Higher profits, lower costs: to what end?

By Lawrence E. Mitchell and Geneva Overholser
lmitch@law.gwu.edu
overholserg@missouri.edu

The possible sale and break-up of Knight Ridder is only one manifestation of a larger problem that affects us all. The values that lawmakers and regulators have enshrined in corporate law and finance threaten to destroy the long-term health of the American economy. They also threaten to destroy our basic freedoms and undermine our security.

The fundamental scandal that drove corporate fraud a few years ago and still drives corporate behavior is the idea that corporations exist for the purpose of maximizing shareholder wealth. For the most part, this means constantly increasing stock prices.  In only a few decades this idea has made its way into law, finance, and American business consciousness. As of October 2005, the stocks traded on the New York Stock Exchange were changing hands at a rate of 103 percent per year, all in pursuit of higher stock prices.

Academic and business studies increasingly show how shareholder valuism, as the idea is known, leads corporate managers to emphasize the short term in pushing up stock prices even with the knowledge that it leads to long term corporate and social damage. Business-friendly voices like The Economist have started to question whether shareholders put too much short-term profit pressures on management. And, as The New York Times recently reported, even pensions – the ultimate long-term investors, are investing heavily in hedge funds, the ultimate short-term investments – to increase their immediate wealth.

The threat shareholder valuism poses to the long-term health of our economy is bad enough. It also threatens institutions that protect our freedoms, values and way of life. The press is a prime example. Stock market pressures are leading corporations that own print and broadcast media to reduce the amount of space and air time available for news, to cut staff and to eliminate training and other investments in the future.

As the case of Knight Ridder, the nation’s second-largest newspaper-owning company, illustrates, even substantial expense cutting may not protect media businesses from sales forced by investors unhappy with short-term profit shortfalls.  Or consider health care. Corporatization increasingly endangers the quality of treatment provided to Americans dependent on managed care companies, which are relentlessly pressured to keep costs down and profits up.

Stories currently in the news remind us how powerfully communities across the nation are affected by short-term profit emphasis. Perhaps nothing will save General Motors, but laying off 30,000 workers helps the stock price. Meanwhile, cutting back on research and development and short-changing quality further undermine the corporation. Companies like Wal-Mart reshape the commercial profile of town after town, yet fail to pay their workers a living wage and decent benefits, snaring them in an endless cycle of working poverty and preventing them from creating greater opportunities for their children, all for the sake of stock price. Ordinary workers who have produced shareholder wealth for years increasingly learn that they are sacrificing their pensions to the pockets of those same shareholders.

The problem has a solution that should have almost universal appeal: Change the capital gains tax rules to give shareholders incentives to become long-term investors. Long-term investment means patient capital, which gives corporate managers time to worry about the future health of their businesses. That means the future health and well-being of all of us who rely on those businesses and provide them with their profits. Long-term investment means long-term management, which means jobs, pensions, and skills-training for workers, the development of new products, greater attention to product quality and safety, and overall corporate concern for the communities of consumers and workers from which they derive their profits.

To qualify for the lower tax rates applied to long-term capital gains, an investment must be held for at least a year and a day. For most businesses, a year means little. We ought to calibrate our capital gains taxes in a way that makes the long-term mean something. For some industries this might be one year; for others it might be ten years. In any case, we should impose highly punitive capital gains taxes (say, for example, 90 percent), for very short term trading (or “flipping”), and provide a sliding scale of decreasing taxes until we reach complete tax forgiveness for meaningful long-term holdings. 

We would of course need exceptions for those who sell stock because of emergencies and other unanticipated financial needs. Perhaps we also need exceptions for stock exchange specialists and other traders who professionally stabilize the market, although the new tax structure alone should make the market far more stable.  Other than this limited set of exceptions, a new capital gains structure would turn us into a nation of investors, not a nation of speculators, and allow our corporations to become more focused on business than on stock price. Only then will the business of America be business, and the business of America benefit us all.

[Editor's note: An earlier version of this essay incorrectly stated that capital gains rules treated six months plus one day as long term holdings.]

Geneva Overholser, a 1986 Nieman fellow, holds the Curtis B. Hurley Chair in Public Affairs Reporting for the Missouri School of Journalism, in its Washington, D.C., bureau. E-mail: overholserg@missouri.edu

Lawrence E. Mitchell is an author and the John Theodore Fey Research Professor of Law and George Washington University. E-mail: lmitch@law.gwu.edu

Comments

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Right problem, wrong answer Posted by Joel Whitaker - Editor, Beverage News Daily 02/53/2006, 02:00 PM The authors correctly identify the problem as "shareholder valuism" and the damage it is doing to our country. However, their proposed solution won't correct the problem because of the overwhelming influence of institutional investors -- mutual funds, pension funds, etc. -- in the market. At Knight-Ridder, institutional investors control more than 93% of the stock. Institutions don't pay taxes. The key to the solution is to realize people do what they get rewarded for doing. And right now the fastest way to grow executive wealth is to sell the company. Why? Because top management gets stock options that vest immediately if there's a sale, as well as "change of control" bonuses. (Nice, isn't it: Sell the company, then get a huge bonus -- three or four times your annual compensation -- because you're no longer in control.) It used to be, when one bought stock, one bought "a share of American business." Executives would resist takeovers, because that meant they lost their jobs. Now we incentivize them to sell the company, because they can get rich(er) doing so. In Tony Ridder's case, he's 64, and soon to retire. If he's going to lose his $1.8 million-a-year job anyway, from his view, it's perfectly logical to sell the whole company at a premium, collect three or four years additional salary -- plus a "loss of control" payment. Step 1 to ending this sort of thing is to prohibit stock options as executive compensation. Step 2 is to prohibit loss-of-control bonuses. Step 3 is to link executive compensation directly to (1) the company's sales, (2) the company's net profit, and (3) gain or loss in net assets on the corporate balance sheet. This is the only way to return executive focus to growing their business, rather than selling the business. Jump to top of list