I’ve been trying to make sense of the recent push, from Hillary Clinton and others on the left, against what’s been dubbed “quarterly capitalism,” or the alleged tendency of publicly held companies to act in the short-term interests of speculators rather than in the long-term interests of more patient investors, and indeed the broader economy. The basic concern, as I understand it, is that in the age of activist shareholders, publicly held companies are not investing enough in increasing their productivity or in developing innovative new products. Rather, they are seeking to extract as much value out of the enterprise as they can through stock buybacks and other measures that enrich shareholders, including senior managers. But is this really a problem? Is Corporate America letting us all down by slavishly chasing returns when managers should be investing for the long term?
I should say that I don’t find the notion that quarterly capitalism is a problem absurd on its face. A number of thoughtful people, like the Harvard management theorist Clayton Christensen, have lamented the short-termism of U.S. corporate executives and the shareholders they serve. One irony of the fact that the Left is embracing a critique of quarterly capitalism is that private-equity firms — which, among other things, buy publicly held companies outright to restructure them, with an eye toward making them more valuable — represent one antidote to short-termism. As you’ll no doubt remember from the 2012 presidential campaign, it wasn’t so long ago that private-equity firms were the villain of the day.
It turns out that privately held firms play an important role in the quarterly-capitalism debate. Critics of quarterly capitalism have pointed to research by the economists John Asker, Joan Farre-Mensa, and Alexander Ljungqvist. They find that privately held firms invest more than similar publicly held firms, which implies that the demands of the stock market are leading publicly held firms to underinvest. What we don’t know, however, is whether these firms are really as comparable as they appear to be. It could be that there is a reason some companies choose to remain private while others go public that bears on their investment decisions.
In June, a blogger who goes by the name “modest proposal” observed that in the tech sector, at least, companies tend to go public at later stages of the lifecycle of their main product. While these companies generate large amounts of cash, they have a surprisingly hard time putting it to good use. Some companies hoard money to avoid paying U.S. taxes. Apple, for example, has over $200 billion lying around in liquid assets, most of which is offshore. Companies can invest in innovation or acquiring other companies, which is exactly what critics of quarterly capitalism want them to do. Or they can return money to shareholders, which critics of quarterly capitalism do not want them to do. Why are these companies being pressured to return money rather than to reinvest? The problem with investing in R&D, according to modest proposal is that the failure rate of doing so is quite high, and shareholders can be very skeptical about the value of any given project. And so activist shareholders press for these companies to give the money back to their investors, in the form of dividends or through buybacks. Modest proposal argues that this isn’t an entirely bad thing:
If public investors give free [rein] to tech companies to deploy their capital in moonshots, [Venture Capital’s] relatively small capital base would be overwhelmed. Apple, Microsoft and Google alone generate $100B in free cash flow per year, the entire VC industry invests something like $50B. By restricting public companies from deploying capital, public investors provide the white spaces for VCs to invest alongside entrepreneurs. I also don’t believe that on net the economy suffers, and likely it actually does better when the investing is done by smaller, entrepreneurial firms. Most studies of innovation would say capital deployed by smaller nimbler organizations leads to better outcomes than in large enterprises.
To put this differently, a short-term focus on earnings within a given firm might be a good thing if it frees up resources that can be invested in other business enterprises, including start-ups. Many large, publicly held companies, such as Microsoft, are notorious for overinvesting in doomed efforts, and it’s at least possible that the vast sums of money Microsoft spent on Zune might have been better returned to shareholders as dividends, to be reinvested elsewhere at higher returns.
A short-term focus on earnings might be a good thing if it frees up resources that can be invested in other businesses.
But wait. Is it really true that shareholders are reinvesting their dividends in other business enterprises? J. W. Mason, an iconoclastic economist and blogger who is always worth reading, has suggested that this is not the case, as there appears to be no increase in the share of corporate investment attributable to smaller, younger corporations. One important thing to note about Mason’s analysis, however, is that I believe he is looking at listed firms. Allocations toward venture-capital firms and other forms of capital are presumably part of the story too. Moreover, it’s not clear that “investment” and “capital expenditure” are the key variables per se, as many of the investments that new firms make come in the form of organizational capital, which can be difficult to measure. If we’re focused solely on capital accumulation, investment narrowly understood is the most important thing. But if we care about innovation in some broader sense, nailing down the accounting can be difficult.
Mason also points to the fact that the correlations of investment with profit and borrowing have weakened. Yet this is exactly what we’d expect to see happen if capital were flowing more freely to firms offering more and better investment opportunities. In a 1988 paper, Steven Fazzari, Glenn Hubbard, and Bruce Petersen found that internal cash-flow generation was correlated with investment, and they saw this as evidence for the proposition that firms had a difficult time accessing capital markets to make important investments. Because firms had such a difficult time, they had little choice but to rely on internally generated profit. One possibility is that as access to capital markets has improved, firms have identified other, more attractive sources of financing, and so the correlation of investment with profit has declined. (I should stress that there are scholars who don’t share the view of Fazzari et al., and I’m sure Mason sees this correlation differently.)
Let’s say shareholder payouts are not being reallocated from firms that lack attractive internal investment opportunities to other business enterprises, including start-ups. Where is the money going? Are shareholder households simply spending all of the money? This seems unlikely, as shareholder households have high incomes, and high-income households have a lower propensity to consume than lower-income households. But if these households aren’t spending the money, they’re presumably saving it, and these savings are presumably flowing to other capitalized companies.
That certainly doesn’t mean that we have nothing to be concerned about. Even if capital is getting reallocated from one group of businesses to another, the critique of quarterly capitalism speaks to a broader set of anxieties about the failure of Corporate America to generate the employment levels and the wage and productivity growth we’d like to see. This is why it’s so important that the policy measures we implement to address the (supposed) problem of quarterly capitalism do more good than harm. And judging by Hillary Clinton’s proposals, at least, I’m not optimistic.
Essentially, Clinton believes that the way to fix short-termism is to drastically raise taxes on capital gains from investments that last for less than six years, at which point the rate would fall to its current 20 percent. Len Burman of the Tax Policy Center offers a detailed critique of Clinton’s proposal, warning that it might lead investors to decide that intermediate-term investments, of five years or less, no longer make sense. Victor Fleischer, writing for Dealbook, has also made the case against Clinton’s approach, and he offers a clever alternative centered on how managers are compensated that I can see getting behind.
If our goal is to encourage firms to invest more and hoard less, there is a fairly straightforward option available to us: We could cut the corporate-income tax. As it stands, the very high U.S. corporate-income tax drives investment from the U.S. to other advanced economies. Furthermore, there is strong evidence to suggest that higher corporate tax rates suppress wage growth. Cutting corporate taxes might not be the kind of policy critics of quarterly capitalism have in mind. But it would go a long way toward addressing their underlying gripes about Corporate America.