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Investment, Productivity, and the Bonus Culture

Weak growth is far and away the most important economic problem facing the United States. This problem is not simply the result of the financial crisis or the severe recession that followed; the period of low growth began in 2000. Rather, it is the result of a much earlier reduction in business investment.

While shortterm growth depends on demand, it is rising supply—the ability of the economy to increase output—that determines eco­nomic success over time. America’s problem is the slow growth of its potential to supply goods and services caused by two decades of underinvestment.

Although commentators have blamed this weakness on various issues, the data show that the major cause has been a change in the way company managements are paid. The 1990s saw the arrival of the bonus culture, which massively shifted management incentives and thus changed management behavior. Sadly, the change did immense damage to the economy. Managements were encouraged to invest less and, with lower investment, growth faltered.

The change in how managements were paid had immediate and profound impacts on their behavior. Before 2000, companies in­creased investment in response to corporate tax cuts, but afterwards, they stopped doing so.1 There are, of course, other things that affect investment, such as the invention of new technologies. But government policy can influence these outcomes, at best, only indirectly. A more straightforward, and likely more effective, policy approach would seek to restore investment and strong growth by reversing the damage done by the bonus culture.

Had the U.S. economy continued to grow as rapidly over the past dozen years as it had before, the incomes of Americans—as well as spending on schools, law enforcement, and public health—could be 20 percent higher than they are today, without any increase in tax rates or public debt. Not only would there be more prosperity and less poverty, there would also be more resources available to address other problems. Restoring growth should therefore be the major priority for the United States, and that will require higher levels of investment.

Low Investment Is the Problem

Why has U.S. economic growth been so poor since 2000? As dis­cussed at greater length in my book Productivity and the Bonus Cul­ture, roughly two-thirds of the slowdown in growth during this period has been due to weaker productivity, and one-third to aging. We can do nothing about aging, so boosting productivity should be the key policy objective.

Unemployment fell rapidly after the 2008 recession but has recovered, suggesting that a lack of demand, or some hangover from the financial crisis, is not the main issue. It is supply, rather than demand, that has been the problem. Output has risen slowly because the economy’s ability to increase production has deteriorated: compa­nies have cut back on investment, preferring to spend money on acquisitions and share buybacks.

I illustrate this change in behavior in Figure 1. Investment fluc­tuates with the cyclical state of the economy, so I use ten-year averages for both series to iron out these blips. The chart shows a steady fall in tangible investment and a similar rise in cash payouts. Compared with the average for the decade from 1990 to 2000, invest­ment has fallen from 90 percent of U.S. nonfinancial companies’ cash flow to 73 percent, while money distributed to shareholders via dividends and buybacks has risen from 26 percent to 45 percent.

Investment depends on two things: the rate at which technology improves and the willingness of companies to spend money on new equipment. As technology improves, there are more opportunities for profitable investment, and the extent to which these opportunities are seized depends upon their expected return. Companies seek to pre­serve or improve the return on their equity capital, which is the net worth of their assets after deducting their debt. When the expected return on equity for a new investment exceeds a minimum level, known as the hurdle rate, companies invest; if it falls short, they don’t. Expectations also depend partly on confidence, so the three things that determine the level of investment are changes in technology, the hurdle rate, and those swings in confidence that Keynes called the “animal spirits” of entrepreneurs.

The Cause of Low Investment Is the Bonus Culture

The fall in investment, and the rise in cash payouts to shareholders, followed directly after the revolution in the way senior executives were paid, which occurred in the 1990s. As I show in Figure 2, a significant change occurred in both the total compensation amount, which rose by more than three times, and in the proportion of com­pensation that was paid in bonus arrangements rather than as basic salary. Since the purpose of incentives is to affect behavior, we should not have been surprised—as we appear to have been—that the change in the way managements were paid altered the decisions they took. Unfortunately, the new incentives discouraged investment and dam­aged the economy.

With the arrival of the bonus culture in the 1990s, the changes in management compensation had the effect of raising hurdle rates, and thus caused investment to fall. Before 2000, companies would demand a lower expected return threshold on new investments than they do now. We can show that this has occurred by comparing the impact on investment of changes in corporate taxes before 2000 with the effect afterwards.

The prospective return on new investment goes up if the corporate income tax rate falls and down if it rises. We would therefore expect to see cuts in corporate taxes followed by a rise in business investment and vice versa. As Figure 3 shows, this is what happened from 1951 to 2000, but it stopped happening afterwards. (As a fall in corporate tax rates should lead to a rise in investment, the scale for the level of investment is inverted so that the two series move up and down together in the chart.) Since 2000, even large reductions in the tax rate have not produced rising rates of investment.2

Companies can use the cash they generate (plus cash from additional debt or equity raises) in a variety of ways: they can finance acquisitions, distribute cash to shareholders through share buybacks and dividends, invest in the creation of new assets, or increase worker pay, among other things. In making these decisions, company man­agements consider the interests of their companies, and perhaps the overall economy and society, but they are also motivated by their own self-interest. When it comes to compensation incentives, bonus systems vary, but virtually all are profit-related and typically depend on short-term changes in earnings per share (EPS) or total shareholder returns (TSR). In the short term, the less a company spends on capital investment and the more it spends on acquisitions, buybacks, and dividends, the better these metrics will look, and the higher management’s pay will be. Furthermore, the bonus element is usually so sensitive to profits that small improvements can cause large jumps in pay.

In the longer term, however, it is dangerous for companies to invest too little. If your competitors invest more than you (and are not uniquely bad capital allocators), they will be able to improve their efficiency and lower their costs of production. They can then under­cut your prices or spend more than you on marketing; either way, you risk losing market share. Decisions to invest thus depend on the balance between the longer-term risks of losing market share and the shorter-term benefits of higher management bonuses. The arrival of the bonus culture in the 1990s shifted this balance and encouraged managements to increase the longer-term risks to their companies for the sake of higher pay in the short term.

Because of the attention given to current share prices, this change in incentives, and thus behavior, is more pronounced for publicly traded companies than for private ones, including the U.S. subsidiaries of foreign companies. We would therefore expect to see a greater cutback in capital investment by public companies relative to others, and this is just what has occurred.3

The Bonus Culture and Increased Profit Volatility

Companies have considerable flexibility in the way they publish their profits, and we would expect them to respond to the higher rewards for short-term profits by changing their financial presentation. In tough times, profits fall and there is little that management can do about this. They don’t get bonuses, but they don’t get a salary cut, either. It therefore pays for them to write down their com­panies’ assets as hard as they can during unprofitable periods, a pro­cess known as “throwing the kitchen sink at it.” The value of invento­ries, trade credit, and tangible and intangible assets are matters of opinion, not fact. Auditors will seldom if ever object when managements suggest that their balance sheet values should be written down. When they are, this year’s profits fall, but future profits will be higher. When the inventories are sold, and creditors pay their debts, the profits recorded will be higher if their values were previously written down, and they will also benefit from a lower charge for depreciation.

When a company’s profits take a dive, it is also common for the performance targets that determine bonuses to be reset. Executives will argue that there can be no incentive if the targets are clearly out of reach, and remuneration committees generally accept this dubious argument. Senior executives may be sacked when profits fall, but whether the company is run by survivors or new arrivals, both will want a bad year to be as bad as possible, so that profits will rise sharply in the future. These subsequent forecasts belong to a rare group of management promises—those that are usually met.

Figure 4 shows the extent to which companies have changed the way they report profits since the arrival of the bonus culture. The chart compares the volatility of profits after tax as shown in the national accounts with those published by the companies in the Standard & Poor’s 500 Index. Until the ten-year period which ended in 2002, the volatility of the two series moved closely together, but published profits then became more volatile. Around 2008, especially, companies took advantage of the recession to throw the kitchen sink at their published profits, thus allowing an exaggerated recovery thereafter and producing a sharp rise in volatility as shown in the chart.

Reduced Competition Alone Does Not Explain Low Investment

There are other possible explanations for the poor levels of U.S. investment and growth. It certainly seems that the pace of improvement in technology is slow, and animal spirits among entrepreneurs may be at a low level. In addition to these issues, some economists, such as Germán Gutiérrez and Thomas Philippon, have pointed to claims that monopoly power has increased and suggested that this may have depressed investment. Their arguments are based on the assumption that high profits resulting from lower competition reduce any motivation to increase profits through investment.4

If monopoly power has increased in the United States, however, it has not produced historically high profit margins.5 A reduction in competition is not the only factor that can cause temporary fluctuations in profit margins, of course, so the chart does not prove that monopoly power has not increased. But profit margins tend to be high when demand is strong and unemployment low, so below-average margins are unexpected when, as in 2019, unemployment was exceptionally low. On the other hand, a high exchange rate tends to depress profit margins, and the dollar has been relatively high in recent years as U.S. interest rates have been above those offered in most currencies. One probable reason why profit margins fluctuate is that prices and wages respond to a recovery in demand at different speeds, with prices typically rising more quickly than wages. This fits with the recent pattern in which margins expanded in the first five years of the recovery after 2008 but, more recently, they have narrowed as wages have caught up. Short-term fluctuations in profit margins are not, therefore, evidence that competitive conditions have changed, nor are the latest data, which show profit margins in the first nine months of 2019 to be below average, conclusive evidence that competition has strengthened. But they do suggest that any decline in competition has been insignificant.

Gutiérrez and Philippon base their arguments concerning mono­poly and lower investment on the claim that companies’ published profits have been understated because depreciation is charged at too high a rate on intangible investment.6 This, however, cannot be cor­rect: comparing the long-term stable return on equity with the long-term average P/E ratios on published profits shows that companies have habitually overstated their profits. This indicates that depreciation has been understated, and an even lower rate of depreciation would amplify the error, as discussed in detail in my book.7

On the other hand, it has been said that monopoly profits don’t last forever, but you can retire on them. Whether or not competition has weakened over the long term, there are always likely to be some companies that enjoy, albeit temporarily, the benefit of exceptionally high profits. Typically, management might seek to preserve these profits as long as possible by maintaining investment. Under the incentives of the bonus culture, however, management will tend to favor investment less than they would have done previously, especially in companies least threatened by competition. The bonus culture is therefore likely to exacerbate short-term-focused management behav­ior among those cur­rently reaping monopoly-style rents even more than among those who aren’t. These incentives will adversely affect investment, even if there is no overall decline in competition across the whole economy.

Economic policy should aim to promote competitive conditions so that profits are the reward for entrepreneurs who advance productivity, rather than for successful monopoly rent gouging. This is sensible for many reasons, but it is improbable that attempts to enhance competition alone will produce any significant improvement in the level of investment.

Subsidizing R&D Alone Will Not Work

Investment and growth respond to improvements in technology, and policies aimed at improving the rate at which technology advances should therefore be beneficial. Unfortunately, the method that has been used in the past to encourage more spending on research and development has been singularly unsuccessful in recent decades.

As Figure 6 shows, a tax credit for research and development (R&D) was introduced in 1981, and it appears to have been highly successful in en­couraging R&D spending. After averaging 12 percent of total busi­ness investment over the previous twenty years, the amount spent on intellectual property (IP), which is largely R&D, rose steadily and comprised 36 percent of total business investment by the third quarter of 2019.

On the other hand, the contribution to growth made by improvements in technology, measured by total factor productivity (TFP), has declined since 1981. The great expansion in R&D spending has thus produced a steadily falling return. Either companies are spending increasing amounts for less and less benefit or, as anecdotal evidence suggests, companies have succeeded in gaming the system and have been claiming increasing amounts of the tax credit without necessarily increasing their spending on “real” or productive R&D. The cynical view is that companies have steadily shifted the way they designate the time spent by their employees, with a rising proportion being devoted to R&D and a falling proportion to their more traditional management duties. Alternatively, in creating IP, companies may have shifted to “inventing patents” over “patenting inventions.”

Regardless, further R&D tax credits are unlikely to accelerate the rate at which technology improves. While it would be most helpful to improve TFP and accelerate innovation, we seem to have no clear way of doing so. Until we find one, we will have to look elsewhere for an effective way to accelerate the growth of labor productivity.

Reforming the Bonus Culture: Policy Solutions

As neither tax subsidies for R&D nor a tougher competition policy are likely to significantly increase investment, the best way to im­prove growth rates would be to reverse the damage done by the bonus culture. Success in reversing the negative impact of the bonus culture is also likely to boost the animal spirits of entrepreneurs, further improving growth.

There are three ways in which the damage caused by these bad compensation incentives might be ended or even reversed. The least radical approach is to improve our knowledge of the productivity performance of individual companies. The most radical—and least plausible—is to regulate the terms under which bonus-type payments are made. And the one most likely to succeed is to reform corporate tax policy so that management is incentivized to increase rather than depress investment.

Companies do not currently publish their productivity data. This is not because the data would be difficult or expensive to collect, but because they are not required to do so. It is said that “what gets measured gets managed,” but it’s probably more accurate to say that what gets reported gets managed. The productivity of a firm or an economy is its output per hour worked. Companies would incur virtually no additional cost if they published their output and the hours that their employees work, as they already have these data. Output, for both companies and an economy, is the sum of labor income plus profit, and as companies know these figures, they must be able to publish their output at virtually no additional cost. They must also know the hours that their employees are contracted to work and any overtime for which they pay. If they are required to publish these figures, we will know their productivity and can com­pare the change from year to year. It would be especially useful if the data were available separately for companies’ U.S. operations as well as for their worldwide activities.

While some companies are more generous than others, most basically pay their employees the market rate. Hence those that have above-average improvements in labor productivity will have rising profit margins and, either through more competitive pricing, more marketing, or more investment in new equipment, will be able to improve their market share and grow rapidly. If companies published their data on productivity, their managements would take note and seek to improve the results, and they would encounter adverse comments from analysts if they failed to do so. These concerns would be given an added push if bonuses were linked not only to changes in EPS and other profit-related metrics but also to the achievement of some productivity target. Companies which introduced such bonus schemes would improve their reputations, which have suffered from the rise in management pay at a time when overall economic performance has been poor.

Probably the most effective way to boost corporate investment would be to introduce tax credits for tangible investment rather than for R&D. It is difficult for management to pretend—at least to anywhere near the same extent that occurs with R&D—that their salaries are spent on installing new equipment, which is largely pur­chased from suppliers rather than fabricated by a company’s own employees anyway. Furthermore, it is important that the reduction in the tax paid by companies should come from a credit rather than accelerated depreciation, because of the difference in the impact on published profits. The level of corporate tax could also be adjusted to be revenue neutral, after deducting the tax credits earned from tangi­ble investment, but companies spending more on investment would pay a lower tax rate, while companies spending little on investment would pay higher rates.

Under the current system, companies tend to have lower profits in the short term if they invest, and they certainly have less cash available for dividends and buybacks. If tax credits were given for tangible investment, the situation would reverse so that profits after tax would rise with investment in the short term. The change would therefore not just remove the current disincentive to invest, it would reverse it and change the economic impact of the bonus culture from perverse to beneficial. This reform of the corporate tax code is thus likely to be the most effective way to stimulate investment and boost growth by improving labor productivity.

The Bonus Culture, Debt, and Inequality

The decline in business investment has not only stultified growth but has also depressed the level of intended investment in the U.S. private sector below the level of intended savings. As savings and investment must be equal, this imbalance will either be resolved by falling incomes and rising unemployment, or offset by rising debt. But this only exacerbates the growing U.S. debt problem, which is already significant, in both the private and public sectors. The debt of the private sector, which includes both individuals and companies, is lower than it was at its peak in 2008 because the household sector has reined in its borrowings. But the business sector’s debt, after initially receding, has now reached a new peak.

Judging by the experience of the UK and Japan after the Napoleonic Wars and World War II, when government debts were well above today’s U.S. levels, the level of business sector debt should be of greater concern than that of the public sector. Nonetheless, public debt levels are also worryingly high. While short-term de­mand weakness will need to be met by some combination of fiscal and monetary stimulus—with my preference being for the former— policymakers should look for ways of boosting demand over the longer term. America badly needs a policy which will stimulate de­mand without driving up debt levels. Tackling the bonus culture is thus important for financial stability as well as growth.

After nearly twenty years of low investment and growth as a result of the bonus culture, the importance of restoring growth is obvious. Yet when GDP rises, the benefit is not always spread evenly. Rising income inequality only exacerbates the pain of slow growth, and both issues have contributed to the rise in voter cynicism and dissatisfaction in recent years.

This discontent is both justified and dangerous. It is justified because economic policymakers ignored those—among whom I am pleased to have been numbered8—who warned about excessive debt and high asset prices in the 2000s; the result was the financial crisis. And policymakers continue to ignore the damage done by the arrival of the bonus culture, accepting, with apparent complacency, the slow growth that has re­sulted.

But voter discontent can also be dangerous if the anger leads to less thinking, not more. The failure of conventional wisdom, which re­sulted in the financial crisis, the ensuing recession, and the longer-term, bonus-culture-driven decline in growth, will not be mended by anger but by a better understanding of our economy.

This article originally appeared in American Affairs Volume IV, Number 2 (Summer 2020):  18–31.


1 Andrew Smithers, Productivity and the Bonus Culture (Oxford: Oxford University Press, 2019). This book was written before the Trump administration’s cut in corporate tax rates. When that was announced, I predicted, correctly, that the expected rise in business investment would not take place. See also: Germán Gutiérrez and Thomas Philippon, “Investment-less Growth and Empirical Investigation,” NBER Working Paper No. 22897, January 2017; Thomas Philippon, The Great Reversal: How America Gave Up on Free Markets (Cambridge: Harvard University Press, 2019).

2 The r-squared correlations were 0.41 before 2000 but only 0.19 afterwards.

3 See John Asker et al., “Corporate Investment and Stock Market Listing: A Puzzle?,” Review of Financial Studies 28, no. 2 (February 2015): 342–90.

4 Robin Döttling et al., “Is There an Investment Gap in Advanced Economies? If So, Why?,” SSRN, July 2017; Philippon, The Great Reversal.

5 Appendix 8 of my book Productivity and the Bonus Culture explains why profit margins should be mean reverting in theory and Figure 5 shows that this works in practice.

6 Gutiérrez and Philippon, “Investment-less Growth”; Philippon, The Great Reversal.

7 Smithers, Productivity and the Bonus Culture, Appendix 5.

8 See, for example, Andrew Smithers and Stephen Wright, “Stock Markets and Central Bankers: The Economic Consequences of Alan Greenspan,” World Economics 3, no. 1 (January–March 2002).

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