We must stop bonuses destroying businessAnthony Hilton
The London Evening Standard , 23rd March 2016
The Centre for Economics and Business Research is that rare thing in economics — a consultancy with a tendency to get things right. What are we to make then of its latest paper, which suggests that — far from having a balanced Budget at the end of this Parliament, or one slightly undone by the decision to backtrack on cuts to disability benefits — the Government could be looking at a £30 billion black hole?
The consultancy points out that the Chancellor is running out of things to cut. The U-turn at the time of the Autumn Statement made it clear that axing tax credits for working families was politically unacceptable — and now the row over disability payments, ignited by Iain Duncan Smith’s resignation, has in effect put a ring-fence around most of the welfare budget on top of the protections already given to the NHS, pensioners and education. At the same time, the Chancellor seems to have grasped that reductions in infrastructure spending are counter-productive as they reduce long-term growth potential of the economy.
Similarly, most of the economy is taxed out. There are pledges in place not to hike income tax and National Insurance rates. Elsewhere, taxes are already at a level where increasing them further is unlikely to bring in any more revenue and may well have the opposite effect.
This means that if growth falters, or falls below the average of 2.1% that is predicted from now until 2020, there will be no obvious or easy way to recoup the lost tax revenues, and therefore no way to balance the books. The CEBR thinks productivity will be worse than the Office for Budget Responsibility expects and therefore economic growth will be lower at a likely average of 1.7%. This would see the deficit ballooning towards £30 billion.
This is, of course, only a prediction but it highlights the crucial importance of productivity growth and underlines yet again the long-term negative implications for living standards, social cohesion and political stability if we cannot find a way to lift it. It also highlights the importance of the work of Andrew Smithers, who has been saying for some years now that the slump in productivity is in large part the result of the short-term thinking which has infected boardrooms since we began to give senior executives massive bonuses rather than sensible salaries.
In his latest iteration of the theme in a paper submitted to the Aspen Institute*, Smithers and co-author Norman Eisen first point out that productivity growth is at its lowest for at least 50 years. Its long-term average is a little over 1% a year whereas for the past five years it has been below 0.3%. They add that fixed capital investment is similarly low. For the past six years, it has been less than at any time since 1952.
But this low rate of investment is not because of poor profitability. Corporate profit margins are at a record high level and six percentage points above the long-term average. Neither is investment being inhibited by a high cost of capital. Quite the opposite — but it is surely significant how the level of investment has not been stimulated at all by the record low interest rates.
If none of the above are stifling investment it must be something else — the low expectations for future growth or the strong disincentive to invest provided by the dramatic change that has taken place in the manner and amount of management remuneration.
Simply put, the short-term nature of these reward systems encourages management to inflate profits by pushing up prices and cutting back on investment. In the longer term, this weakens the business because it loses market share to more efficient, lower-cost competitors. But by then, the executive has collected his bonus and moved on. And if all the executives in the sector are on similar bonuses and doing similar things, an individual firm does not lose that much competitiveness.
It is significant, too, that this unwillingness to invest is clearly noticeable in quoted companies where these bonus systems are in place. It is much less apparent in private companies where such bonus systems are rare.
This multiplication of substandard, profit-gouging businesses being run several notches below their optimum competitiveness severely damages the wider economy and goes to show that what is good for shareholders — higher profits — is not necessarily good for the economy and society as a whole. Smithers compares it to the situation in which a company has a monopoly and it benefits the company and its shareholders to exploit its position and power but damages the wider public interest and justifies Government intervention to put things right.
Nor should it be ignored. It is not just public welfare that is undermined, it is also producing an increasingly unstable political climate as populist politicians play on the resentments aroused by years of disappointing growth and stagnating incomes. Stagnating productivity is potentially extremely serious.
Smithers’ key point is that there will be no improvement unless we recognise the cost of the problem and address the pay issue, and he proposes doing this by saying that all bonuses should be linked to increased productivity. There can also be other metrics but unless productivity increases by 1% a year, none should be paid. Companies would not be allowed to offset the cost of bonuses against tax unless they passed the productivity test.
Will this ever happen? It is worth noting that Smithers spent much of the first decade of this century warning that the excesses in the financial markets would lead to a crash, and no one listened. He is now warning that the excesses of executive pay are leading us into more quicksand. Again no one is listening. Perhaps we should.
*”Short-termism, Perverse Management Incentives and Poor Productivity”, by Norman Eisen and Andrew Smithers.
© 2017 Andrew Smithers