28 October 2016
Hillary Clinton is proposing a tax incentive for firms to introduce profit sharing with their employees. Photo: AFP
Hillary Clinton is proposing a tax incentive for firms to introduce profit sharing with their employees. Photo: AFP

Why profit-sharing programs are unpopular with US firms

Over the last 35 years, real wages in the United States failed to keep pace with productivity gains.

For the typical non-farm worker, productivity grew twice as fast as real wages.

Instead, an increasing share of the gains went to a tiny fraction of workers at the very top – typically high-level managers and chief executives – and to shareholders and other capital owners.

In fact, while real wages fell about 6 percent for the bottom 10 percent of the income distribution and grew a paltry 5-6 percent for the median worker, they soared more than 150 percent for the top 1 percent.

How can this troubling trend be ameliorated?

One potential solution is broad-based profit-sharing programs.

Together with job training and opportunities for workers to participate in problem solving and decision making, such programs have been shown to foster employee engagement and loyalty, reduce turnover and boost productivity and profitability.

Profit sharing also benefits workers.

Indeed, workers in companies with inclusive profit-sharing and employee ownership programs typically receive significantly higher wages than workers in comparable companies without such arrangements.

About half of Fortune magazine’s list of the 100 best companies to work for have some kind of profit-sharing or stock ownership program that extends beyond executives to include regular workers.

Despite the demonstrated benefits of broad-based profit-sharing programs, only about one-third of US private-sector workers participate in them, and about 20 percent own stock in their companies.

If these programs work so well, why are they not more widespread?

First, executives for whom shared profits already account for a significant portion of income may resist programs that distribute profits to more workers, fearing that their own income would decline.

Even when such programs increase overall profitability, they could reduce the profits going to top management and shareholders.

Second, workers are concerned that profit-sharing may come at the expense of wages, with the substitution of uncertain profits for certain wages resulting in lower overall compensation.

Effective profit-sharing schemes must be structured to prevent this outcome, and strong collective bargaining rights can help provide the necessary safeguards.

Third, if inclusive profit-sharing programs are to have the desired effect on productivity, they should be combined with other initiatives to empower workers.

One way to achieve this is by establishing “works councils”, elected groups of employees with rights to information and consultation, including on working conditions.

Works councils and strong collective bargaining rights, both features of high-productivity workplaces, are common in developed economies.

But they are lacking in the US, where federal law makes it difficult for companies to establish works councils and prohibits negotiations between employers and employees over working conditions outside collective bargaining, even though most workers lack collective bargaining rights.

Promisingly, the United Automobile Workers union recently announced that, as it continues to push for collective bargaining rights, it is also cooperating with management to form a works council in the German-owned Volkswagen plant in Tennessee.

The fourth impediment to the establishment of profit-sharing programs is that they require a fundamental shift in corporate culture.

Though most companies emphasize the importance of their human capital, top executives and shareholders still tend to view labor primarily as a cost driver, rather than a revenue driver – a view embedded in traditional and costly-to-change human-resources practices.

Unlike the financial benefits of reducing labor costs, the financial benefits of profit sharing, realized gradually through greater employee engagement and reduced turnover, are difficult to measure, uncertain and unlikely to have an immediate effect on earnings per share, a major determinant of executive compensation.

It is unsurprising, therefore, that the advantages of profit-sharing are undervalued by many companies, especially those that focus on short-term success metrics.

Moreover, even when they do recognize the advantages of profit sharing, companies may lack the technical knowledge needed to design a program that suits their needs.

Some states have established technical-assistance offices primarily to help small and medium-size companies overcome this gap.

The federal government should create its own technical-assistance program to build on states’ efforts and reach a larger number of companies.

From a policy perspective, much more can be done to encourage firms to create broad-based profit-sharing arrangements.

US law allows businesses to deduct from their taxable income the wages of all employees except the top five executives, for whom deductions are limited to US$1 million of annual pay, unless the excess compensation is “performance-related”.

Spurred partly by this tax incentive, corporations have shifted top executives’ compensation toward shares, options, and other forms of profit sharing and stock ownership, largely leaving out regular workers.

Some have proposed limiting the tax deduction for performance-based pay to firms with broad-based profit-sharing programs. But, although this approach might encourage profit sharing with more workers, it would continue to provide companies with significant tax breaks for huge compensation packages for top executives.

US presidential candidate Hillary Clinton has a more targeted proposal: a 15 percent tax credit for profits that companies distribute to workers over two years.

By providing temporary tax relief, the scheme would help companies offset the administrative costs of establishing a profit-sharing program.

In order to limit costs and prevent abuse, profits totaling more than 10 percent on top of an employee’s wage would be excluded; the overall amount offered to individual firms would be capped; and safeguards against the substitution of profit sharing for wages, raises, and other benefits would be established.

The tax credit could also foster changes in corporate culture by spurring board-level discussions not only of the benefits of profit sharing but also of sharing information and decision-making authority with employees.

The stagnant incomes of the majority of US workers are undermining economic growth on the demand side (by discouraging household consumption) and on the supply side (through adverse effects on educational opportunity, human-capital development and innovation).

It is time to take action to promote stronger and more equitable growth.

Clinton’s profit-sharing proposal is a promising step in the right direction.

Copyright: Project Syndicate

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a former chair of the US President’s Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley, and a senior adviser at The Rock Creek Group.

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