Improving Capitalism

Capitalism Is A Powerful Tool But It Would Work Better If We Made A Fundamental Change To How Corporations Are Taxed

DavidGrace
Mar 14, 2017 · 12 min read

By David Grace (www.DavidGraceAuthor.com)

No tool or system is perfect right out of the box. Time, experience, planning, insight and thought will usually reveal ways to make even a good system better.

Changing Times Require Changes In Business Rules

Moreover, things change. Over time, technology, economic and political systems, education levels, demographics, and many other factors change and those new circumstances require that our tools and business systems change with them.

Marketing Changes

The marketing methods and advertising models that were extremely successful when radio and print magazines were king had to change when we entered the age of television, and they had to change again even more drastically in the age of Facebook and Google.

That doesn’t mean that radio and magazine advertising was a bad system or is totally obsolete. It means that good systems don’t stay good in the face of fundamental change unless those systems are modified to take societal and technological changes into account.

Changes To Capitalism

Over the years since Adam Smith wrote The Wealth Of Nations capitalism has changed in ways that made it work better and that allowed it not only to survive but to prosper.

Changes Required By The Growth Of Monopolies

We understand today that monopolies are the enemy of capitalism. For capitalism, monopolies are cancer. In order to keep capitalism vital and successful we had to adopt sweeping anti-trust laws.

Changes Required By The Need For A Level Playing Field

We understand today that to function well businesses need a level playing field. Free-market competition is impossible if fly-by-night operators are free to flood the market with copycat, shoddy products with latent health and safety defects.

Producers need uniform basic product standards and minimum toxics and safety requirements in order to preserve consumer trust in their products, a level playing field, and the viability of the free market.

For the free market to survive, producers need to be able to compete in the market on features, price and quality in a world where all products meet basic standards of performance and safety.

The Communists Threw Out The Baby With The Bath Water

The communists seized on the abuses of monopolies, unhealthy products and unconscionable working conditions as proof that capitalism was a bad system.

There was nothing basically wrong with the core of capitalism — entrepreneurship, market competition and the profit motive. The communist’s complaints only revealed that raw capitalism was not automatically a perfect system. It was a powerful system, but one that needed to be refined.

Child-labor laws, workplace safety laws, anti-trust laws, truth-in-advertising laws, and pure food and drug laws were all vital in honing capitalism into an even more effective economic system.

New Refinements Are Now Required

But we aren’t done making modifications, adjustments and improvements to capitalism.

The transition to global markets, the ability of companies to perpetrate product frauds on hundreds of millions of consumers, and environmental and toxic disasters on a global scale are all threats to capitalism in the early twenty-first century in the same way that monopolies challenged it in the late nineteenth century and toxic products and unconscionable working conditions challenged it in the early twentieth century.

In our history, when faced with the choice of abandoning capitalism or improving it, we chose to recognize its weaknesses and fix them.

It’s now time again to recognize capitalism’s current shortfalls and again improve it.

Dealing With Corporate Abuses Primarily Through Government Regulations

For many decades we’ve been engaged in a spiral of corporate abuses followed by regulatory legislation followed by different abuses which incited even more legislation — Enron, British Petroleum, General Motors, Volkswagon, and Wells Fargo were all big stories but there were hundreds if not thousands of other incidents of corporate abusive behavior on a smaller or at least on a less publicized scale.

And beyond the criminally or civilly wrongful activities there were the other business practices that drew public ire — already profitable companies shipping jobs abroad so that they could make even more money, raising the prices of life-saving generic drugs by factors of five and six, the imposition of gotcha fees designed to sidestep price comparison and thwart market competition. The list goes on and on.

I’ve written three articles [links shown below] exploring various strategies that might deter criminal, civil or other corporate activities that are seen as abusive, but I think we can adopt a more systemic solution.

If You’re For (Or Against) Government Regulations, This Post Is For You. The Real Force Driving Government Regulations Isn’t Left-Wing Ideology. The prime driver behind government regulations is human nature, the normal human response to a negative stimulus.

Could This Be The New Trillion-Dollar Product That Vastly Reduces Bureaucracy?

Another Strategy To Avoid More Government Bureaucracy. Breaking The Cycle That Drives Government Regulations.

Legislation, Regulation, & Litigation Is Not An Efficient System

The tactic of trying to deter disliked conduct with legislation is fraught with problems.

First, you have to legislatively define the prohibited conduct, and that always leaves loopholes.

Then you have to discover the violations of those regulations, which is a hit and miss, expensive and difficult process.

Then you have to obtain admissible proof of the illegal conduct, which is even harder.

Then you have to prosecute the conduct, which is time-consuming and expensive.

Finally, you have to collect whatever penalty, if any, is finally assessed.

And when you’re all done you still can’t be sure that the same company won’t do it all over again, leastwise that there aren’t a hundred other similarly situated companies that are or will do the same thing.

Instead of primarily relying on society’s customary response to disliked behavior with the legislation–>discovery–>proof–>trial–>penalty–>collection process I suggest that we adopt a new, systemic, self-executing solution.

The Answer Is To Make The Profit Motive Work For You

It’s a basic fact of human nature that the businesses humans control primarily engage in bad behavior in order to make more money. If bad behavior doesn’t make a company or its executives material additional money then they’re unlikely to do it.

A fundamental strategy to deter disliked business conduct is to take the profit out of it. The smart solution to corporate bad behavior is to make the profit motive work for you instead of against you.

How do we take the profit out of businesses’ bad behavior?

How Businesses Increase Profits

There are two fundamental ways that businesses use to increase profits.

Increasing The Number Of Units Sold

Selling more units is expensive because each additional unit requires additional expenditures for labor, materials, marketing, customer support, warranty obligations and capital equipment.

Increasing sales may well require that the company increase its marketing budget, offer more discounts, open new offices or distribution centers, add a second shift or authorize overtime work, purchase additional capital equipment, bring on additional suppliers, etc.

Each of these activities may well increase the per-unit cost. In fact profits as a percentage of gross revenues may actually decrease at the same time that sales volume increases.

Increasing The Profit On Each Unit Sold

On the other hand, collecting a higher profit per unit sold is a far more desirable tactic to increase profits because increasing prices without increasing production brings in more revenue without any corresponding increase in manufacturing costs, marketing costs, customer support costs or capital costs.

There are two basic ways a business can increase its profit per unit sold: It can cut costs and/or it can increase prices.

Cutting Per Unit Costs

You can cut costs by cheapening the product, lowering wages, switching from full-time workers with benefits to part-time workers with no benefits, curtailing safety procedures, shipping production to countries with cheaper labor costs, skimping on toxics disposal, reducing customer support or warranty programs, etc.

Increasing Per Unit Prices

You can increase per-unit revenues by adding hidden fees or service charges, or, if you’re in a market without meaningful price competition, by increasing prices.

In certain industries such as medicine you and your competitors may have an unspoken agreement of price matching so that as each company raises its price its so-called competitors voluntarily follow, essentially creating a cartel without an explicit agreement among the participants.

The Conflict Between What’s Good For The Company & What’s Good For The Public

The end result is that a company can increase its profits more effectively and easily by cheapening the product and/or raising the price than it can by increasing its sales.

The manufacturer’s easiest way to increase profits is to decrease quality and other costs and increase prices while the public’s primary desire is for the manufacturer to increase quality and decrease prices.

The customer and the public want the manufacturer to make more money by selling more units without raising prices while the manufacturer wants to make more money by selling the same number of units, or even fewer units, each of which has lower costs and a higher price.

The customers and the public may respond to the lower quality, higher prices and additional fees with complaints about the shoddy quality, the hidden fees, the lack of customer support, the safety problems, the toxics issues, the apparent monopoly pricing and the like.

Something needs to be done! Legislation must be passed!

And while the producers are spending millions dealing with the new regulations and further millions lobbying Congress to amend or repeal the regulations their lawyers are diligently searching for ways around the new regulations.

It’s More Effective To Encourage Good Behavior Than It Is To Punish Bad Behavior

The cheaper, simpler, more effective solution is to give the manufacturer an incentive to increase profits by increasing sales and a disincentive to increase profits by raising prices and reducing costs.

We can do that by changing the corporate tax system to recognize and take into account the relationship between profits and costs.

What’s The Lowest Ratio Of Profits To Costs That Will Still Be High Enough To Give Entrepreneurs & Investors A Strong Incentive To Start New Companies?

Recently, Apple’s profits as a percentage of gross revenues have been in the range of 18% to 23%. Microsoft’s from about 13% to 25%. On the low end, in 2015 IBM’s profit as a percentage of gross revenues was only about 5.5%.

If a good-to-high profit-to-gross-revenues ratio is 20% then each billion dollars in revenue can be thought of as being composed of roughly $200 Million representing profit and $800 Million representing the recapture of costs. Or, put a bit differently, $200 M profit/$800 M costs equals a ratio of profits to costs of about 25%.

Interestingly, when we look at Mylan, famous for its EpiPen monopoly-price increases of approximately 600% over a ten year period, we find that its profits were approximately 45% of gross revenues or that each $1 billion in revenue could be viewed as being composed of roughly $450 M in profit and $550 M in the recapture of costs, or a ratio of profit to costs of $450/$550 or about 82%!

Clearly, a profit-to-cost ratio of about 25% was enough to motivate IBM, Microsoft, Apple and other companies to greatly innovate, aggressively invest, strongly compete and actively introduce new products.

A ratio of profits to costs of about 25% then seems to be more than enough to keep the capitalist engine working hard.

Let’s call this the Profit-To-Cost ratio a measure of Top Profits.

Let’s call profits in excess of a ratio of profits-to-costs of 25% Superfluous Profits.

Superfluous Profits Example Numbers

How would we calculate Superfluous Profits?

Assume that your gross revenues are $1 billion and your costs are $800 million leaving you with profits of $200 million. $200 Million in profits/$800 Million in costs = 25%.

If you doubled your prices and, because of the quasi-monopoly nature of your market, your sales volume remained the same, your gross revenues would increase to $2 billion, your costs would remain at $800 million and your profits would be $2 B — $800M = $1.2 billion in profits.

$1.2 Billion in total profits — $200 Million in Top Profits (25% X $800 Million in costs) = $1B in Superfluous Profits taxed at 99%.

Gee, I guess there was no point in doubling your prices since all that extra money you made was taken away in Superfluous Profits taxes.

On the other hand if you had doubled the number of units sold, your sales would also be $2 billion but your costs would be $1.6 billion and your profits would double to $400 Million ($2B revenues — $1.6B costs = $400M). $400 Million in profits/$1.6 Billion in costs = 25%. No Superfluous Profits tax here.

So, doubling your price gets you nothing but doubling your sales doubles your profits.

How A Company Increases Its Sales

Companies increase unit sales by making better products, providing better customer service, improving distribution and marketing, lowering prices, and offering discounts and special promotions. These are all things that both the companies’ customers and the public want companies to do.

Supplying A Disincentive To Increasing Profits By Raising Prices And Cutting Costs

What did this Superfluous Profits tax do? It told the producer that doubling the price got him nothing while doubling the company’s unit sales doubled his company’s profits.

We want to create an economic disincentive to companies increasing their profits by raising prices, adding fees and cutting costs.

By highly taxing Superfluous Profits, human nature and the profit motive will both encourage companies to increase profits by increasing sales and cause companies to avoid trying to increase profits by increasing prices and cutting costs.

We supply that disincentive by taxing Superfluous Profits at 99%.

Wait, isn’t that contrary to the fundamental idea of capitalism? Isn’t the purpose of capitalism to facilitate entrepreneurs making as much money as possible?

No, it’s not.

The Purpose Of Capitalism

Einstein taught us that what we see depends on where we stand. Our perception of time, velocity, length and simultaneity are all dependent on our frame of reference, our point of view.

Think about a seal in the circus. The trainer tosses the seal a beach ball. The seal catches the ball on its nose, balances it and then bobs its head and tosses it back to the trainer. The trainer then tosses the seal a fish.

From the seal’s point of view the whole point of the exercise is to operate a system that will supply the seal with fish.

In the same way that the seal thinks that the point of the trainer throwing the ball is to create a system that supplies him with fish, from the businessman’s point of view the whole point of capitalism to provide him with a system that will make him rich.

But, from the trainer’s point of view the whole point of the exercise is to provide entertainment for the audience. From the trainer’s point of view, tossing a fish to the seal is only an incentive to get the seal to put on a show.

From society’s point of view the purpose of capitalism is not to make people rich, but rather to use the hope of getting rich as a lure, an incentive, to get investors and entrepreneurs to start companies and build products.

The trainer’s only question is: Is the fish big enough to keep the seal catching the ball? If it is, a bigger fish is just a waste.

Society’s only question is: Are the potential profits big enough to get entrepreneurs and investors to continue to build new businesses? If they are, then any higher profits are just a waste, they are superfluous profits.

The purpose of capitalism is not to make entrepreneurs and investors rich. The purpose of capitalism is to give entrepreneurs and investors the possibility of profits that are big enough to motivate them to create and operate companies. The possibility of their getting even higher profits than what are needed to provide that motivation is just a waste.

The Effect Of Taxing Superfluous Profits

If there is a close to total Superfluous Profits tax, a company will not go to extremes to cut costs. It will not increase prices. Instead it will do everything it can to increase unit sales while hitting a profit-to-cost ratio or no greater than 25% in order to avoid the tax.

Instead of needing to employ armies of government investigators, bureaucrats and inspectors to discover, prove and then prosecute tens of thousands of anti-trust violations, unsafe working conditions infractions, toxics failures, hidden fees, fraudulent conduct and the like, by taxing Superfluous Profits the market itself will work to curb the unwanted activities by taking away the money that those activities would otherwise have generated for the company.

If we make those activities unprofitable we also make them irrelevant.

If companies lose money by rewarding employees and cutting prices and they make more money by paying employees less and charging customers more then, of course, as often as possible they will cut wages and increase prices. That’s human nature.

On the other hand, if cheapening your products and reducing compensation gains you nothing except a big tax bill, then it’s unlikely that you’ll choose to do it.

Instead, you’ll spend your energy increasing your profits by increasing your sales which often is achieved by offering better and cheaper products with a side effect of less corporate bad behavior and consequently fewer government regulations, less government interference, and a smaller government.

— David Grace (www.DavidGraceAuthor.com)

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DavidGrace

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Graduate of Stanford University & U.C. Berkeley Law School. Author of 17 novels and over 200 Medium columns on Economics, Politics, Law, Humor & Satire.

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