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Predistribution and profits: extract from Economics in Two Lessons

May 15th, 2016

Over the fold, another extract from my book-in-progress, Economics in Two Lessons. Encouraging comments appreciated, constructive criticism even more so.

Predistribution and profits

As we’ve seen in previous sections, the social constructions of property rights and institutions surrounding employment makes a big difference to the determination of wages and working conditions. These social constructions affect ‘predistribution’, the distribution of income and wealth that arises before the effects of taxes and public expenditure are taken into account.

Predistribution is equally relevant to the other big source of personal income: profit derived from private businesses and corporations. Without legal structures designed specifically to protect businesses from the risks of failure, profits would be far less secure, and the difficulty of establishing and running a business much greater. Corporate profits are not a natural outcome of a market society, but the product of specific structures of property rights introduced to promote corporate enterprise.

The risks of running a business in the 18th century, and well into the 19th, were substantial and personal. There was no such thing as bankruptcy: a business failure meant debtors prison, where debtors could be held until they had worked off their debt via labor or secured outside funds to pay the balance.

After a brief and disastrous experiment in the early years of the 18th century (the South Sea Bubble), joint stock companies were also viewed with grave suspicion.

The prevailing view was Quoted in John Poynder, Literary Extracts (1844), vol. 1, p. 268. [1]

Corporations have neither bodies to be punished, nor souls to be condemned; they therefore do as they like.

This is often misquoted as

“Did you ever expect a corporation to have a conscience, when it has no soul to be damned, and no body to be kicked?

Adam Smith was similarly scathing, though with more of a focus on the principal-agent problem

The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own…. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

Exceptions were made only for specially authorised quasi-governmental ventures like the East India Company, focused on foreign trade. In general, limited liability companies were not permitted in Britain or most other countries. The partners in a business were jointly liable for all its debts.

These same rules applied in Britain’s American colonies and continued to prevail in the United States until the middle of the 19th century. The introduction of personal bankruptcy laws put an end to debtors prison, greatly reducing the risks of running a business. The creation of the limited liability company was an even more radical change.

These changes faced vigorous resistance from advocates of the free market. David Moss, in When All Else Fails, his brilliant history of government as the ultimate risk manager, describes how the advocates of unlimited personal responsibility for debt were overwhelmed by the needs of business in an industrial economy. The introduction of bankruptcy and limited liability laws took much of the risk out of starting and operating a business.

By contrast, in Economics in One Lesson, Hazlitt doesn’t mention limited liability or personal bankruptcy and seems to assume (like most defenders of the market) that these are a natural feature of market societies. More theoretically inclined propertarians have continued to debate the legitimacy of bankruptcy and limited liability laws, without reaching a conclusion.

This debate over whether bankruptcy and corporation laws are consistent with freedom of contract is really beside the point. The distribution of income and wealth is radically changed both by the existence of these institutions and by the details of their design. In particular, the massive accumulations of personal wealth made possible by capital gains from share ownership would simply not exist. Perhaps there would be comparable accumulations of wealth derived in some other way, but the owners of that wealth would be different people.

A crucial policy question, therefore, is whether current laws and policies relating to corporate bankruptcy and limited liability have promoted the growth of inequality and contributed to the weak and crisis-ridden economy that has characterised the 20th 21st century. The combination of these factors has produced absolute stagnation or decline in living standards for much of the US population and relative decline for all but the top few per cent.

There can be little doubt that this is the case. As recently as the 1970s, a corporate bankruptcy was the last resort for insolvent companies, typically leading to the liquidation of the company in question. As well as being a financial disaster, and a source of shame for all those involved. For this reason, nearly all major companies sought to maintain an investment-grade credit rating, indicating a judgement by ratings agencies that bankruptcy was, at most, a fairly remote possibility.

Since that time, bankruptcy has become a routine financial operation, used to avoid inconvenient liabilities like pension obligations to workers and the costs of cleaning up mine sites, among many others. The crucial innovation was “Chapter 11”, introduced in the Bankruptcy Reform Act of 1978.

The intended effect of Chapter 11 was that companies could reorganise themselves while going through bankruptcy, and re-emerge as going concerns. The (presumably) unintended effect was that corporate managers ceased to be scared of bankruptcy. This was reflected in the spectacular growth of the market for ‘junk bonds’, that is, securities with a high rate of interest reflecting a substantial probability of default. Once the preserve of fly-by-night operations, junk bonds (more politely called ‘high-yield’) became a standard source of finance even for companies in the S&P 500.

At the same time, legislative changes and the growth of global capital markets greatly enhanced the benefits of corporate structures, while eliminating many of the associated costs and limitations. At the bottom end of the scale, the ‘close corporation’ with only a handful of shareholders, became the standard method of organising a small business. This process was aided by a long-series of pro-corporate legislative changes and court decisions (notably in Delaware, which has long led the way in this process, and where vast numbers of US companies are incorporated). At the top end, the rise of global financial markets from the 1970s onwards allowed the creation of corporate structures of vast complexity, headquartered in tax havens and organised to resist scrutiny of any kind.

At the behest of these corporations, governments have negotiated agreements supposedly designed to ensure that corporate profits are not taxed twice in different jurisdictions. In reality, using a combination of complex corporate structures and governments (notably including those of Ireland and Luxembourg) eager to facilitate tax avoidance in return for a small slice of the proceeds, the effect has been to ensure that most global corporate profits are not taxed even once in the countries where they are earned.

What can be done to redress the balance that has been tipped so blatantly in favor of corporations. The obvious starting point is transparency. Havens of corporate secrecy, from Caribbean islands to US states like Delaware must be made to reveal he true ownership of corporations, in the same way that tax havens like Switzerland, used mostly by wealthy individuals, have been forced to disclose the ownership of previously secret accounts.

The use of complex corporate structures to avoid tax is a much more difficult problem to tackle. Some measures are being taken to attack what is called “Base Erosion and Profit Shifting’, but past experience suggests that slow-moving processes of this kind will at best keep pace with the development of new forms of avoidance and evasion. It’s necessary to re-examine the whole structure of global taxation agreements. Instead of focusing on the need to avoid taxing corporate profits twice, the central objective should be to ensure that they are taxed at least once, in the place where they are actually generated.

More generally, though, the idea that corporations are a natural part of the economic order, with all the human rights of individuals, and none of the obligations needs to be challenged. Limited liability corporations are creations of public policy, useful to the extent that they promote the efficient use of capital but dangerous to the extent that they facilitate gross inequalities of income and opportunity.

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  1. Geoff Edwards
    May 15th, 2016 at 11:20 | #1

    Your overall hypothesis seems robust to me, Prof John, and seems to me to explain the fatal flaw in the ideology of those who talk of “government intervention in the economy” as if the economy isn’t more or less a creature of government.

    You have covered a lot of themes in this summary and in the eventual work it would be good to separate them. A theme about which I published last year is that the approval of registration to a corporation (an act which grants it limited liability) is akin to the allocation of tenure over property. A person has no rights over a parcel of land until tenure is granted, either by the state directly or by transfer from a previous holder of a title legitimised by the state. Once tenure is granted, a range of regulatory restrictions come into play – workplace health and safety, labour laws, environmental protections. As with land tenure these are impediments or restrictions upon the property rights that they would otherwise enjoy. They are third-party restrictions placed by public authorities unrelated to the body (ASIC more or less) that initially grants the tenure.

    Much corporate social responsibility theory leaves me unimpressed as it seems to rely upon goodwill or the ethical stance of the company’s leaders. Far more powerful would be to build principles of corporate social responsibility into the instrument of tenure (in this case the instrument of registration of a company). Breaches of the code or principles then become grounds for forfeiture of title rather than merely grounds for third-party prosecution.

    Much is made in the American literature of the regressive precedent of the court decision that granted corporations personhood. I suggest that your chapter deal with whether this would matter in Australia. In Australian law, in parallel with tenure, a corporation surely has only the rights granted by corporations law. Under our English common law tradition and lacking a Bill of Rights, persons on the other hand have a wide canvas of rights limited only when specifically fettered by statute.

    Your post above implies that the Chapter 11 provisions in the US marked a shift in thinking towards aggressive capitalism. I would have thought that Milton Friedman’s essay arguing that corporations serve the public interest because (or to the extent that) they create wealth for shareholders was also a pivotal point. It seems that from the 1990s onwards, company leaders articulated the view that corporations exist to funnel wealth from the community to the pockets of their shareholders, a departure from the original public purpose. Limited liability was granted to allow corporations to trade at a scale larger than the local family firm. This is a public interest purpose in itself but has been corrupted. The remedy might lie not only in statute but in public advocacy by our political leaders reminding corporations that they exist at the will of the people and in order to serve the community purpose. I don’t see that happening anytime soon in Australia, as our leaders are under the spell of the IPA and the Murdoch press.

  2. May 15th, 2016 at 11:50 | #2

    There is another way of funding enterprises that gets away from equity. Instead of investors owning the means of production investors own future output. We see this today with Crowd Funding via pre-purchases of goods and/or services.

    When we Crowd Fund with transferrable pre-purchases we use regular buy and sell contracts. There can be a market in transferrable pre-purchases. Importantly when investors get their returns they do not take capital out of the business. They take their returns as output. Owners of businesses are responsible legally for the businesses but they do not have to raise money on Capital Markets nor do they have to find cash to pay interest on loans.

    Here is a proposal I made two years ago on how this could be arranged. Like pre-payments for infrastructure it may be that this idea’s time has come as it is an alternative stable transparent liquid investment to shares. This is something savers are looking for and with low interest rates they are more likely to take them up.


    This was the way the Merchants of Venice funded their ventures. They funded voyages and took a share in the output when or if the ships returned. Note also that it can be thought of as a variation on corporate bonds without the risks of changing interest rates and inflation.

  3. Ikonoclast
    May 15th, 2016 at 19:27 | #3

    I don’t understand the following paragraph or at least one key sentence in it. The fault might be mine or J.Q.’s in assuming the lay reader has more knowledge than he/she does have.

    “This debate over whether bankruptcy and corporation laws are consistent with freedom of contract is really beside the point. The distribution of income and wealth is radically changed both by the existence of these institutions and by the details of their design. In particular, the massive accumulations of personal wealth made possible by capital gains from share ownership would simply not exist. Perhaps there would be comparable accumulations of wealth derived in some other way, but the owners of that wealth would be different people.”

    I can accept sentences one and two. But sentence three I do not understand. Maybe sentence three follows logically from sentences one and two but I cannot see the logic. It feels to me like a few steps of the argument are omitted or that dunderheads like me need more help to see the steps of that logic. I can understand that the distribution of income and wealth must be radically affected both by bankruptcy and corporation laws. I can even understand in general that removing them must seriously affect accumulation of capital gains from share ownership. But I cannot understand how removing them would mean “accumulations of personal wealth made possible by capital gains from share ownership would simply not exist”.

    Is there a simple fact I am missing here? JQ, do you need to spell it out more for lay readers or am I just being a complete dunderhead?

  4. Ernestine Gross
    May 15th, 2016 at 23:08 | #4

    JQ, a very readable text, which, IMHO, conveys the critical points in the history of corporations, while being accessible to a broad audience. Hopefully, the latter includes the writers of economic textsbooks, particularly those used in ‘service’ units in departments or faculties of commerce and management or in law-economics or law-commerce combined degrees.

    I concur with your conclusion:

    “More generally, though, the idea that corporations are a natural part of the economic order, with all the human rights of individuals, and none of the obligations needs to be challenged.”

    Indeed. Corporations are a legal construct. (IMHO, this is one of the markers which assists in distinguishing between capitalism and a market economy.)

    “Limited liability corporations are creations of public policy, useful to the extent that they promote the efficient use of capital but dangerous to the extent that they facilitate gross inequalities of income and opportunity.”

    Yes, the legal constructs are the outcome of public policy. However, I would query or qualify the statement that corporations promote ‘the efficient use of capital’, by noting that a distinction between physical and financial capital is required. Yes, the corporate form of enterprise is useful for physical capital intensive enterprises (in which case it doesn’t really matter whether it is a government corporation or a public corporation – ie a listed corporation). No, the corporate form of enterprise is not useful for financial capital (eg investment banks used to be partnerships where wealthy people put their own money where their beliefs were; now they are corporations and the resulting mess can no longer be handled via bankruptcy.) No also to service provides (law firms, medical practises, schools and universities….).

  5. Ikonoclast
    May 16th, 2016 at 00:07 | #5

    @Ernestine Gross

    I think you should write a book too. I mean it. You have an interesting viewpoint which does not fit the standard matrix of these debates.

  6. Michael Robinson
    May 16th, 2016 at 04:31 | #6

    I’m new here (by way of Equitable Growth: Must Read).

    I’ve always thought it tragic that the “The Great Transformation” was so very badly written. If you were able to extract the key historical facts, lessons, and insights from that book, and incorporate the essence into your book (with the clarity and lucidity evidenced here), it might go some way toward redressing that tragedy.

  7. May 16th, 2016 at 08:58 | #7

    Here is what happens. It may be behind what JQ is saying? A corporation (or person) becomes bankrupt when they cannot meet their current debt obligations. This means the owners of debt have a higher priority than the owners of equity when cash flow becomes an issue. The simplest way to accumulate assets is to persuade an owner of assets to take out a loan or to issue shares. You then influence the business so that its become “distressed”. This is ridiculously simple if you get control of the company or are able to influence it by cutting off cash flow or by calling in debt. The owner of debt now takes control of all the assets. They are now able to purchase distressed “assets” for less than their true value. To add insult to injury often the assets of the Company are used by the owner of debt to obtain more cash to fix the cash flow. This is one reason why the Financial Industry is so profitable. It extracts its fees from the windfall gains made possible by the bankruptcy and corporation laws. Many of the Private Equity buyouts use variations of this strategy.

  8. paul walter
    May 16th, 2016 at 09:44 | #8

    I was pleased to see Prof.Quiggin examining the question of the limited liability and bankruptcy after witnessing the painful death of sovereign risk, prosecuted by the oligarchy during the Meltdown some years back.

    As for debtor’s prisons, a person with a modicum of perception will recall the unhappy adventures of
    Duncan Storrer last week and recall that the deliberately worsened welfare system creates an open air prison for many, many thousands of quite harmless Australians.

  9. Geoff Edwards
    May 16th, 2016 at 09:57 | #9

    I concur with Ikonoclast and Kevin Cox above. I think the question of how undue profits arise is worth a detailed explanation in this chapter. By “undue profits” I mean profit over and above what might be reasonably expected as a reasonable product of investment of a person’s time, labour, capital and bright ideas. Undue profits can arise from ticket clipping (much of the financial industry); from taking advantage of others’ distress (as explained by Kevin Cox); and by convincing governments to grant monopolies such as through allocation of tenure over minerals or assignment of property rights through rezoning and development approval. It annoys me intensely that people like Gina Reinhart are lauded as self-made entrepreneurs and drivers of economic prosperity, when in fact they or their parents were able to talk governments into granting them monopolies. These large profits come at public expense.

  10. Kate
    May 16th, 2016 at 22:11 | #10

    I don’t know if we can tell this story about corporations without noting the “government engineering” that was always present, though at fluctuating levels, through corporate capitalism. And it’s not just the intimate involvement of corporations in colony development. Government fingerprints were all over the first big US ones — railroads — through the post-war period, as business grows off of the defense industry, highway/infrastructure development. It’s only in the 1970s that you see government shrug the job of economic development off of its shoulders. Maybe. Unless you believe a story about government purposely supporting the financial industry by backing out of business. Anyway, I’m sure you’ve read Trachtenberg’s critical history, William Roy’s “Socializing Capital,” etc.

    Regardless, though I’m convinced that corporate capitalism is not free market capitalism, nor is it a soviet-style command economy. There *is*, in the US, a hard distinction between public and private. Corporate autonomy from government does exist. And perhaps *should* exist.

  11. Peter Kirsop
    May 17th, 2016 at 16:59 | #11

    some points on corporations
    1 you could insert something on that favourite of libertarians “Moral hazard” , here the company being a separate legal person from its shareholders creates the hazard -or in reality removes it, a shareholder is no longer liable for the debts. You can refer to what is seen as the foundational case on separate legal personality Saloman v Saloman & Co
    An example of this form of moral hazard is the investment in unprofitable (or at least less profitable than other investments) railway companies ratther than other investments more profitable but because the entities did not have limited liabilty more risky. Railway companies were incorporated in England by separate Act of Parliament (partly because they were given the power to resume land) (see LCB Gower Modern Company Law Chapters 1 & 2)
    2 What you refer to as Chapter 11 Bankruptcy had been in force for US railroad companies for many years You might find some useful information in books on railway finance.
    3 Can you deal with the manipulation by insider trading (for example -again on US railroads in the 1880s the directors of the Delaware Lackawana and Western (a very reputable “widows and orphans” investment up to the Great Depression) constructed an extension from Binghamton N Y to Buffalo NY incorporating the extension as a separate company which they then sold to the D L &W for $10,000,000 (then a huge sum!!!) more than the cost of construction (See T T TAbor Delaware Lackwana and Western Railroad in the 19th Century (I can supply page references if you need them))

  12. Peter Kirsop
    May 17th, 2016 at 17:04 | #12

    I am sorry I seem to have made the whole of what I wrote after Saloman’s case a link .

  13. BilB
    May 18th, 2016 at 04:15 | #13

    Another aspect of bankruptcy protection is that it does not apply just to business, it also applies to the other side of the ledger, the customer. Customers are protected to some degree from over exploitation by business through a group of instruments such as consumer protection standards, consumer grievance tribunals and ultimately bankruptcy protection.

    One area that needs addressing is intra business liability where partners deliberately set out to damage the interests of other partners. Unfortunately business management accumulates the low empathy end of the personality spectrum to a higher degree than other sectors of the community. This leads to economic and political distortions of many kinds.

    One of my favourite kinds of business stabilising mechanisms is the business cross ownership structure that is common in Europe. In this three or more companies with a complementary business perspective use surplus cash to buy each others shares. This has many benefits such as protection against hostile takeovers (allowing asset building stability), cross fertilisation of business expertise, internal financing of development, and a stabilising of the customer base.

  14. Socrates
    May 23rd, 2016 at 07:23 | #14

    I like this section a lot, because it speaks to the reality of how corporations operate in an economy, rather than the almost fictional theory.

    I have similar concerns with theories of the internal working of firms, such as agency theory, and the reality of executive power. There is a notion that a Corporation is run for the benefit of shareholders, and that they elect the directors of a corporate board to oversee the actions of executives in this regard. This is nonsense. In the present day, at least in the US and Australia, more than 70% of the shares in listed companies are owned by institutional investors such as super funds and trusts. The fund investors do not get to vote on the actions of the fund managers. Hence most share ownership is now indirect. This has greatly increased executive power over firms. Almost every AGM vote, including on executive remuneration, is determined by the proxies of the institutional shareholders. This creates the obvious potential for collusive games to occur between corporate executives, directors and fund managers, who often have multiple interlocking roles. The end result is that, far from being a vehicle for shareholder profits, corporations are too often a tool for furthering the private interests of the executives.

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