Re: Yes, the Earth is Round (2) With self-financing depreciation cashflows

[Shann Turnbull <sturnbull@mba1963.hbs.edu>]

In response to David Ellerman's posting on October 19, he provides an
incomplete analysis in explaining "who ends up paying for ESOP shares?"

The analysis does not recognise the nature of the assets of the business,
their depreciation cashflows/operating life.  The analysis uses Earnings
Before Interest and Tax (EBIT) rather than Earnings Before
Depreciation/Depletion Interest and Tax (EBDIT).  It is the
depreciation/depletion cashflows which can make the assets and/or the whole
business "self-financing" and so procreative.  (Note that the assets of the
business can still be procreative and add value to society even if the
business is not self-financing due to the cost of transfer payments in the
form of interest and tax).  It is perhaps by using EBIT instead of EDBIT
that allowed David to form the view "why the stuff about 'self-liquidating
loans' was intellectual fog..."!.

By omitting consideration of depreciation cashflows David has avoided
raising the old hoary question of "How can economists be right when
accountants are wrong?"  Accountants can be wrong because they are trained
to look backwards not forwards to the future to determine the useful life
of business assets.  Accountants and even their managers are not fortune
tellers who can tell the future.  This is why investments are risky and
require equity finance according to the risk.

The useful life of business assets determines the yearly rate of
writing-off (amortising) their acquisition and set up costs.  This has a
major impact on the earnings and profit reported in each accounting period
and explains why profits can be so arbitrary.  The cashflows generated from
depreciation also depends upon the tax regime, what the authorities will
permit, and the options selected by management.  Dividends generally
represent only a fraction of these cashflows and so are not usually
sufficient to make investments self-financing as noted by David.

It is the doctrines and conventions of accountants that perpetuate a "shell
game" on investors and this combined with the legal, tax and monetary
structures of leading industrial societies may also confuse some
economists.  The result is misunderstanding on how all viable businesses
become self-financing and yet some publicly traded companies can report
profits while going into bankruptcy!   

All cash returns from an equity investment can only be considered a return
OF the investment until it has paid for itself.  Only then can an equity
investment produce cashflows which can represent a return ON the investment
to generate "surplus values" for the owners and community.  However, as
many equity investments take more than one accounting period to become
self-financing, accountants use conventions to describe some of the
cashflow as depreciation and/or depletion costs.  Depreciation, which is
the guessed annual cost to replace the investment, represents a return OF
the investment.  In other words accountants describe a return of an
investment as a cost!  

The residual cashflow in the accounting period is then treated as a return
ON the investment even though the asset may have not yet paid itself off!
So if operations ceased before the self-financing period, investors would
make a cash loss even though the company had been reporting a profit!  A
"legal" shell game or confidence trick if every there was one
 
David says "the company pays twice the money it receives in an ESOP loan,
once with new shares issued to the ESOP".  However, this is not a cash
payment but a payment in stock.  The stock issue appears on the liability
side of the balance sheet but it is matched by the assets acquired.  I do
not understand his next statement "The tax break on the loan payback
reduces the 100% dilution of the second time the funds are paid for to
whatever is left after the tax break" because there is no first time cash
payment.  There can be dilution on the earnings per share from the
additional cost of paying off the ESOP loan with pre-tax dollars.  And
there can be a contingent liability in the balance sheet to make such
payments if the company guarantees the ESOP loan.  However, these are not
mentioned in David's example nor the dilution of earning from using pre-tax
dollars to repay the loan as he uses the same $1030 EBIT for both the ESOP
and non ESOP example.  This makes his example inconsistent with his
statement that "the general result I referred to is that without any
productivity effect on workers".  But is not significant in the numbers
used  which assumes the productivity of labor increases sufficiently with
the ESOP to reduce operating costs by the $200 required to pay for the cost
of the ESOP loan to the Employee Share Ownership Trust (ESOT).

This is illustrated by extending David's example by assuming existing
assets and those acquired by the stock issue to the ESOP are depreciated in
a straight line over 5 years (20% p.a.) to create a tax deductible "cost"
from the returns OF the investment in self-financing assets.  David used a
pre-tax profit $1,000 and I have assumed that this represents a modest 10%
pre-tax return on assets.  This gives total assets of $10,000 to provide
depreciation cashflows of $2,000 per year as shown below.  EBEDBIT is
Earnings Before ESOT contribution, Depreciation, Interest and Tax.  Wages
costs are assumed to reduce by 200 with the ESOP to allow the EBIT in both
cases to be the same as used by David.  As a rule of thumb, turnover is
typically around the value of total assets and wages around one third of
turnover as assumed in the extended model below.

                          No ESOP             ESOP
Revenue                 10,000             10,000
Wages      35% Rev. 3,500     33%   3,300
Equity         98% TA 9,800   100%  10,000
Debt            2% TA     200      nil           0
Total Assets (TA)    10,000            10,000
EBEDIT  30.3%Rev  3,030    32.3%  3,230
ESOP Contr.                 0                  200
EDBIT     30.3%TA  3,030               3,030
Deprec.    20%TA    2,000               2,000
EBIT       10.3%TA  1,030               1,030
Interest (15%)              30                  *30
PBT       10% TA    1,000                1,000
Tax (50%)                 500                  500
PAT          5%TA       500                  500

*30 This is not an interest cost of the company but of the ESOT but is
shown here to be consistent with David's numbers. It really should be shown
as an increase in the ESOP contr. from 200 to 230.

The purpose of extending the model is not to highlight inconsistencies but
to indicate the importance of depreciation cashflows and their role in
making business investments self-financing.  My objective is not to refute
that tax breaks are used in the US to pay for ESOP shares or that dilution
may not exist.  It is to show that ESOP's could be made self-financing
without additional tax deductions through using depreciation cashflows.
However to do this in the US, the ESOT rather than the company would need
to purchase the new equipment and lease it to the company.  The ESOT would
borrow the funds to acquire the equipment supported by the guarantee of the
company in the same way as for financing shares.  In this way employees
could finance what I describe as "offspring" operations to become suppliers
or customers of their employer in somewhat a similar way Mondragon firms
spin off part of their operations when their employment levels approach
500.  (This is also how Ownership Transfer Corporations would expand as
described in my 1975 book Democratising the Wealth of Nations).  The
arrangements can vary from place to place according to the accounting,
legal, tax, banking, corporate law and other institutional contexts.  

The fundamental point is that all viable business assets are self-financing
before transfer payments.  This means anybody who has access to finance
during their payback period can become the owners of the means of
production to democratise the wealth of nations. To achieve the mission of
COG we need to change the institutional rules of the game established by
bankers, tax authorities and others.  (refer to my posting of October 21st
to Tim Mitchell shared with the Homestead list )  

One of my own proposals is that no one should obtain a tax write off for an
asset unless they also wrote off their ownership by transferring ownership
to its stakeholders at the same rate of the tax write-off.  If they did not
seek a tax write-off then they could maintain ownership.  It would be a
free choice.  But more of this in my next posting to discuss the ideas of
my 1975 book Democratising the Wealth of Nations.

Regards  

Shann


At 12:17 AM 20/10/1999 , you wrote:
>
>
>
>
>This is in response to several EMs, one from Michael Harrington on 8/10 and a
>brief one on 10/14, and to an intervening one from Shann Turnbull on10/13.
>
>1. I am abit puzzled by the continuing criticism of orthodox economics that 
>they
>don't understand the "productivity of capital"!  This is one of the kooky
>aspects of Kelsoian economics--the idea that capitalist economists don't know
>about the productivity of capital because of the journalistic emphasis on the
>statistic of "labor productivity" which is sometimes shortened to
>"productivity".  Please crack any text and read about capital theory.  I am 
>just
>baffled how anyone could really think capitalist economists have fallen
down on
>their job to emphasize the productivity of capital.
>
>Perhaps the logic is like this.  Kelsoians discover that the earth is
round and
>then after some bizarre reasoning conclude that the moon is made of green
>cheese.  When others deny that the moon is made of green cheese, the
Kelsonians
>accuse them of not realizing that the earth is round.  Let me assure all
>Kelsonians within earshot that conventional economists really do understand 
>that
>capital is productive.  The disagreement must lie somewhere else!
>
>Anyway on to substantive issues.
>
>2. One of the issues about ESOPs is who ends up paying for ESOP shares?  MH
>dodged the issue by modeling it as a case of borrowing money to buy equity and
>then paying off the loan with the proceeds from the equity.  MH is trying to
>model the ESOP on the limiting case of a 100% leveraged buyout where the ESOP
>trust, in effect, plays the role of the acquisition shell.  But ESOPs work for
>any percent of ownership, and the general result I referred to is that without
>any productivity effect on workers or changing wage demands and things of that
>sort, then the value of the shares that end up in the workers hands comes from
>dilution and tax breaks. In the near 100% or 100% buyout case, there are no
>other shareholders to dilute so the LBO enterprises often ended up having to
>partially decapitalized to make the payments for the loans that financed the
>LBOs (remember the 80s?)--sort of a self-dilution.  Alot of the hoopla in the
>80s was about all the productivity improvements that the new management was
>going to make to be able to pay off the loans without decapitalizing the
>companies.  I will submit my paper on "Who Pays for ESOP Shares?" to the
>discussion list.  It gives a derivation of these results.
>
>In general, ESOP loans are hardly paid for out of dividends (as I pointed
out).
>If they were, then indeed it would be a trivial transaction to analyze, namely
>borrowing to buy equity and paying the debt off strictly from that equity.
>
>To better see the problem, perhaps one should focus on the shell game involved
>in the two descriptions of the ESOP transaction.
>
>ESOP descriptions often involve a type of "shell game" of switching
between two
>quite different interpretations of the transaction.  The front-end is
described
>as an equity injection?a purchase of shares at full market value.  And the
>back-end of the transaction is described as paying off a loan with pretax
>dollars.   But if the front-end is described as shares being purchased with
>money borrowed by another party (the ESOP), then it should be added that the
>corporation itself pays off the other party's loan with the ESOP contributions
>[the corporation and ESOP can only be identified in the 100% case].  And
if the
>back-end of the transaction is described by paying off a loan with pretax
>dollars, then it should be added that the company has already "paid for" the
>cash injection (the loan) with the transfer of shares to the ESOP.   But ESOP
>descriptions often focus on either the front-end equity injection or the
>back-end tax-favored loan payments without giving the effect of the whole
>transaction.
>
>In fact, the company pays twice for the money it receives in an ESOP loan,
once
>with the new shares issued to the ESOP (a quid pro quo transaction) and the
>second time with the loan payback.  The tax break on the loan payback reduces
>the 100% dilution of the second time the funds are paid for to whatever is
left
>after the tax break.  If the company is in a 40% bracket, then 40% of the ESOP
>shares value is paid by the tax break and the remaining 60% is dilution.  This
>is all shown rigorously in the aforementioned paper.
>
>If the ESOP loan buys say 10% of the shares, then the company (which is 90%
>different from the workers) is paying off the loan which means less value to 
>the
>equity (90% owned by others) and that is dilution.  But the company gets the 
>tax
>break to pay off the loan that way, so the dilution is less than it would
>otherwise be due to the tax break.  One has to carry through this analysis to
>see why the stuff about "self-liquidating loans" was intellectual fog to cover
>up the dilution.
>
>MH's attempt to use CAPM-style arguments is a non-starter since one can go
>through the whole analysis of dilution & tax breaks under conditions of
>certainty (so clearly the risk premium on equity is not the essence of the
>argument).  Suppose a model has characteristics A and B, with A presented as 
>the
>cause of B.  But then one takes another model without A and finds that B is
>still there, so A (worker risk-bearing) was apparently not the cause of B 
>(value
>of shares ending up in worker hands).
>
>Naturally one should also be cautious about attributing the CAPM risk 
>premium to
>some special productivity of capital since it derives from the assumed
>risk-averse nature of the economic agents, not from a characteristic of the
>capital goods or financial capital.
>
>
>Let me move on now to Shann's EM of 10/14.  He starts off with saying that
>according to his interpretation of my Chapter 6, I don't understand "that
>productive assets provide a source of greater productivity, income and
growth."
>Many thanks, Shann, for pointing that out.  I guess I must have missed that.
>[You see Vic, I am learning already from this debate so it isn't totally
>stupid.]
>
>Shann goes on to say that the dilution argument is possible only because
>"bankers" don't enforce "ownership sharing" where the latter I think means
>Shann's form of expiring (dynamic) property rights in capital (like the 
>expiring
>property rights in intellectual capital).  Perhaps this would be a good 
>place to
>comment on that idea.  There already are examples of essentially such property
>rights, namely ownership of rental properties in rent-controlled districts.
>With no de facto or de jure subletting, then the people living in those
>apartments are in effect getting part of the rental (being allowed to not 
>pay it
>to the property owner) so the rental control has the (well-known) effect of
>attenuating the property right.  This does not model the time-change in
Shann's
>expiring equity rights but it does model the attenuation and that is the
source
>of the problems.  There is firstly a problem with the switchover.  The
owner of
>the property might have bought it for full price so the imposition of the
>attenuated-right scheme amounts to a partial expropriation which may cause a
>political problem to more people than "bankers."  Secondly, there are 
>well-known
>supply effects.  Given a choice, no one would build rental properties in
rental
>controlled areas.  Or to be more precise, if the rent controls took away say
>half the return, then one would only build super profitable properties so that
>the attenuated rate of return to invested capital would be normal.  Thus the
>effect of this suggestion would be to cut down on the production of the
capital
>to which the attenuated property rights apply, a funny suggestion from one who
>is accusing others of not appreciating the productivity of capital.
>
>Anyway, moving on, Shann goes on to say that the chapter shows that "Ellerman
>believes that economic development is created by the productivity of labor
>rather than the productivity of productive assets..."  In other words,
Ellerman
>must not realize that the earth is round since he does not buy our conclusions
>that the moon is made of green cheese.
>
>The next few paragraphs talk about Harold Moulton's notion of "procreative
>assets" which are "a special class of productive assets which over their
useful
>life create more value than the cost of their establishment and operations
>before the transfer of any value in the form of interest payments and taxes.
>That is, all procreative assets must by definition become self-financing.  It
>would seem that modern economists no longer use the concept of procreative
>assets and so have lost an intellectual tool to ..."  Shann, you really
have to
>take a peek at any economics or corporate finance text.  That is simply the
>ordinary notion of a capital asset which might yield a profit after the
>subtraction of all costs of acquisition and operation.  That is perfectly
>ordinary capital theory in Samuelson's or any other text.  How could you
>possibly think that is some sort of discovery??
>
>I don't think I will be long for this debate if I am called upon to explain 
>that
>capitalist economists really do understand the notion of capital goods
that are
>profitable to buy and operate.  If that is supposed to be the discovery that
>Kelsoians have made, then I think we have a clue why economists don't take
>Kelsoians seriously.  Actually, Kelso discovered something much more important
>which I spelled out in the chapter but which could be rephrased as a way to
>dilute absentee shareholders in favor of workers all under a verbal
smokescreen
>about the wonders of "capital."  Now that really is an accomplishment!
>
>The dilution + tax break argument is still the starting point to
understand the
>key point of who pays for ESOP shares, and, so far, the commentators have not
>engaged the argument.  Ranting that others don't appreciate one's discovery of
>the round earth will not do.
>
>Instead of wasting your and our time with such a banality from Moulton, the
>first president of the Brookings Institution, why don't you read Brookings
>himself?  He suggested
>
>
>     to  require  that  [interstate]  corporations  should reincorporate 
>under a
>     federal  incorporation  act;  which  act,  while securing to capital a 
>fair
>     return  at  a  fixed rate of interest and dividends, risk considered, 
>would
>     divide  all  additional  profit  or  accretions in the form of labor 
>shares
>     between  the  employees  (management  and  labor)  in  the  ratio  of 
>their
>     individual  contribution,  probably  as  recorded  by  their wage or 
>salary
>     compensation.  [Brookings,  Robert  S.  1932,   The Way Forward.  New 
>York:
>     MacMillan, 17-18]
>
>
>     This  reform  would consist largely in the rental of capital by the 
>workers
>     and  management,  stabilizing a fair rental return for it while leaving 
>the
>     workers  and  management  as their remuneration all the profits. 
>[Brookings
>     1932,  The Way Forward.  New York: MacMillan, 73-74]
>
>
>
>
>
>_______________________________
>David Ellerman
>Economic Advisor to the Chief Economist
>World Bank, Room MC4-335
>1818 H St., NW
>Washington, DC 20433
>Ph: 202-473-6368
>Fx: 202-522-1158
>
>

Shann Turnbull
P.O. Box 266 Woollahra, Sydney, Australia, 1350
Phone: 02 9328 7466 office; 02 9327 8487 home
Fax: 02 9327 1497 home & office.  Mobile 0418 222 378
Outside Australia, replace first "0" with "61" after international access code
Life long E-mail: sturnbull@mba1963.hbs.edu
http://www.mpx.com.au/~sturnbull/index.html