Explaining rising income inequality

Corporate executives are receiving extravagant sums for not doing their jobs.

The ongoing crisis of the major Western capitalist economies has citizens on both sides of the Atlantic asking why the incomes of the business elite keeps rising even as companies cut jobs, banks foreclose homes, and the threat of penury faces many families who thought they were solidly middle class.

In the United Kingdom, the High Pay Commission in its report last November stated that “pay at the top has spiraled alarmingly to stratospheric levels in some of our biggest companies.”  At BP the pay of the chief executive was 16.5 times that of the average worker in 1979-80 but 63.2 times in 2009-2011. At Barclays this ratio more than quintupled from 14.5 to 75.0 over the same time period.  The annual remuneration of the chief executives of both BP and Barclays in 2009-2011 was about £4.4 million.  The Commission concluded that this high degree of income inequality manifested “a toxic form of free market capitalism” that undermines worker motivation and ultimately innovation. 

This toxic form of capitalism is even more virulent in the United States. According to data for the largest corporations reported by the AFL-CIO, CEO:worker pay ratio was an excessive 42:1 in 1980, an extravagant 107:1 in 1990, an astonishing 525:1 in 2000, and an outrageous 343:1 in 2010.  The average annual pay in 2010 dollars of the top 500 highest paid executives named in US corporate proxy statements has been as high as $40.5 million in 2000 and averaged $17.9 million in 2008-2010.

Most critics argue that this growth in income inequality is unfair, plain and simple. The problem, however, goes much deeper than that.  As shown by our research from projects funded by the European Commission, the Ford Foundation, and Soros’ Institute for New Economic Thinking, these overpaid corporate executives are getting these huge bonanzas for not doing their jobs.

In a world of rapid technological change and intense global competition, the main job of the top executive is to direct the company’s investment strategy, allocating corporate resources to generate new products using new processes.  Through these investments in innovations, executives seek to create value in the companies over which they exercise allocative control.  In sharp contrast, outsized executive pay reflects their ability to extract value from their companies, often at the expense of value creation, and of taxpayers and workers who have contributed to it.

If you ask these high-paid CEOs for their job description, they will undoubtedly say “maximizing shareholder value”.  There is a lot of ideology packed into those three words. It says that of all the economic actors who contribute labour and capital to the company, it is only shareholders to whom the market does not guarantee a return, and hence only shareholders who bear risk.  If the company does well, shareholders gain; if the company does poorly, shareholders lose.

In making these arguments, corporate executives are simply parroting what has been taught since the late 1980s by financial economists at leading Western business schools.  The central assumption that shareholders are the only participants in the corporate economy who bear risk is, however, false.  To be sure, shareholders who provide companies with the committed equity finance required to develop new products and processes put their capital at risk. In addition, however, in an innovative economy, taxpayers and workers are constantly contributing capital and labour to support the innovative strategies of companies without a guaranteed return.

The government uses taxpayers’ money to invest in physical and human resources that are made available to companies below cost, often with explicit subsidies, without a guaranteed return to taxpayers.  The Internet, aerospace, biotech, nanotech, and cleantech are all examples of growth-inducing technologies that originated in the willingness of the government to take on the early, high-risk investments. When these technologies achieve commercial success, taxpayers are owed a return.

Workers also contribute their skills and efforts to the innovation process without a guaranteed return. Large numbers of employees work long and hard, collectively and cumulatively, to develop and utilize new products and processes, incentivized by the prospects of secure, remunerative, and fulfilling careers. Yet, especially in a world in which “flexible employment” has become the norm, workers make these productive contributions without those returns guaranteed.  When the companies for which they work achieve commercial success, these employees are owed a return.

And what do public shareholders do? They buy and sell shares, hoping to get a return on investments in productive resources that other people – private shareholders, workers and taxpayers – have made. Yet, in both the UK and the US, corporations are currently being run to maximize the extraction of value in the name of those very economic agents who typically take the least risk.

Indeed, especially through stock-based compensation, we bestow huge rewards on top executives for overseeing this process of value extraction.  For the highest paid US executives over the past two decades, gains from exercising stock options have ranged from 50% of their total pay when the stock market is down to 90% when it is up. To give a boost to their companies’ stock prices, and hence to their own pay, corporate executives do massive buybacks of their own companies’ shares. For S&P 500 companies, buybacks totaled almost $3 trillion over the past decade, including about $400 billion in 2011. 

In comparison with the United States, the rise in UK executive pay has been somewhat constrained by the Combined Code of Corporate Governance established in the 1990s and a much more class-conscious labour movement. In addition, US companies have historically been richer and stronger than UK companies so that in the United States there have been larger accumulations of value for US executives to extract. Nonetheless, UK executives have done quite well in imitating their US counterparts in devising ways how to make out for themselves.

It is commonly argued that even if large established companies are no longer the engines of innovation that they once were, we can look to enterprising startups to invest in new products and processes. Indeed, UK policy-makers have long envied the United States for its high-tech industrial districts, epitomized by Silicon Valley and Route 128. Yet the huge fortunes made from venture-backed startups in the United States in the 1980s and 1990s would not have been possible without decades of government investment to provide startups with publicly available high-tech knowledge bases. Moreover in the biotechnology industry, which is massively supported by the National Institutes of Health, the vast majority of startups that do initial public offerings fail to generate commercial products. Those failures do not, however, deter these companies’ venture capitalists, entrepreneurs, and executives from using the speculative stock markets to cash in for themselves.

There is growing evidence that since the late 1990s the US venture-capital model has become one in which impatient capitalists expect a quick return, even if the extraction of this return undermines the innovation process itself.  In this, the Bush tax cuts have been a major boon. Ironically, as in the early 2000s US venture-capital model was turning from value creation to value extraction, the UK Labour Party embraced the US venture-capital model, reducing from ten years to two years the duration of time that private equity has remain invested in a company  to be eligible for capital gains tax rates on its profits .

The growing concentration of income at the top in the United Kingdom is both unfair to workers and taxpayers, and damaging to the growth and competitiveness of the economy.  The British need only look at what has happened in the United States over the past decade to see the economic stagnation, social decay, and political gridlock that results when this concentration of income at the top becomes ultra-extreme.  It is time to put an end to it, now.

Mariana Mazzucato is Professor of Economics and RM Phillips Chair in Science and Technology Policy at the University of Sussex. She is the author of The Entrepreneurial State.

William Lazonick is professor of economics and director of the UMass Center for Industrial Competitiveness.

Photo: Getty Images
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What's to be done about racial inequality?

David Cameron's words on equal opportunities are to be welcomed - now for some action, says Sunder Katwala.

David Cameron made the strongest, clearest and most high profile statement about ethnic inequalities and the need to tackle discrimination ever yet offered by a British Prime Minister in his leader’s speech to the Conservative Party conference in Manchester.
“Picture this. You’ve graduated with a good degree. You send out your CV far and wide. But you get rejection after rejection. What’s wrong? It’s not the qualifications or the previous experience. It’s just two words at the top: first name, surname. Do you know that in our country today: even if they have exactly the same qualifications, people with white-sounding names are nearly twice as likely to get call backs for jobs than people with ethnic-sounding names? … That, in 21st century Britain, is disgraceful. We can talk all we want about opportunity, but it’s meaningless unless people are really judged equally”, said Cameron.
While the proof of the pudding will be in the eating, this was a powerfully argued Prime Ministerial intervention – and a particularly well-timed one, for three reasons.

Firstly, the Prime Minister was able to root his case in an all-but-universally accepted appeal for equal opportunities. It will always prove more difficult in practice to put political energy and resources behind efforts to remedy discrimination against a minority of the population unless a convincing fairness case is made that values cherished across our whole society are at stake. Cameron’s argument, that any party which tells itself that it is the party of the ‘fair chance’ and ‘the equal shot’ must have a response when there is such clear evidence of discrimination, should prove persuasive to a Conservative Party that has not seen race inequalities as its natural territory. Cameron argued that the same principles should animate responses to discrimination when it comes to race, gender and social class. Put like that, wanting job interviews to be fair – by eradicating conscious and unconscious patterns of bias wherever possible – would strike most Britons as offering as clear a case of the values of fair play as wanting the best baker to win the Great British Bake-Off on television.
Secondly, Cameron’s intervention comes at a potential "tipping point" moment for fair opportunities across ethnic groups. Traditionally, ethnic discrimination has been discussed primarily through the lens of its impact on the most marginalised. Certainly, persistent gaps in the criminal justice system, mental health provision and unemployment rates remain stark for some minority groups. What has been less noticed is the emergence of a much more complex pattern of opportunity and disadvantage – not least as a consequence of significant ethnic minority progress.

Most strikingly of all, in educational outcomes, historic attainment gaps between ethnic minorities and their white British peers have disappeared over the last decade. In the aggregate, ethnic minorities get better GCSE results on average. Ethnic minority Britons are more likely, not less likely, to be university graduates than their fellow citizens. 

As a result of that progress, Cameron’s intervention comes at a moment of significant potential – but significant risk too. Britain’s ethnic minorities are the youngest and fastest-growing sections of British society. If that educational progress translates into economic success, it will make a significant contribution to the "Great British Take-Off" that the Prime Minister envisions. But if that does not happen, with educational convergence combined with current ‘ethnic penalties’ in employment and income persisting, then that potential could well curdle into frustration that the British promise of equal opportunities is not being kept.  Cameron also mirrored his own language in committing himself to both a ‘fight against extremism’ and a ‘fight against discrimination’: while those are distinct challenges and causes, actively pursuing both tracks simultaneously has the potential, at least, depolarise some debates about responses to extremism  - and so to help deepen the broad social coalitions we need for a more cohesive society too.

Thirdly, Cameron’s challenge could mark an important deepening in the political competition between the major parties on race issues. Many have been struck by the increase in political attention on the centre-right to race issues over the last five to ten years. The focus has been on the politics of representation. By increasing the number of non-white Conservative MPs from two to seventeen since 2005, Cameron has sent a powerful signal that Labour’s traditional claim to be ‘the party of ethnic minorities’ would now be contested. Cameron was again able to celebrate in Manchester several ways in which his Cabinet and Parliamentary benches demonstrate many successful journeys of migrant and minority integration in British society. That might perhaps help to ease the fears, about integration being impossible in an era of higher immigration, which the Home Secretary had articulated the previous day.

So symbolism can matter. But facial diversity is not enough. The politics of ethnic minority opportunity needs to be about more than visits to gurdwaras, diversity nights at the party conference fringes and unveiling statues of Mahatma Gandhi in Parliament Square. Jeremy Corbyn’s first speech as Labour leader did include one brief celebratory reference to Britain’s ethnic diversity – “as I travelled the country during the leadership campaign it was wonderful to see the diversity of all the people in our country” – and to Labour bringing in more black, Asian and ethnic minority members - but it did not include any substantial content on discrimination. Tim Farron acknowledged during his leadership campaign that the Liberal Democrats have struggled to get to the starting-line on race and diversity at all. The opposition parties too will no doubt now be challenged to match not just the Prime Minister’s rhetorical commitment to challenging inequalities but also to propose how it could be done in practice.

Non-white Britons expect substance, not just symbolism from all of the parties on race inequalites.  Survation’s large survey of ethnic minority voters for British Future showed the Conservatives winning more ethnic minority support than ever before – but just 29 per cent of non-white respondents were confident that the Conservatives are committed to treating people of every ethnic background equally, while 54 per cent said this of Labour. Respondents were twice as likely to say that the Conservatives needto do more to reach out – and the Prime Minister would seem to be committed to showing that he has got that message.  Moreover, there is evidence that ethnic inclusion could be important in broadening a party’s appeal to other younger, urban and more liberal white voters too – which is why it made sense for this issue to form part of a broader attempt by David Cameron to colonise the broad centre of British politics in his Manchester speech.

But the case for caution is that there has been limited policy attention to ethnic inequalities under the last two governments. Restaurateur Iqbal Wahhab decided to give up his role chairing an ethnic minority taskforce for successive governments, unconvinced there was a political commitment to do much more than convene a talking shop. Lib Dem equalities minister Lynne Featherstone did push the CV discrimination issue – but many Conservatives were sceptical. Cameron’s new commitment may face similar challenges from those whose instinct is to worry that more attention to discrimination or bias in the jobs market will mean more red tape for business.

Labour had a separate race inequalities manifesto in 2015, outside of its main election manifesto, while the Conservative manifesto did not contain significant commitments to racial inequality. The mid-campaign launch in Croydon of a series of race equality pledges showed an increasing awareness of the growing importance of ethnic minority votes - though the fact that they all involved aiming for increases of 20 per cent by 2020 gave them a slightly back-of-the-envelope feel. 

Prime Ministerial commitments have an important agenda-setting function. A generation ago the Stephen Lawrence case opened the eyes of middle England to racist violence and police failures, particularly through the Daily Mail’s persistent challenging of those injustices. A Conservative Prime Minister’s words could similarly make a big difference in the mainstreaming of the issue of inequalities of opportunity. What action should follow words? Between now and next year’s party conference season, that must will now be the test for this Conservative government – and for their political opponents too. 

Sunder Katwala is director of British Future and former general secretary of the Fabian Society.