How the sources of corporate profits weakens capitalism

Herman Mark Schwartz points to another direction of enquiry in understanding what ails capitalism, the sources of corporate surpluses, 

Changes in corporate strategy and structure from the postwar era to the current era changed the distribution of profits among and within firms and led directly to our present problems. While the distribution of profits across firms was highly unequal in both eras, changes in corporate strategy and structure have concentrated profits in firms with small labor head counts, a low marginal propensity to invest, and relatively easy tax avoidance. Reduced invest­ment and worsening income inequality in turn slow GDP growth and aggravate social and regional tensions. While these changes are generic to the rich countries, they have gone furthest in the United States.

The essay charts the changing nature of the economy in the US, especially manufacturing. The long period of stable and mutually beneficial growth which was built on capital intensive factories, vertical integration and large and unionised workforces, reached its climax by the seventies. 

Privately, firms began to disperse concentrated production and shed legal responsibility for their workers by de-merging, moving produc­tion offshore, contracting out (both on- and offshore), dispersing production geographically, and adopting variants of the franchise format. IBM, for example, shed 40 percent of its workforce between 1990 and 1994, abandoning most manufacturing in favor of R&D, soft­ware, and patent licensing. Similarly, both GM and Ford spun out their parts production as the independent firms Delphi and Visteon in 1999 and 2000. By 2008, both Delphi and Visteon had more Mexican than American employees. Where the old GM had generated 70 percent of final value in house, and Ford 50 percent, almost all automobile firms were down to 20 percent by the 2000s. Contracting out created smaller firms and smaller factories, both of which are harder to unionize.

The new strategy for firms came to be centred around the intangible capital,

Firms’ new profit strategy sought monopoly profit via control over intellectual property (IP) via intellectual property rights (IPRs), like patent, brand, copyright, and trademark, while ejecting workers and physical capital. IPRs convey an exclusive right to extract value from a given production chain. For example, Qualcomm’s patents on the technologies linking cellphones to cell towers and Wi-Fi enable it to levy a 2 to 5 percent royalty on the average selling price of almost all cellphones... many firms outside of tech have pursued an IPR-based strategy. Franchised restaurant chains are the most obvious “low-tech” example, with a high-profit brand own­er licensing the use of its brand and production methods to small­er, lower-profit owner-operators in the bottom tier. In both high-tech and low-tech industries, the general pattern is vertical disintegration and the segregation of IP ownership into a small number of legally distinct and highly profitable firms. This largely involves a rearrangement of legal boundaries, not production as such.

Sample this example from the low-tech world,

The major hotel brands neither own physical buildings nor directly employ most of the workers inside. Hilton Worldwide Holdings, for example, is a firm whose major asset is its intellectual property: 5,900 registered trademarks and 15 carefully gradated and curated hotel brands as of December 2018. Hilton directly owned or leased only 71 of the 5,685 properties labeled with those brands. The hotel buildings themselves—the mid­dle layer in the new industrial structure—are a large physical asset, variously owned by private equity firms, family trusts, and real estate investment trusts (REITs). For example, a different “Apple”—Apple Hospitality Real Estate Investment Trust—owns 242 hotels in the United States, operating under the nominally competing Hilton and Marriott brands. Apple REIT’s buildings are managed by hotel man­agement firms operating under contract. These management firms either directly employ or contract in labor from third-tier firms like Hospitality Services Group. These jobs can be “gig”-like but are more often standard employment relations. Thus even a low-tech sector like hotels has a tripartite division combining legally separate but functionally integrated firms specializing in IP production, firms holding physical capital, and firms supplying low-skill labor power.

The result of all this,

First, it skews the distribution of income upward, reducing demand and weakening the state’s fiscal base. Second, and most important, the three-tier structure creates firms with lots of profit but a low marginal propensity to invest, and firms with a high marginal propensity to invest but profits too weak to enable robust productive investment. 

In many respect, this new capitalist organisational structure may be the apogee of the search for efficiency (from the perspective of capital owners) and profit maximisation. From their perspective, the three-tier structure not only maximises efficiency but also creates a perfect hierarchy of income distribution among the various stakeholders. This arrangement in turn gets its ideological support from the prevailing norms around the likes of superiority of intellectual capital, meritocracy, and financial engineering.

In other words, capital itself split into two parts, the physical and intangible capital. Among capital, the unbundled manufacturing model and new organisational structures enabled the appropriation of greater share of profits towards the intangible capital. The owners of the intangible and physical capital too were different, with financial market interests and IPR-rich firms dominating the former. 

And physical capital, in turn, squeezed an ever expanding share of labour in the third tier to at least partially make up for its diminished returns. This was complemented with the inter-firm redistribution arising from the dynamic of surplus concentration in a handful of superstar firms. Automation, globalisation, and de-unionisation merely amplified these dynamics. While production remained essentially the same, the shifts in legal boundaries within the production system were hugely consequential. 

It is not easy to reverse the trend. Any regulation driven approach is unlikely to work. It will have to be a more organic endogenous effort. But regulation has its role to play. 

It needs to be borne in mind that the unbundling has been facilitated by enabling regulations, which allowed private appropriation of incremental gains and externalisation of costs. After all the whole idea of mandatory employment benefits for workers arose from the need to make businesses internalise the life-cycle costs of employment, which went beyond just wages. If that requirement has now been removed and labour protections have fallen back on governments, it is only appropriate that the same be recovered from the businesses which have benefited from these shifts. 

To give a sense of the importance of such regulatory arbitrage, a group of ride-hailing and delivery companies led by Uber, Lyft, and DoorDash have spent a staggering $200 million to garner support for a California ballot measure, Proposition 22, that would exempt them from a new state labour law that would exempt them from treating their riders as employees (thereby saving the need to provide them benefits). In fact, the stakes are so high that the movers of Prop 22 have inserted a provision mandating a staggering seven-eighth of legislators should agree before any changes can be made to the law once the Prop is passed. 

While the enabling regulations legalised the creation of the large pool of low-paid and unprotected workforce, academicians and opinion makers at business schools and think tanks have provided the ideological credibility. 

It was not just labour regulations. Accounting regulations allowed capitalisation of different forms of intangible capital, broadening of the application of intellectual property regulations allowed rent-seeking, and so on. 

In fact, far from capturing a share of the profits from capital to support the new social security liabilities, governments have lowered both corporate and income taxes. Further, intangible capital has received more preferential treatment by way of changes in the taxation systems. The greater globalisation and financial market integration have allowed them to indulge in practices like tax avoidance to drive down their profits to the lowest minimum. 

Governments have faced the double whammy of increased labour force obligations and reduced revenues. 

It is to be noted that the problem is not per se with the unbundling itself. By itself, it did enhance efficiency and globalisation has lifted hundreds of millions out of poverty. Further, there is merit in differentiated labour market depending on the different types of skills. Instead, the problem is with the excesses that have spawned from these shifts. In particular, the disproportionately high levels of profit appropriation by capital and executives. 

One could of course argue that once cost-less unbundling was permitted, these dynamics were inevitable.

The knock-on effects were predictable,

Because consumption spending accounts for about 70 percent of GDP, rising income con­centration slows GDP growth. Buying one South Carolina–built BMW SUV generates fewer jobs and less subsequent consumption than buying three Ohio-built Honda Accords.

A disproportionate share of profits were cornered by intangible capital, whose owners (typically finance and IPR-rich firms) were less likely to invest, especially in productive and job creating activities. The squeeze on labour meant diminished disposable incomes to spend on consumption to support economic growth.

An accompanying consequence of the unbundling and outsourcing has been the hollowing out of the productive parts of the US economy like manufacturing and the cessation of the space to foreigners, especially China. Its consequences being played out now are an entirely different set of problems. 

As a concluding snippet, sample this,

But investment banks increasingly rely on Class 705 business process patents to protect new derivatives and processes. In 2014, for example, Bank of America filed roughly the same number of successful U.S. patents as Novartis, Rolls Royce, or MIT, and J.P. Morgan filed as many as Genentech or Siemens. Bespoke derivatives and other forms of rent seeking enable key finan­cial firms to extract rents from nonfinancial firms... IPR-rich firms accumulated immense passive cash hoards. Micro­soft, for example, would have been the eleventh largest holder of U.S. Treasury bonds if it were a country in 2019, excluding tax havens; Apple has been described by the Economist magazine as an investment bank that also makes phones... the winners from this were big U.S. retail and financial firms, and manufacturers with recognizable brands, and the losers were the rest of the domestic manufacturing base and its labor force. The winners increasingly parked their profits offshore in tax havens, while the losers drew on an increasingly weak state and feder­al government fiscal base.

In sum, the shifts in capitalist organisational structures has engendered a giant profits misallocation problem, whose negative effects cascade across the economy.