Today I’m going to start telling the story of the downfall of the American economy, and how misguided tax cuts achieved what our enemies never could.
We begin the story with a successful family company, ABCcorp.
Started in the late 1920’s, ABCcorp almost didn’t make it. The Founder, his last two employees and the oldest of his sons kept it alive by working for next to nothing through the dark days of the 1930s. Some weeks the only food on the table was the day-old bread his wife brought home from the bakery where she worked the morning shift.
Before the Crash, ABCcorp made custom fittings for private rail cars and gentleman’s clubs. In the Depression they made replacement parts and did repairs on rail cars and trolleys, and were not too proud to take any machining work they could get. As the Founder often said “If you want it made of metal, we can make it. If it’s already made, we can copy it. If it’s broken, we can fix it.”
ABCcorp did its part for the war effort in the 1940’s, hiring hundreds of Rosie the Riveters while the men were fighting in bug-infested jungles, cold muddy foxholes, or Flying Fortresses lumbering along like ducks in a carnival shooting gallery. Once again they were manufacturing, but now they were doing it with an assembly line.
When the war ended, there was serious concern about the sudden influx of millions of workers (former servicemen), decline in demand for its wartime products, and extraordinary debt taken on by the government to prosecute the war.
There was also legitimate fear of inflation as wartime wage and price controls were released.
On top of that, the crazy socialists running the government were giving away billions to rebuild Europe and Japan, and paying more billions to send veterans to college and subsidizing subprime mortgages with only 5% (or lower) down payments.
When war hero Eisenhower was put in charge, he didn’t reverse the trend toward socialism, either. Instead, he made government even bigger, and took over the highways from the states where that power had always been, and doubled the gasoline tax, which had been thought of as a special wartime expediency.
With a little boost from the sales of war materiel to support the Korean Police Action, ABCcorp succeeded in shifting its factory over to consumer/industrial products.
Unlike the early years for industrial companies like ABCcorp, the post-war landscape had changed. When it wasn’t allowed to give its employees raises during the war, ABCcorp had started giving benefits, like a pension and family health insurance. Ever anxious to keep its corporate citizens happy, the government responded by making the money spent on those benefits tax deductible for the company, but not taxable for the employees. The cost shifting away from corporations had begun.
Just imagine — what if you could make yourself into a corporation, and pay for your retirement and your family’s health care in pre-tax dollars. All the chumps paying out of pocket for those necessities after first paying taxes would basically be subsidizing your share of the government services you were all using. Hmmmm….
Companies could also deduct the cost of travel, meals and entertainment if it was business related, and depreciate investments that made the company more profitable. Life was good for a company owner. You just had to make sure your personal salary wasn’t too high, given the 91% income tax for high incomes, and you could look forward to a very comfortable life.
Some day your estate would be taxed, but you’d have the wonder of compounded earnings on all of your reinvested corporate income, and even then, the tax bite was one time only, and quite a bit lower rate than income tax. If you had paid out over time instead, the effective tax rate on income in your company holdings would amount to only a couple of percent per year.
As the 50’s and 60’s chugged along, let’s imagine that ABCcorp managed to turn what had been a $20 million a year profit on $200 million in sales at war’s end into a $100 million profit (after all allowable corporate expenses) on $1 billion in sales. Corporate taxes were hovering in the high 40% neighborhood, but $55 million a year was real money.
Other business owners were taking advantage of the roaring stock market, and going public. Since the Founder’s Firstborn Son (also known as The Old Man by then) was beginning to think about the children from two marriages and a gaggle of grandchildren, it seemed pretty attractive to sell stock and bonds to the public rather than always borrowing from a bank to expand or modernize the business.
The 60’s also featured the first major cut in income tax, so getting a salary in the six figures wasn’t so bad any more. Besides, the country club membership, the company car, vacations, health and life insurance, executive pension plans and plenty of other “perks” were available, all from the taxpayer’s dime, since those expenses came off the top before the company had to pay any tax.
With those tax cuts in mind, the private owners of ABCcorp floated their first public stock offering late in the 1960’s. Not much changed at the company, though, because the family that owned the company still had several seats on the Board and huge shareholdings. The head of the family was now CEO and Chairman of the Board, and one of his early Baby Boom children was already working his way up through the company with a stint on the production line. The Old Man was firmly in charge, but now taking a salary about 25 times what he paid the production workers. Life was good.
As the 70’s got going, ABCcorp was doing well, maintaining a healthy balance sheet and reporting $150 million a year in profit. Of that, the company paid roughly 40% in taxes, or $60 million, after taking into account depreciation and other non-cash tax deductions.
The Arab oil embargo handed ABCcorp its first losing year (1974) in nearly 20 years. It wasn’t as if ABCcorp used much energy or any petroleum products other than plastic in its manufacturing. (And the plastic had been a huge money-saver when they replaced metal controls and casings with plastic during the 60’s and early 70’s.) It was how the doubling of the price of oil affected everything else that was a shocker.
Toilet paper in the plant restrooms, for example, or corrugated shipping boxes, which themselves replaced the wooden crates their shipping department had built for each outgoing order in days gone by. It seemed like everything eventually doubled in cost, even if it did take about 18 months to ripple through the system.
So 1974/75 was really tough. ABCcorp actually laid off half its R&D group, and cut back to one shift at the new factory they had opened in 1970, flush with IPO cash. Still, the Old Man was in control, and he had never forgotten the lessons of the Depression from his youth. Now that was bad, and it almost put the company his father had started out of business. Those lessons served well, and the company owed very little to its banks, so it weathered the storm.
As the economy recovered in the new world of inflation after the big scare of the mid-70’s, the Old Man retired and passed away, and some of his children eventually sold some of their stock. Still, one son was at the helm, and to an outsider, ABCcorp didn’t seem all that different from its decades as a family business.
Something had definitely changed, though. The only salaries that kept up with inflation were those in the executive suite. Out on the factory floor, paychecks went up about half as fast as inflation, and the benefits weren’t keeping up with inflation, either.
Still, the numbers were good. Sales were automatically boosted by inflation, and slower pay and benefits increases actually maintained and increased profit margins to 25%. By 1980, ABCcorp stock was trading at an all-time high, roughly eight times after-tax earnings.
From its $400 million a year of gross profit on $1.6 billion in sales, the company was paying out roughly 30% in taxes after taking into account the foreign operations that sheltered some income, or $120 million. At eight times multiple, the market capitalization of ABCcorp was at $280*8, or $2.24 billion.
Let’s say there are 100 million shares outstanding, trading at $22.40 a share. The founding family still owns 33% of the stock, with the grandson of the founder who is running the show holding 10%, and his siblings and relatives holding the other 23%.
The company dividend is 90 cents a share, so even the profligate brother who sold all but two million of his shares gets a nice annual paycheck of $1.8 million.
The company had a good cash cushion even after paying a 4% dividend ($90 million), and it owned all but its newest $500 million dollar plant free and clear, and even that one carried a 60% LTV mortgage that cost the company less than $35 million a year at what Son of Old Man thought was an outrageous rate of nearly 11%.
After taxes, debt service, pension expense and dividends, the company was producing more than $100 million a year in cash.
If only their grandfather, or even their father, could see what had become of that little machine shop in that grimy warehouse space in the 1930’s.
Then, in 1981, came the chance for the monetarists and free market theoreticians to control the government, with the blessing of the populace, who were sick and tired of seeing the country managed by people whose first impulse was to seek a compromise.
The new team in the White House and Congress truly believed that government is the problem, and they were determined to run the largest economic and political experiment since the Bolshevik Revolution by getting government out of the way of capitalism, and by redefining freedom.
From the days the Founders had written the Constitution and the Declaration of Independence, freedom was basically an individual thing, and much of the purpose of government was to protect individuals from encroachment on those freedoms by institutions, along with the universal governmental mandate to protect private property.
Now freedom was expanded to be a right held by capital. Capital should be free to seek its own highest reward, without having to pay for inefficient government the way it had for the first century of the Republic. Except (possibly) the individual right to own guns, the government of the 1980’s was dedicated to the proposition of protecting and expanding freedom of capital.
The rewards from having more investment and more retained profits from investment were sure to help everyone.
Even for individuals, a huge differential was set between earned and unearned income. The top income tax bracket for earned income was 40% (plus another 12%+ in payroll or self-employment tax). Unearned income, from investment partnerships or dividends, would be taxed at half that rate, and there would be no payroll or self-employment tax at all for individuals who invested to make a living.
Imagine two people that each own a business in the 1980’s, doing the exact same thing with the exact same profit margins. One is legally an individual who is self-employed, while the other is an owner of a limited partnership corporation. The schmuck who just runs his business (successfully) and pays his taxes on the earnings was paying 40% in income tax, and FICA taxes that went up over the decade to from 7.05% to 12.4%, and covers his medical insurance for his family out of what’s left. The other business owner pays just 20% or 28% (depending on the year) on the income that gets paid out in dividends.
Let me repeat: One keeps less than half the income, while the other keeps 72% to 80%. Guess who ends up owning more at the end of the game?
But we’re talking about ABCcorp, and it’s well past the small business stage of corporate life in our parable.
Instead, it’s a boring old line conservative company whose founding family lives quite well on the dividends. It trades on the New York Stock Exchange. A classic cash cow.
Along comes a junk bond financier, and his group looks at ABCcorp, and realizes it can easily afford to pay $200+ million per year in debt service (the $120 million in taxes and the $100+ million in positive cash flow). In fact, it can probably pay a lot more if need be, since the $90 million in dividend payments are “tax inefficient.”
So let’s say $300 million a year in debt service using only the current cash flow, and that’s not doing anything with the cash cushion the company has, nor its fully paid real estate, nor its old-fashioned pension fund.
At 10% for junk bonds in the late 80’s, the LBO specialist can offer $3 billion for the company without breaking a sweat. Shareholders of the $2.24 billion ABCcorp stock simply can’t resist. They sell.
The new management team pays the LBO arranger (themselves) a giant ($150 million) fee, and pays Wall Street another $75 million or so to sell the junk bonds. Son of Old Man takes the $300 million his 10% of the company represents, and becomes Chairman Emeritus.
His brothers and sisters take their piece, too, and they all shed a crocodile tear for the end of the family company their grandfather started, but the total payout to the descendants of $1 billion for the third of the company they still own makes that mourning period brief and very comfortable. Even Profligate Brother gets $60 million for his 2% shareholding.
Meanwhile, back at the company, the LBO Boyz are “realizing shareholder value.” First, they raise another $500 million by executing sale-leasebacks on the real estate that doesn’t have mortgages. They dividend a huge $400 million of it up to the private equity partnership that executed the deal.
Since the LBO partnership is managed by the very same people, they take their compensation in “carried interest”, so they don’t pay a dime of taxes on that dividend, now that it has become part of their capital gains for their partners. Even though they only owned 10% of the fund in 1983, by 1990 the compounding effect of their carried 20% management fee has shifted the ownership of the entire fund to 60/40 in favor of the managers while total fund assets more than quadrupled.
But the investors are happy as clams, because their share has grown at 16% per year over ten years.
But enough of this top-level stuff with Bahamian holding companies and 2-and-20 compensation schemes. We need to check in on ABCcorp.
In the drive for maximum efficiency, the way the new management kept the members of the old team that they really wanted was to issue stock options on “phantom stock” that will make the line managers of ABCcorp moderately rich if the company can succeed in growing its bottom line.
In keeping with the governmental drive to have businesses succeed, the managers of ABCcorp pay their employees with stock options that cost nothing to issue, yet they get to count the “value” of those options as compensation for tax purposes. It actually gets better than that — the employees are going to pay the company for the stock when they cash in their options.
Nice trick, eh? Pay your team with paper you create out of thin air, and have them pay you cash for the privilege of working for you!
Let’s stop a minute and look at the numbers. The company sales are around $1.6 billion with 25% gross profit margins that have swelled to 30% through staff cuts and alternative incentives like stock options. In fact, the stock options are now running $200 million a year in awards, half of which are allocated to the new management team, and the other half of which go to the old employees and the managers that were retained.
On a cash basis, the company had $300 million in cash before the takeover, it was paying $90 million a year in dividends, $120 million in taxes, $50 million toward the pension fund and just $33 million on its only long-term debt (a mortgage).
After paying out $225 million in fees and commissions, there is still $75 million in cash, which quickly grows to $550 million after the leases are executed for the older real estate (and another $25 million in fees are paid from the $500 million financing).
Cash payrolls have dropped by $1o0 million per year, so the former $400 million of top-line profit has grown to $500 million. $300 goes to pay the junk bond interest. $33 pays the mortgage on the new plant, and $50 pays the leases on the older plants and headquarters building. New hires don’t get a pension, and older workers are encouraged to take cash payouts to leave and give up their pensions and health plans. Needless to say, the common stock dividend is history.
After using roughly $150 million of the company’s cash to pay off over half their workforce (2,000 people at $75K each), and $400 million to pay a dividend to the LBO partnership, the company has used its cash, except, of course for the $500 million per year in gross profits.
Positive cash flow is 500 – 300 – 50 – 33, or just over $110 million a year. Fortunately for them, they get a $200 million per year deduction for stock options, so they don’t have to pay any taxes at all, even though the company is still generating more than $100 million a year in free cash flow.
Let’s look at what happens to the ownership. The LBO partnership owns the whole shooting match ($3 billion, or 100 million shares) right after the buyout. A year later the first changes have been made, and $200 million of stock options vest at the 8x value of $4 billion. That’s a 5% dilution. So the stock goes from $40 a share to $38 with the additional shares.
The limited partners of the buyout partnership are thrilled with the 26.67% increase in stock value and the net $550 million increase in cash on hand at the fund ($150 million of initial fees, plus special dividend). That’s right around $1.5 billion in profits at the LBO fund, and most of the money actually spent on the deal was borrowed, and relies exclusively on ABCcorp to pay it.
They could care less that the managers of the buyout fund, two of whom are also officers at ABCcorp, who get nearly $320 million in management fees from the ABCcorp part of the portfolio. Then there’s the stock options for those two partners that are wearing two hats, running ABCcorp day to day. But why begrudge them their payday? Without them the investors in the private equity/LBO fund wouldn’t be making more than 20% this year.
Back at ABCcorp, another round of headcount adjustments are made when the new administration raises taxes and the nation moves toward a balanced budget after a decade of deficit spending, in spite of increasing payroll taxes to nearly three times what Social Security and Medicare are costing.
Luckily for the guys running the show, they don’t have to show much current taxable income, and capital gains tax rates stay at 28% for the highest earners in the 1993 tax hikes, which amounted to a cut from an effective top rate of 33% that had been in place since the 1986 Tax Act.
When it came time to roll over the junk bonds at their five-year maturity, the company hass sales that simply grew with inflation and the general economy at a rate of 6% per year, or 33.8% over the five years. With sales of $2.14 billion, and the same gross profit of 30%, the company is much healthier, and shows nearly $650 million of top line profit. Even a slight decline to 28% profit margins implies $600 million gross profit.
Debt service and lease obligations are still sitting around $300 million per year, so the company has enough free cash flow to justify $2 to $3 billion in acquisitions. Just deploying the available cash into growth of this sort would double the value of the company to $6 to $8 billion, and give it earnings expectations after debt service of $600 million per year.
On that basis, the LBO partnership could then do an IPO of the stock.
Here comes the tax-advantaged sweetener: All those stock options, valued at roughly $1 billion ($200 million per year) at the time they were awarded would be “in the money” so many employees would exercise them, and hand the company $1 billion in cash.
With all that cash, it should be no problem for the company to refinance all its debt, and even take out more cash in fees and special dividends to the LBO partnership.
But how to make the company even more profitable after the IPO?
Easy – tell the current workforce that they can’t have their union any more, and move to another state where 10 years of tax abatements make the company even more profitable as states give up taxes in exchange for jobs. From paying no Federal tax, now the company is paying no state or local tax, either.
It all goes like this until one time the debt comes due during a recession. At that point, the only choice is to declare Chapter 11, close down the plants, mail the keys to the bondholders, and take the production to China or Indonesia. The patents and designs are sold to a private equity firm that has the contacts for offshore manufacturing.
The new owners run sales out of Grand Cayman, and make all the markup in a privately-held marketing company there in the Caribbean. In the US, the products are sold by a commission-only sales force (no benefits). The price paid to the export/import marketing company is very close to the final sale price to the customer, plus the minimal overhead incurred by the hollowed out shell called ABCcorp of America.
Some say that what we need to do is reduce corporate tax to zero, capital gains tax to zero and estate tax to zero. I love the non-sequitur they follow with:
They say that would result in more investment and creation of jobs.
I say it would result in more profit-taking. That’s selling, not investing.
The only jobs it would create would be for accountants and lawyers who would specialize in turning every possible form of personal income into corporate expense or capital distributions for the clever few that “extract the value.”
It’s hard to imagine how the stripping of America’s wealth could go faster, but I’m quite sure that would do it.