con­tro­ver­sial, but his con­clu­sion is: When the re­turn on cap­i­tal ex­ceeds the rate of eco­nomic growth, the ra­tio of wealth-to-gdp in­ex­orably in­creases over time. In a free mar­ket econ­omy, what inevitably fol­lows is that ‘in­equal­ity’ nat­u­rally in­creases as the wealth­i­est sit back, clip their coupons and live off of their grow­ing wealth.

Pick­etty’s analysis touched a chord in many coun­tries, par­tic­u­larly in the UK and the U.S. — both of which were still re­cov­er­ing from the worst fi­nan­cial and eco­nomic cri­sis since 1937 as well as the po­lit­i­cal dis­tur­bances of the ‘oc­cupy move­ment’ and rail­ings against the ‘1%’. Just as John May­nard Keynes be­came the voice of lib­eral in­ter­ven­tion­ist eco­nomic pol­icy in the 1930’s, Pick­etty has be­come the voice of left lean­ing pol­i­cy­mak­ers and jour­nal­ists af­ter the fi­nan­cial cri­sis.

This has been par­tic­u­larly true in Canada, where re­cent Lib­eral gov­ern­ments in Ot­tawa and Queen’s Park have owed much of their suc­cess to ‘strength­en­ing’ the mid­dle class by in­creas­ing taxes on the 1%. As al­ways, much of the analysis flow­ing into Canada comes from rhetoric from the U.S. and UK. But how true is it of Canada, and how con­cerned should Cana­di­ans re­ally be about in­equal­ity?

Although wealth and in­come in­equal­ity are dif­fer­ent, I will fo­cus on in­come in­equal­ity. What mat­ters here is where you start, what you count, and how you fac­tor in taxes and gov­ern­ment trans­fers. This is be­cause in­equal­ity is in­sep­a­ra­bly bound up with the growth of gov­ern­ment spend­ing and debt. As most econ­o­mists rec­og­nize, taxes are a cost and tend to be pushed for­ward so that pre-tax in­equal­ity is sig­nif­i­cantly dif­fer­ent from in­equal­ity based on dis­pos­able in­come — that is, af­ter we ad­just for taxes and gov­ern­ment trans­fers. For ex­am­ple, in Post Cap­i­tal­ist So­ci­ety,

Peter Drucker pointed out that the U.S. ex­pe­ri­ence up to the early 1990s dis­proved the no­tion that taxes can per­ma­nently af­fect the dis­tri­bu­tion of af­ter-tax in­come.

Prior to World War I, there were no in­come taxes in Canada and fed­eral gov­ern­ment rev­enues were al­most en­tirely derived from cus­toms du­ties and ex­cise taxes, with spend­ing fo­cused on na­tion build­ing. Yet be­tween 1871 and 1918, the av­er­age rate of real eco­nomic growth was 5.4% and real per capita in­come in­creased 2.5X — or an av­er­age of 2.1% per year. There was sig­nif­i­cant in­come and wealth in­equal­ity at the time be­cause, to a great ex­tent, in­equal­ity is an in­evitable side ef­fect of a dy­namic econ­omy — as we will see. All of this changed af­ter World War I.

Be­tween 1914 and 1919, Gov­ern­ment of Canada debt in­creased five fold, with per­sonal and cor­po­rate in­come taxes in­tro­duced to pay the in­ter­est on the debt, which by 1919 had in­creased nine-fold since 1914.

In 1939, the sec­ond half of the Ger­man war started and made things worse, as Gov­ern­ment of Canada debt — which had barely in­creased over its 1919 level — in­creased six-fold by 1946. How­ever, 1946 was not like 1919, as the Gov­ern­ment of Canada in­tro­duced a wide range of en­ti­tle­ment pro­grams such as Old Age Se­cu­rity, fam­ily al­lowances and ex­panded em­ploy­ment re­lief. By 1952, this in­crease in so­cial pro­grams had quickly jumped from zero to cost 20 per cent more than the cost of ser­vic­ing the much big­ger pub­lic debt, while at the same time, the Korean War sig­nif­i­cantly in­creased de­fence spend­ing.

It is at this time that taxes started to dra­mat­i­cally in­crease. In 1939, per­sonal in­come taxes had raised $45 mil­lion and cor­po­rate taxes $78 mil­lion, while in 1952, af­ter the pas­sage of the In­come Tax Act in 1948, they had in­creased to $1,225 and $1,227 mil­lion, re­spec­tively. In 1949, the top tax rate was 84 per cent, but more im­por­tantly, the tax rate hit 50 per cent at $25,000 a year — and de­spite rapidly-in­creas­ing in­fla­tion, stayed about that level un­til tax re­form in 1987.

In Canada, the U.S. and the UK, the early post-war pe­riod is com­monly re­ferred to as one of ‘fi­nan­cial repres- sion’, as the pri­or­ity was to lower the bur­den of the pub­lic debt in the face of in­creas­ing gov­ern­ment spend­ing. In the UK, the sit­u­a­tion was ex­ac­er­bated by what Cor­relli Bar­nett calls ‘Chris­tian So­cial­ism’, where out of a sense of ‘fair­ness’, the UK continued to sub­sidise the 19th cen­tury in­dus­tries that Great Britain’s wealth had been based on— mainly coal, ship build­ing and steel—long af­ter they were past their prime.

To fi­nance this spend­ing, the top in­come tax rate in the UK as late as 1979 was 83 per cent on earned in­come and 98 per cent on un­earned, that is, in­vest­ment in­come. The in­evitable eco­nomic prob­lems with the ef­fec­tive con­fis­ca­tion of cap­i­tal led to an IMF bailout in 1976, and to paraphrase Mar­garet Thatcher, a be­lated recog­ni­tion that ‘The prob­lem with so­cial­ism is, sooner or later, you run out of other peo­ple’s money’. In 1974, the UK hit the wall in a sim­i­lar fash­ion to Greece in 2010, as other peo­ple re­fused to fi­nance continued gov­ern­ment spend­ing.

In Canada, the prob­lems of the post-war pe­riod were not as se­vere, but the in­ef­fi­cien­cies in­tro­duced by the mount­ing tax bur­den led to the Carter Com­mis­sion re­port in 1966. The ba­sic rec­om­men­da­tion was to lower per­sonal in­come tax rates to no more than 50 per cent on any form of in­come and to broaden the tax base. These rec­om­men­da­tions were not adopted un­til 1987, when tax re­form low­ered the top rate to 43.5 per cent and with a de­lay, in­tro­duced the GST.

How­ever, re­form­ing the Canadian tax sys­tem — while si­mul­ta­ne­ously ex­pand­ing so­cial pro­grams — only led to mount­ing gov­ern­ment deficits and bal­loon­ing debt. By the mid 1990’s, Canada had run into the same prob­lems faced by the UK in the 1970’s: It had largely run out of money. Fi­nanc­ing the deficit was crowd­ing out pri­vate in­vest­ment, with fi­nanc­ing needs al­most 10 per cent of GDP (al­most at Greece’s level). It was left to the Lib­eral gov­ern­ment of Jean Chre­tien to sort out Canada’s fis­cal mess with across­the-board cuts of 20 to 30 per cent in gov­ern­ment pro­grams that moved the deficit into a sur­plus by 1997 and re­stored some san­ity to gov­ern­ment fi­nances.

The 1970’s in the UK and the 1990’s in Canada rep­re­sented un­sus­tain­able pe­ri­ods in fi­nan­cial his­tory.

This short his­tory les­son is im­por­tant, be­cause most analy­ses of ris­ing in­equal­ity use the 1980’s as a bench­mark, as in ‘in­equal­ity has in­creased over the last 30 years’. Fur­ther, they sim­ply look at the statis­tics with­out any dis­cus­sion of the un­der­ly­ing eco­nomic sit­u­a­tion that gen­er­ated them. Yet the ba­sic fact is that the 1970’s in the UK and the 1990’s in Canada rep­re­sented un­sus­tain­able pe­ri­ods in fi­nan­cial his­tory. Many of us re­mem­ber in­fla­tion over 10 per cent, Trea­sury Bill yields over 20 per cent, gov­ern­ment deficits near 10 per cent of GDP and a gov­ern­ment com­mit­ted to ex­pand­ing en­ti­tle­ments be­yond its ca­pa­bil­ity to fi­nance them. True, it was a pe­riod of rel­a­tively low in­equal­ity and ‘a chicken in ev­ery pot’ — but it was paid for with bor­rowed money and could not con­tinue.

The sec­ond prob­lem is that in­equal­ity is a nec­es­sary con­di­tion of a dy­namic econ­omy. To an econ­o­mist, labour has a price, just like any other com­mod­ity. When bug­gy­whip man­u­fac­tur­ers faced com­pe­ti­tion from cars, the mar­ket sig­nal was not just a loss in value for the firms in­volved, but also dif­fer­en­tial wages, that is, in­equal­ity to en­cour­age work­ers to shift to car as­sem­bly lines. Only in a stag­nant econ­omy will there be rel­a­tively few changes in in­equal­ity, since there are no new mar­ket sig­nals. The buggy-whip man­u­fac­tur­ers and their em­ploy­ees would doubt­less wish that cars had never been in­vented, but for the rest of us, we need in­come in­equal­ity to meet our needs, not those of em­ploy­ees in dy­ing in­dus­tries. In this con­text, be­ing ‘fair’ and tax­ing work­ers in the car in­dus­try to sub­si­dize work­ers mak­ing buggy whips is the most short-sighted eco­nomic pol­icy I can think of.

So, what are the dis­rup­tive changes that may have in­creased in­come in­equal­ity to­day? The two main can­di­dates are in­for­ma­tion tech­nol­ogy (IT) and glob­al­iza­tion.

There is ab­so­lutely no ques­tion that IT is rev­o­lu­tion­iz­ing in­dus­tries — par­tic­u­larly if you are a taxi driver ( Uber), a ho­tel owner ( Airbnb), a re­tailer ( Ama­zon) or in mar­ket­ing ( Face­book and so­cial me­dia). No­tice the names of these dis­rup­tive new firms: They are all Amer­i­can. Now ask your- self a sim­ple ques­tion: Would you like Face­book to have been founded in Toronto rather than Bos­ton, Mi­cro­soft in Van­cou­ver rather than Seat­tle, Google in Mon­treal rather than Santa Clara? Of course, the an­swer is Yes, as they have cre­ated thou­sands of very well-pay­ing jobs and count­less multi mil­lion­aires. Equally ob­vi­ous: In­come in­equal­ity in Canada would be far greater, be­cause the more dy­namic the econ­omy, the greater the in­come in­equal­ity.

There is an in­di­rect ef­fect of IT, as well as a di­rect ef­fect. To il­lus­trate, sup­pose you go into a pub in Manch­ester, Eng­land and there are ten peo­ple hav­ing a beer, all earn­ing $40,000 to $60,000, so the av­er­age and me­dian (mid­dle) in­come is $50,000. In walks Paul Pogba. For those who don’t know, Pogba, at 24, is the world’s most ex­pen­sive foot­ball player, whose club, Manch­ester United, pay him about $400,000 a week, even when there are no games, and who, with celebrity en­dorse­ments, prob­a­bly makes at least $30 mil­lion a year. As a purely sta­tis­ti­cal matter, the av­er­age in­come in the pub im­me­di­ately jumps to $2.77 mil­lion ($30.5 mil­lion/11) even though the me­dian (mid­dle) and modal (most likely) in­come is still $50,000.

In this case, the pub has im­me­di­ately gone from hav­ing very low in­come in­equal­ity to one with a highly un­equal dis­tri­bu­tion of in­come. How­ever, what is im­por­tant is that the ten peo­ple hav­ing a beer be­fore Pogba walked in are no worse off af­ter he came in than they were be­fore. What re­ally mat­ters is not whether in­come is un­equal, as that is a quag­mire of statis­tics, but in­di­vid­ual stan­dards of liv­ing.

The Pogba ex­am­ple is also im­por­tant be­cause foot­ball is an in­dus­try. The Foot­ball As­so­ci­a­tion (FA) in 1885 ini­tially re­stricted play­ers to am­a­teur sta­tus, then to pro­fes­sion­als within a six-mile ra­dius, then to salary caps and fi­nally to con­tracts that re­stricted them from join­ing other clubs. Re­mov­ing these con­straints were vic­to­ries won in the face of fierce op­po­si­tion from the clubs, who saw an ob­vi­ous threat from mar­ket wages to their prof­itabil­ity. In the end, it took a de­ci­sion by a UK High Court Judge to al­low mar­ket wages and for Pogba to earn his mar­ket value.

If you think this bankrupted English foot­ball clubs, think again. In 2012, Forbes ranked Manch­ester United as the rich­est pro­fes­sional sports fran­chise in the world. English foot­ball has gone from a six mile fran­chise around the club to a regional fan base, a na­tional fan base and now thanks to the In­ter­net, a global fran­chise. In the process, foot­ball play­ers have gone from am­a­teurs, to be­ing paid twice av­er­age in­dus­trial wages, to su­per star salaries.

In a 1999 ar­ti­cle in Rot­man Man­age­ment, I wrote:

“The re­wards for be­ing bet­ter than oth­ers will be phe­nom­e­nal, and the costs for be­ing ‘a bit off ‘ are go­ing to be dis­as­trous, just as a per­fect mar­ket tells us they should be. Dis­ap­pear­ing mar­ket bar­ri­ers and rapid ad­vances in in­for­ma­tion tech­nol­ogy have cre­ated the economies of su­per­stars.”

This fore­cast was only too ac­cu­rate. No­tably in the lat­est rich list for the UK, only two of the top ten were born in the UK and Manch­ester United’s Swedish cen­tre for­ward Zla­tan Ibrahi­movic en­tered the top 1,000 with a wealth just less than $200 mil­lion. That is a phe­nom­e­nal re­turn for a foot­ball player; in­ter­est­ingly, Adele and the stars of the Harry Pot­ter fran­chise were also on the list.

The im­pact of IT on global fran­chises is one as­pect of glob­al­iza­tion. The other is the shift of man­u­fac­tur­ing and out­sourc­ing to cheaper lo­ca­tions. David Ri­cardo’s trade the­ory from al­most 200 years ago showed that as coun­tries spe­cial­ize where they have a com­par­a­tive ad­van­tage, every­one gains — and this is as true now as it was when the UK moved to free and open trade and uni­lat­er­ally re­pealed the Corn (wheat) Laws in 1846. In the process, a cheap food pol­icy dev­as­tated English farm­ing to the great ben­e­fit of lower in­come groups, who spent a greater pro­por­tion of their in- come on food. (think about the im­pact of farm sup­port pro­grams in Canada!)

The sit­u­a­tion to­day is no dif­fer­ent from Eng­land in the 1820s, when Lud­dites de­stroyed tex­tile equip­ment that was tak­ing away their jobs. You can’t halt tech­no­log­i­cal change. When I was grow­ing up, ‘Made in Eng­land’ was a sign of qual­ity; to­day, it is near im­pos­si­ble to find. Amer­i­cans are go­ing through the same process, as ‘Made in China’ has be­come ubiq­ui­tous. In re­ac­tion, they have elected a Pres­i­dent who prom­ises to ‘Make Amer­ica great again’ and bring back jobs; but this isn’t go­ing to hap­pen—any­more than the Lud­dites were go­ing to pre­vent in­dus­tri­al­iza­tion in Eng­land.

Sure, un­der pres­sure from Pres­i­dent Trump, Car­rier has agreed to main­tain pro­duc­tion in In­di­ana, but make no mis­take: all those jobs are not go­ing to stay! As Greg Hayes, CEO of United Tech­nolo­gies, Car­rier’s par­ent re­cently said: “We will take a lot of those jobs that to­day re­quire very low skill and …. elim­i­nate [them] through au­to­ma­tion.” The fact is, the U.S, Canada and the UK should not want jobs in­volved with putting three screws into a gas fur­nace ev­ery 27 sec­onds. Such jobs can and should go to low-skill economies and im­prove their stan­dard of liv­ing.

The World Bank points out that in 1981, 43 per cent of the world’s pop­u­la­tion was ‘ex­tremely poor’; but by 2013, that had dropped to just 10.3 per cent. It took Great Britain 100 years to make the ad­just­ment, but China is on track to see its num­ber drop from 660 mil­lion in ex­treme poverty to 25 mil­lion in 35 years, de­spite an in­crease in pop­u­la­tion. The rea­son for this drop, of course, is free trade, and the shift of man­u­fac­tur­ing jobs from the de­vel­oped world to China. It is a moral ques­tion whether get­ting 635 mil­lion Chi­nese out of ex­treme poverty is worth more or less than the con­se­quences felt in Rust Belt, U.S.A.

So, how im­por­tant have the two trends of glob­al­iza­tion and IT been to in­equal­ity in Canada?

Free trade and glob­al­iza­tion have not af­fected Canada to any­where near the ex­tent they have af­fected the U.S.

The an­swer: Not very. In 2015, the OECD is­sued a ma­jor re­port on changes in in­come in­equal­ity from 1985 to 2015. Apart from the fact that the start date and tone of the re­port re­flect an ob­vi­ous bias, the data for Canada do not re­veal any ob­vi­ous prob­lems: The OECD notes that in­equal­ity has gen­er­ally in­creased, but the change for Canada has been min­i­mal and less than av­er­age. The main fo­cus of the OECD re­port was on the U.S, where in­equal­ity was al­ready amongst the high­est and in­creased even more, ex­ceeded only by Mex­ico.

The ques­tion is, why has in­equal­ity in­creased steadily in the U.S., whereas in Canada, any changes have been be­low av­er­age for a de­vel­oped coun­try?

The an­swer lies in the two afore­men­tioned causes of in­creased in­equal­ity: Free trade and glob­al­iza­tion have not af­fected Canada to any­where near the ex­tent they have af­fected the U.S, for the sim­ple rea­son that man­u­fac­tur­ing is less im­por­tant to Canada. Fur­ther, peo­ple for­get that the Canadian dol­lar was down to US$0.65 be­fore China was ad­mit­ted to the World Trade Or­ga­ni­za­tion in 2001. Since then, com­mod­ity prices have dra­mat­i­cally in­creased, and with them, the Canadian dol­lar, as China has in­dus­tri­al­ized to man­u­fac­ture all those things ex­ported to the de­vel­oped world.

In other words, it doesn’t matter to Canada whether it im­ports from the U.S. or China, but by in­dus­tri­al­iz­ing, China has been buying Canadian raw ma­te­ri­als and cre­at­ing jobs in Canada. The mas­sive ex­pan­sion of the Oil Sands in Al­berta would not have oc­curred if China had not been ad­mit­ted to the WTO.

And now, back to IT: Would Canada be bet­ter off with Google, Face­book, Mi­cro­soft, Ama­zon, Ap­ple etc. based in Canada? Obviously the an­swer is Yes, but our in­come in­equal­ity would then be much closer to that of the U.S. As it is, and un­like the U.S., Statis­tics Canada re­ports that me- dian in­come in Canada in­creased from $46,700 in 2000 to $55,600 in 2014 (con­stant 2014 dol­lars). Put sim­ply, there is no in­di­ca­tion of stag­nat­ing mid­dle-class in­comes in Canada.

In clos­ing

To avoid U.s.-style in­equal­ity, left lean­ing politi­cians and jour­nal­ists would prob­a­bly in­di­cate that they would reg­u­late or tax. But the first thing you learn in a tax course is, you tax the im­mo­bile fac­tor for the ob­vi­ous rea­son: The mo­bile fac­tor leaves, and then you don’t get any tax rev­enues at all. In 2010, the UK gov­ern­ment in­creased its top tax rate from 40 per cent to 50 per cent, but se­ri­ously missed its rev­enue tar­gets. In 2012 the top tax rate was rolled back to 45 per cent and the Chan­cel­lor of the Ex­che­quer, Ge­orge Os­borne, claimed the UK raised more money due to the more com­pet­i­tive tax rate.

Way back in 1901, the foot­ball clubs tried cap­ping salaries in Eng­land, but the re­sult was the for­ma­tion of a com­pet­i­tive league with­out salary caps. If it tried that now, the English Pre­mier League would no longer be the dom­i­nant global sports fran­chise. Many of the clubs have no or very few English play­ers, with lit­tle loy­alty to their clubs ex­cept for their pound ster­ling pay cheques, so they would sim­ply move to the Con­ti­nent. The fact is, Pogba is French, and he is as mo­bile as any other tal­ented pro­fes­sional.

Lau­rence Booth is the CIT Chair in Struc­tured Fi­nance and Pro­fes­sor of Fi­nance at the Rot­man School of Man­age­ment.

Rot­man fac­ulty re­search is ranked #3 glob­ally by the Fi­nan­cial Times.

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