Balancing Corporate Profitability with National Interest

The last ten years have been defined by rapid progresses in technology that have created currencies without countries (Bitcoins, Ethereum, etc.), a dark market place (silk road), new banking conduits (payment banks), and startling improvements in productivity through Artificial Intelligence (AI) and Automation.

It has become then important to gauge the impact of technology especially on how it re-defines the corporate – government relationship going forward. As part of the broader social ecosystem, corporates (loosely defined here to mean productive units) employ labour and use inputs to create an output that leads to value being created for society at large.

The government is entrusted with creation of an ecosystem that allows the corporate to exist. It creates roads, power infrastructure, water & fuel systems, regulation & judiciary, enters into trade and tax agreements with other nations, creates legal barriers to protect domestic businesses from foreign competition etc.

On the other hand, the government also creates regulatory systems to ensure that corporates do not overstep boundaries in their pursuit of profit. The government takes (or is supposed to take) an overall view of the nation’s environmental, social, financial, cultural concerns and also serves the function of managing conflicting interests between a business entity and the general population. In return for this management, the government collects tax from its subjects (corporates and non-corporates). This twin role of the government is obvious, yet sometimes underappreciated and hence bears mentioning.

A corporate entity’s sole purpose of coming to existence is to create value for society (and in the process also enrich itself and its shareholders), and thus there needs to be a constant vigil on the quantum of value created vs. cost incurred.

Cost incurred by a corporate in creating its output is easily gauged, and indeed pink papers are filled with various theories and analyses on them. If a corporate continues to incur costs in excess of the value it adds, it is reflected in scant profits and cash flow. Mismanagement of value vs. internal cost is thus not a huge problem as it usually tends to resolve itself (either by improvement in operations or via bankruptcy of the corporate).

However, there are societal costs that are broader and include health hazards of pollution, disruption of life due to land acquisition, retrenchment of staff, etc. For ease of reference this paper will refer to all such costs as economic costs, and will exclude the internal costs of the corporate to produce its output.

Since economic costs are not reflected in the financial statements of the corporate, it becomes the responsibility of the government to monitor them. If the economic costs out-weigh the value added to society, the government usually steps in. For example, the government taxes ‘sin’ goods (cigarettes, alcohol, marijuana, gambling etc.) at a higher rate than other goods. Polluting diesel vehicles may also be taxed at higher rates. Mining companies may be forced to clean-up after themselves when the mine is exhausted. Chemical producers may be asked to set up effluent treatment plants to clean up their discharges.

What the government is doing here is pushing some of the economic costs on to the books of the corporate to ensure that it does not get profligate in the chase for profits. A corporate that may find manufacturing a poisonous chemical very lucrative, may soon realize that the cost of cleaning up the discharge makes the project nonviable.

As the world moves into a technology driven era, an economic cost is the cost of unemployment driven by technology. The reduction in use of manpower can be explicit (i.e. people being laid off) or hidden (planned future recruitment cancelled or curtailed).

Unemployment may result either by cost shifting, or by efficiency improvement. Cost shifting is merely the movement of costs (such as labour) to lower cost destinations abroad. Efficiency improvement happens when for example, labourers on an assembly line are replaced by robots. For example, one of India’s leading automotive companies sold ~1.3m of its output in 1997 with ~23,000 employees, but in just eighteen years, it required only ~9000 employees to sell ~3.3 million of units! While some of this labour reduction may be attributed to outsourcing from smaller vendor-partners, it does give one the idea of the scale difference technology makes.

Cost shifting is not a major problem for a developing country like India. Indeed, we should try and capture a meaningful share of costs shifted by developed nations to augment our employment levels. It does remain a big concern for developed economies, and what India should be prepared for is a blowback from those governments in the future. Arguably, some of it has already begun from the USA.

Ironically, efficiency improvement is a key concern globally, and more so for India which has shown its penchant for leapfrogging technologies. It is without doubt that efficiency improvement does create employment opportunities elsewhere. However, it should be noted that technology based disruption usually disrupts a low level activity, and creates opportunity in a higher level activity.  For example, the advent of mechanized farming, replaced the bullock cart. Another example could be the advent of computer based word processors which disrupted the typist market in a very short period of time, but created opportunities in fields like Desktop Publishing, and Programming.

A common thread we observe is that technology disrupted roles tend to create new opportunities in roles that require a markedly higher skill than the job they replaced. And as technology advances, the distance between the skill required for the new opportunity and the skill of the displaced job, seems to only be widening.

It does not help that the lower level jobs being replaced are likely employing a staff that does not have the necessary skill, or motivation, or opportunity to pick up the new skills needed. Further exacerbating the issue is that the new jobs will likely be fewer in number than the jobs replaced.

The obvious result is that unless technological changes are long drawn out, we are facing a potential unemployment/ underemployment issue of unprecedented proportions. This may also have the impact of increased income disparity, as those fully employed will continue to draw a higher wage, versus those supported by government that will get sustenance wages only. This will increase the burden on society, thus increasing the economic costs of a corporate looking to add value beyond a point.

In order to prevent social harmony, the government will have to step in to ensure that the unemployed or underemployed are well cared for. This assistance can come either through direct assistance such as unemployment dole, or indirect assistance as government bearing medical expenses, schooling expenses, subsidizing re-skilling workshops, cost of policing (to prevent social unrest) etc.

Since businesses ultimately cater to society, at some point lower employment will likely impact demand for the output of corporate entities as well! However, this will take some time to manifest, and it is exactly for this reason that it the government which will need to gauge the impact, as the corporate at an early stage will be blind to it. The corporate will quite happily pay the tax on the increased income, as the absolute gains of efficiency will more than outweigh any tax on gains (like Income tax).

Therefore, a country will benefit from cost cutting only till the benefit the national exchequer receives from the increased corporate profitability and other ancillary benefits (such as lower wastage, lower pollution etc.) is equal to or greater than the national burden it has to bear for supporting the unemployed populace. This would be the, what I call as, “economic cost indifference point” for the country. Beyond this point, the corporates are merely transferring their cost to the country’s coffers, and there has in fact been no efficiency improvement for the economic ecosystem as a whole.

The computation of this, Economic cost indifference point, would be simply this, corporates can continue to cut costs to the point that:

Benefits to the economy due to efficiency are greater than, or equal to, the economic cost to the country

A more detailed version of the relationship can look something like this:

Additional income due to efficiency * tax rate + other related levies + reduction in wastage of national resources + energy/environmental savings etc.

>=

Workers displaced * non-employment probability * direct/ indirect unemployment dole per head + (people entering employment age * non-employment probability * direct/indirect unemployment dole per head) +social costs of policing/ counseling etc.

In practical terms, this would mean that the government makes clear through law what level of fiscal deficit (as % of GDP) it is prepared to bear every year. Empirically, this level would lie somewhere between 2.5-4.0%. This is the leeway that the government is giving corporates for the enlightened expansion of efficiency.  This would include the “reduction in wastage of national resources etc.” portion of the formula mentioned earlier.

Of excess fiscal slippage, the government should identify the portion related to the transfer of costs by corporates to the economy at large, and transfer it entirely upon the corporates as economic cost taxation. Basically, cut the slack given to corporates.

Such a transfer of costs will sharply bring down the profit growth of the corporate and make it re-evaluate any proposals by taking the full economic costs of its decision into consideration. Ultimately, by protecting the buying power of the economy at large, this would make businesses more sustainable in the long run as well.

As a lifelong believer in free market economics and an advocate of smaller government, I am surprised that I should be writing this. But faced with the unprecedented disruption that AI and automation portend, I believe that economic cost taxation is what an honest market economist would do.

A free market economy is where prices are determined by the unrestricted competition between non-government business entities. However, a truly free market will happen when consumers are able to evaluate the costs of their decisions with as much information as possible. The current demand v. supply driven price determination, only takes into account the costs incurred by the corporate internally whilst completely ignoring the cost paid by the society at large. While decline in prices due to efficient methods of production are welcome (they reduce the environmental burden), decline caused by replacement of labour (as AI, automation, cost shifting seem to be able to do), is only an apparent decline due to the hiding of true economic cost. A cost the consumer ultimately pays through higher taxes (to fund the fiscal deficit), lower social amenities, higher interest rates, vulnerability of the economy to external shocks.

By no means am I presenting this paper as finality to this discussion. Quite the opposite, I hope it will serve as a trigger for the discussions on balancing corporate profitability v. national interests. It would be good if more elaborate models were prompted by this paper to prove or disprove or modify this thesis. It will not do to say, this has never happened, hence this discussion is futile. History is nothing but a documentary of things that had ‘never happened, till they did happen.

Note this is a re-presented version of my original work here: https://megadodopublication.blogspot.com/2015/07/economics-balancing-corporate.html