Understanding Growing Inequality, Part 2: How the Rich Got that Way
In the 1970s, something about the economy changed, and the rich started getting richer a lot faster. It explains last year's top CEO salaries, as well.
In the first part on understanding growing inequality, I talked about some of the reasons for the “poor getting poorer” part of inequality in Canada - because so little has changed in many provinces in Canada since 1986. It’s not just social assistance rates - it’s income as well that has stagnated.
In this chapter we’ll try to explain the rich getting richer part.
To recap -
Every New Year’s Day, the left-ish Canadian Centre for Policy Alternatives announces in the incomes of the top CEOs in Canada compared to the average worker.
“the think tank’s data series that began in 2008, with an average pay of $14.9 million. That’s 246 times the average worker’s pay in Canada, up from 241 times in 2021, when the average was $14.3 million.”
That multiple has more than doubled in the last 25+ years.
In 1998, the Top CEOs were paid 105 times the average wage, while in 2012, the richest CEO’s earned 189 times the salary of the average worker. This year it’s 246 times the average workers’ pay.
At the top of the list for 2022 was J. Patrick Doyle, Executive Chairman of “Restaurant Brands International Inc,” a holding company owned by a Brazilian Investment fund, 3G Capital. RBI in turn owns Tim Hortons, Burger King, Popeye’s Chicken and Firehouse Subs - very major brands.
Doyle has drawn no salary at all - all of his compensation $151,812,911 is either from selling shares, and from cashing in options on shares. RBI’s CEO, José Cil, is number 10 on the list. He did take a salary, of $1.266-million and he also received $17,666,379 in share-based awards, $0 in options, and $2,974,398 in “Non-equity incentive plan compensation.”
So, two executives at RBI, between the two of them, earned $175-million, and the story of RBI is worth telling.
RBI and 3G Capital
First, a point about the people making all the money. The folks who now own and run RBI are not the people who took the initial risk of starting and building the companies it owns. They did not mortgage their own houses or take the initial risk of time money and capital in finding investors, starting the first restaurant, and then expanding the chain.
Burger King was founded in 1953 and was one of the largest chains in the U.S. Tim Hortons was founded in 1964 in Canada and built up into a major franchise. Popeyes Chicken was founded in 1972, and Firehouse Subs was founded in 1994.
The businesses that make up RBI were already “mature” and well-established when they took them over in 2014.
For all of Tim Hortons’ cachet as the ultimate Canadian brand, it has been under either Brazilian or U.S. ownership for nearly 30 years.
The U.S. burger chain Wendy’s bought Tim Hortons in 1995, and owned it until 2009. At that time, Tim Hortons reincorporated in Canada and was registered to become a public company in Canada - for tax purposes. That is because Canada’s corporate income tax rate had been continually lowered from 30% to 15% - lower than the U.S. and many other jurisdictions.
Tim Hortons came to dominate fast food in Canada - selling three out of every four cups of coffee, and doing bigger business in Canada McDonald’s, it was also a company that made the most of tax advantages.
In 2010, 3G Capital bought Burger King, and in fact 3G now owns a number of “iconic” Canadian brands. They own ABInBev, which owns beer companies around the world, including Labatt, which was the largest brewer in Canada and was bought in 1995. AbInBev also owns Anheuser Busch and brands including Budweiser, Stella Artois and Corona.
Canada’s other “national staple” - KD, or Kraft Dinner, is also owned by 3G, which bought Kraft and Heinz, which were already two mega-food companies.
This chart is out of date, but it gives an idea of the brands that are owned by each mega-food company (and some of them have since been sold off.
It’s part of a growing trend over the decades of independent companies being bought out and bought up, made part of a much larger conglomerate.
The modern managers of these companies, who did not take the much larger initial risk of starting and growing the companies, then squeeze extra profits out of the company, using tax and financial engineering.
It has to be said - while people blame the government for “letting this happen” through a lack of taxation or other action, the actual choices and financial engineering is being done by private individuals in the private market.
When people blame government, it’s not because government officials did it, but that they stood by and “let it happen” - which is exactly what the ideological economic and policy changes of the 1970s demanded, at every level of the economy:
Governments were told to left “management” of the economy to the market, which would self-regulate (it doesn’t)
Corporations adopted “shareholder value” as an ideology
Central banks were independent and would exist for one reason, to try to control inflation my manipulating interest rates
Elected Governments would withdraw from the economy, cutting taxes, eliminating “New Deal” laws and regulations, and encouraging “labour mobility” by encouraging layoffs.
Productive Efficiency and Innovation
There is a critical distinction to be made about two types of innovation that reduce costs and generate profit through greater efficiency.
The first is that certain types of innovations and inventions reduce prices because they make a process enormously more efficient in terms of steps taken, energy and resources used.
Edward Chancellor talks about it in terms of “good and bad deflation”
You call for a distinction between good and bad deflation?
Yes, I distinguish between good deflation which comes from productivity growth, and bad deflation that comes from a collapse in the credit and banking systems. The good form of deflation actually benefits the working people, because things get cheaper. Your computer, your next car are a bit cheaper than last year. Technological improvements bring down the price: What’s not to like?
In the 1800s, lower-cost steel made the Industrial Revolution possible. The technology of the railway, steam engines, steam shipping, the construction of steel-girder buildings, bridges and more - it was a revolution that lowered the cost of technology, construction, transportation, and for every facet of the economy. Tools, machines, power systems.
In his indispensable book on engineering, “The New Science of Strong Materials” the engineer and professor J.E. Gordon writes that:
“The cheapening and improvement of iron and steel during the 18th and 19th centuries was the most important event of its kind in history - or perhaps, the most important event in history,” adding in a note “The price of steel was reduced more than tenfold during the reign of Queen Victoria” (from 1837-1991).
Innovations in technology like these have huge impacts on society. The new ideas, material or technology - electricity, information technology, construction, agriculture, transportation - not only create new possibilities for further innovation and growth, they reduce costs.
It is real science, real engineering, real world solutions. Such innovation (in science and in engineering) make take years or decades, and while it requires capital to turn the ideas into new tools, these are true efficiencies and true economies that while disruptive, change the course of human societies.
There are some individuals who drove or oversaw invention and technical innovation to great wealth - Edison with electricity and his light bulb, Alexander Graham Bell and the telephone, Steve Jobs and Apple, George Lucas and the technical innovations developed by Industrial Light and Magic.
All created new innovations that redefined industry and changed the way people lived.
This is completely different than financial engineering, which is the basis of the high incomes and wealth of many of the top earners.
It’s an important lesson - and a critical distinction between the “real economy” and the economy based entire on making money from money - finance, insurance and real estate.
Financial Engineering & the Myth of the Takeover Turnaround
The way 3G has built wealth is a basic model, and it’s important to understand how it works.
3G Capital, has “a reputation for deep cost-cutting and single-minded focus on shareholder value." (We’ll get to shareholder value in a moment).
3G buys existing, established, successful companies, and they reduce costs, largely by laying people off.
This is what happened when 3G bought Tim Hortons in Canada, as well as when they bought Heinz and Burger King. “About 450 middle managers and higher-ups were fired from Burger King when it was acquired by 3G in 2010,” and about 3,400 people at Heinz.
Step 1: Find a highly successful, profitable company
There’s a myth that these takeovers are about finding a struggling company, and coming in and turning things around and making them profitable.
The companies they are buying are already successful and profitable established brands. Burger King did not invent burgers and fries, Tim Hortons did not invent coffee and donuts, Popeye’s did not invent fried chicken.
The fact that they are successful means they already have a dedicated customer base, and the takeover company can then strip value out of it the way people strip copper out of houses.
Step 2: Borrow money to finance the purchase, and use it as a tax write-off to juice profits
The financial industry uses the term “leverage” to describe debt. “Leveraged buyouts” mean that the people buying are using borrowed money to pay for it.
So a leveraged buyout may mean the buyers only put down a small “downpayment” of 5% on the purchase price of the company. The strange part of this is that the debt is going to go on the company’s own books.
While you would think that adding all of that debt to a company you were buying would be bad, the increased debt costs can be used to reduce the taxes the company is paying, resulting in an immediate impact on the bottom line. There may also be cuts in R & D.
Step 3: Under the guise of “Efficiencies” layoff a large portion of the workforce, and cut costs everywhere else possible.
This “hollowing out” of companies can result in their collapse, as Joshua Kosman wrote, using the specific examples of the two top companies in the mattress market, Sealy and Simmons.
Sealy and Simmons were bought by a private equity firm in the early 1990s. They stopped competing with each other, eliminated the middle range of products and raised prices at twice the rate of inflation, and were sold back and forth between private equity firms several times more. In 2009, Simmons, which had been in business since the 1870s, declared bankruptcy with debts of $1.3 billion. In 1991, it had owed $164-million. 1,000 people, more than a quarter of the work force, were laid off. Bondholders stood to lose $575-million. In the intervening years, during which time it was sold seven times, its private equity owners took $750-million in profits.
“The company is more profitable in one sense: its earnings increase, usually because the private equity firm is starving it a bit of capital. The private equity firm is in the business of buying and selling companies in four or five years, so there is no long-term interest. A Davos study shows this: private equity eliminate more workers than their direct competitors and they typically decrease research and investment and capital expenditures.”
With an effective interest rate near 0% in the U.S., borrowing money was incredibly cheap in the early 2000s. The strategy of maximizing profits through accumulated debt as a write-off failed with the global economic meltdown: no one was lending anymore and sales sagged. More than half the 220 U.S. companies that defaulted on their debt in 2009 had been owned by private equity firms.
All those hollowed-out companies turn into a lot of hollowed out towns and a hollowed-out middle class.
Shareholder Value and Stock Options
After WWII, there was growing anxiety over the class of “professional managers” who were running established companies. In 1976, two finance professors, Michael Jensen and Dean William Meckling published a a paper called “Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure.”
“The article first defined the principal-agent problem and created agency theory. In the authors’ construct, shareholders are the principals of the firm — i.e., they own it and benefit from its prosperity. Executives are agents who are hired by the principals to work on their behalf… Jensen and Meckling argued that when executives squander firm resources to feather their own nests, the result is both bad for shareholders and wasteful for the economy. Instead, the theory goes, the singular goal of a company should be to maximize the return to shareholders.”
One solution was to link executive compensation with the company’s stock price. In 1981, GE CEO Jack Welch helped popularize the term, “shareholder value,” as the strategy to follow, although its roots can be traced back to a blistering polemic by Milton Friedman in the New York Times in 1970.
The idea behind shareholder value was that the CEO was a mere employee of the real owners of the business, the shareholder, and share price became the singular focus of boards, CEOs and companies. Actual performance — profits and losses — became less important than meeting the Wall Street analyst’s expectations of what the share price would be.
In practice, shareholder was a used as a rationale to squeeze all stakeholders and extract maximum profit. Ha-Joon Chang writes that,
“Distributed profits as a share of total US corporate profit stood at 35-45 per cent between the 1950s and 1970s, but it has been on an upward trend since the late 1970s and now stands at around 60%”
Chang adds
“Jobs were ruthlessly cut, many workers were fired and re-hired and non-unionized labour with lower wages and fewer benefits, and wage increases were suppressed (often by relocating to or outsourcing from low-wage countries such as China and India — or the threat to do so.)”
Some companies outsourced work with the precise goal of “boosting” the stock price.
One of the companies that pursued this strategy was GM, once the dominant carmaker on the planet, which ruthlessly cut back, built shoddy products, lost market share and finally went bankrupt in 2009 and required a government bailout.
These reasons, among others may be why Jack Welch of GE himself said that “maximizing shareholder value was the dumbest idea in the world.”
Roger L. Martin, who was Dean of the Rotman School of Management at the University of Toronto has written an entire book on the subject of shareholder value, called Fixing the Game.
He gives the example of a problem for companies and investors alike: a stock that was initially offered and sold to the public at $20 is sold, and re-sold, eventually rising to $100. The company only got $20 from selling its share to the first investor, but the investor who buys it at $100 is going to expect it to perform much better.
Writes Martin:
“The company needs to earn 15 percent on $100 per share of expectations capital, even though it only has $20 of real capital with which to do it. Rather than a 15 percent return on its real equity (or $3/share) it has to earn a 75 percent return on its real equity (or $15/share), a deeply challenging task and one that even the best companies are unlikely to achieve over time.”
Pursuit of profit through “shareholder value” alone undermines the company by increasing the long-term risk for the company, its employees, and the broader economy. Jurisdictions in Europe and elsewhere have sought to “reduce the influence of free-floating shareholders and maintain (or even create) a group of long-term stakeholders (including shareholders) through various formal and informal means.”
Despite all that, it still seems hard to argue against maximizing shareholder value or profit. Isn’t maximizing profit the whole point? It is generally accepted that it is.
There is a simple argument for why shareholders shouldn’t take all the benefits. As Gaël Giraud put it,
“Ownership implies full liability… Full liability was actually the implicit assumption of Friedman (1953) when he claimed that, in the long-run, markets are efficient.”
This, to me is one of the most powerful arguments against shareholder value.
If a company takes on a billion dollars in debt and goes under, the shareholders are off the hook for the debt. Shareholders are specifically legally protected from the corporation’s liabilities when a risk goes wrong. If things go wrong, shareholders will be protected while employees may lose their jobs and pensions, suppliers will go unpaid.
The justification for a different system is that if we are rewarding shareholders for their financial contribution and the risk they are taking, we should recognize that there are other participants who are also taking a risk, and face losses if the risks turn sour: workers, suppliers, and even the local community. Shareholder value denies that.
Stock Options and Shares
In order to encourage CEOs to align their personal interests with those of the company, CEOs were offered compensation not just in salary or performance bonuses, but with stock options. A stock option gave CEO’s the chance to buy a certain number of shares at a certain price: lets say, 25,000 shares at $5. If a CEO could manage the company in such a way that shares hit $10 a share, they could “exercise their option” and do one of two things:
Buy the shares for $125,000 and get $250,000 worth of shares
Buy the shares and sell them immediately, making an immediate profit of $125,000, which because it is a capital gain, would not be treated as salaried income, and would be taxed at a much lower rate
Instead of focusing on actual profits and revenue, what matters in shareholder value is whether a company’s share price is meeting the expectations of the market. It is much easier to manipulate a stock price to ensure it hits a certain price than it is to actually generate long-term profits, and there are a number of ways that companies have done this. One is through accounting manipulations - registering a loss in one month when it occurred in another. Another is “share buybacks” - using company resources (including profits) to buy back stock and drive the price up.
“Share buybacks used to be less than 5 per cent of UD corporate profits for decades until the early 1980s, but have kept rising since then and reached an epic proportion of 90 per cent in 2007 and an absurd 280 percent in 2008. William Lazonick, the American business economist, estimates that, had GM not spent the $20.4 billion that it did in share buybacks between 1986 and 2002 and put it in the bank (with a 2.5 per cent after tax annual return) it would have had no problem finding the $35 billion that it needed to stave off bankruptcy in 2009.”- Ha-Joon Chang
RBI received approval for $1-billion in buybacks this year. Share buybacks often use debt (for tax deduction purposes). Sometimes it’s described as concentrating value because the same total value of company is being divided across fewer shares. If the share buyback is cash, this is true. If it is debt, it is not. With shares, the corporation pays a dividend if it’s making money. Debt has to be repaid whether you’re making money or not. That means swapping equity for debt increases risk. That’s what gives it the temporary boost - they’re borrowing a bunch of money and handing it out, because borrowing money let them cut their taxes. But they’re also cutting the workforce who, up to that point had successfully ensured the corporation’s success, and presumably its share price.
The risk of abuse is very clear: buybacks could be used to fix share prices, or trigger a bonus or exercising an option, all of which are against the rules.
3G is certainly not alone:
Buybacks are regulated, because otherwise there is a risk that could
Personal Tax Benefits : the difference between wealth and income
People being paid or selling shares or stock options, are taxed at lower rates than people’s regular income tax from work. Dividends from stock and money from “capital gains” is taxed at a lower rate than personal income tax from work.
This is the simple, and very important difference between wealth and income. Wealth is owning something that will pay you, even when you are sleeping. Income, you have to work for. And when the work stops, so does the income.
Aside from tax evasion - which is illegal - there is also legal “tax avoidance”. Any form of legal exemption on your tax form is avoiding taxes, but there is a matter of degree here. Yes, writing off your student loan payments is legally avoiding taxes.
It’s also possible to legally avoid (and reduce) taxes by splitting your income, or compensation in shares, across multiple small corporations. In Canada, they’re called Canadian Controlled Private Corporation (CCPC)
“•“While the general corporate tax rate in Canada is 15 per cent, CCPCs can use a lower 11 per cent rate for the first $500,000 of active business income.”
Jack Mintz at the University of Calgary found that “60 per cent of the small business deduction goes to households with more than $150,000 in income.”
The chart below is from a study by Michael Wolfson of the University of Ottawa. He said it was estimated that high-income Canadians, by using corporations, could reduce their income tax bill by 50%.
Finally, there is the issue of “jurisdiction shopping” and the race to the bottom.
RBI is registered as a corporation in Canada for tax purposes - but the board Chair who took $153-million in compensation lives in Florida, which is where Burger King is headquartered.
So, these are some of the many reasons that innovations in financial engineering have come to dominate the means by which incomes have risen. These are measures and tools for legal tax avoidance that are beyond the reach of most earners.
Setting up shell corporations, or better tax rates for shares and stock options are benefits for owners that can’t be accessed.
While the Fraser Institute claims that such high incomes are a reward for the rare qualities of CEO’s, a study by Canadian economists Miles Corak and Patrizio Piraino found that
“One-third of successions between chief executive officers in publicly listed companies in the U.S. involves an incoming CEO related by blood or marriage to the old CEO, the founder, or a large shareholder."
An empirical confirmation of J K. Galbraith’s pithy observation “The salary of the chief executive of a large corporation is not a market award for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.”
NEXT in this series : How debt fuels inequality
DFL
A very informative financial lesson.
Very pertinent.
I just wrote an article about this subject as well. Give it a read!
https://open.substack.com/pub/thepanoramapress/p/in-the-united-states-executive-salaries?r=3hyaiy&utm_campaign=post&utm_medium=web