RE: Developing an economics of ownership (2)

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

Dear Ownership Group

Please do not hesitate to raise questions with me even if you have not read
all my postings or articles available through the COG library.  Different
people come at things from different perspectives so I need to learn about
these new angles to test my ideas.  Also, I may be able to learn how to
better explain my ideas.  I hope other members of the list can forebear my
patience in this regard.  If I do not answer quickly or adequately I would
welcome others to try and do so as I cannot always be available to respond
and it would interesting and useful for others to offer their explanations.

Michael Harrington asks "So, how do we know what is procreative or
degenerative beforehand?"

The answer is we cannot know beforehand. This is the whole point about
making investments under uncertainty.

It is why Table 1 in my 1975 book identifies "Procreative Assets
(Expected)" which divide into "(Actual)" "non-viable" and "viable".  (Table
1 is reproduced as Table 2 near the bottom of my "New Strategies" article
at http://cog.kent.edu/lib/turnbull1/turnbull1.html )

Some other comments on the observations made by Michael:

1. Michael said "I think for valuation purposes financial assets are
comparable to real assets"  I do not think it is appropriate to compare
financial (paper) assets with real assets because physical assets usually
wear out and so have limited operating life for this reason, or for many
other reasons such as reduced prices for their output or in the words of
David Ellerman it could arise from an unfavorable "array of prices".  The
more productive any physical asset is the quicker it is likely to wear out.

2. Michael said "When I think about deferring consumption" - to invest.
The need to defer consumption to invest is not always needed or relevant.
Consider the case of the Yemeni fisherman building his boat in the off
season in my "New Strategies" paper and the "round about method" of capital
formation described by Harold G. Moulton in his 1935 book on "The formation
of capital". Refer also to my Op Ed article (in my posting at
http://cog.kent.edu/archives/ownership/msg00031.html) describing how
savings to finance investment can be created from the savings generated by
physical assets which increase productivity, i.e. procreative assets.  That
is, savings are created from the investment not the other way around.  As
this method does not reduce consumption a virtuous "confluent" process of
development is established as explained in my "New Strategies" article
http://cog.kent.edu/lib/turnbull1/turnbull1.html and in my Op Ed.
"Theorists confuse savings debate"

3 Michael said "If this investment is valued ex post as surplus profits and
taxed or appropriated, my 
diversification strategy has been contravened, no?"  Agreed.

However, the situation is much worse than Michael suggests because: (a)
diversification is not possible with limited risk funds in many specific
assets and (b) because governments typically tax investment returns before
the investor recovers sufficient cash to recover the cost of the investment!  

This latter problem arises because accountants report taxable profits, when
from the investors point of view, there are only paper profits.  This is
because accounting doctrines assume that a viable "array of prices" remain
sufficiently into the future to recover all funds invested!  This makes
accountants de facto "fortune tellers" even if they use what in their
double speak they use what they describe as "historical" cost accounting!

Take for example an investment of say $10M for a gold dredge or $100K for a
bull dozer which produce a 40% Earnings Before Depreciation Interest and
Tax (EBDIT) on the investment each year for its estimated useful life of
five years.  This means that if there is no cash drains of either interest
payments or taxes it will take 2.5 years to recover the cost of the
investment, ie 40%+40%+20%=100% to reach an investment "break even".  If
the price of gold halved or the bull dozer fell over a cliff and operations
had to cease without any scrap value available after only two years then
the investor(s) would have recovered only 40%x2=80% of the funds invested
and so suffer a cash loss of 100%-80%=20%. 

However, if a five year straight line depreciation rate is used to create
an annual notional "cost" of 20% of the investment value p.a., the taxable
profit will be become 40% -20%= 20% (assuming no debt to create interest).
If the tax rate is 50%, then taxes will be 50%x20%=10% of total investment
value p.a. to create a 10%x2=20% cash drain over the first two years.  The
return OF the funds invested reduces from 40% p.a. to 30% p.a. so when
operations cease at the end of year two the investor(s) have only obtained
30%+30%=60% of their funds back!  It would take 3.3 years for the investors
to obtain a cash break even.  That is 1.8 years or 72% longer than when no
tax was payable during the payback period!  Return ON funds invested is
obtained for only 1.7 years.

If the gold dredge was financed entirely by equity as the only asset of a
publicly traded company the directors would have reported a 20% before tax
profit in the first two years.  However, when operations then ceased, the
investors would have discovered that they had actually made a 40% cash loss
after the business was wound up and the funds returned to stockholders!
Investors might want to sue the directors for false profit reporting even
if they used conservative historical cost accounting!  Diversification,
which is a concern of Michael's is not normally a practical option in the
situations considered or for the farmer he mentioned.

Investors in assets which rely on market prices in non-monopoly situations
rarely speculate on obtaining any cashflow returns after 5 years to justify
making an investment.  Big projects with some market dominance may extend
to 10 years in the most socialy and politicaly stable environments as noted
in my "New Strategies" paper.  Infrastructure projects with a protected
cashflow can go out to 30 years or more as demostrated by the many Build
Own Operate and Transfer (BOOT) projects in Australia and elsewhere.

In the case of the gold dredger or bulldozer, the investors would recognise
that their investment would wear out, it could breakdown, the business
opportunity might evaporate, it could be subject to technological
obsolence, social, political, environmental or other type of disruption or
be subject to a non-viable "array of prices", etc. etc. So the investors
would not want to rely on obtaining any casflows after 5 years to provide
the incentive to invest.  That is, the investors use a five year "time
horizon".  Because there is no limit to human greed, they would still want
any cashflows available after 5 years.  However, these are not required to
provide them with the incentive to invest so any cashflows after 5 years by
definition becomes a surplus profit.

The investors in the gold dredger or bulldozer anticipate making at least a
40% EDBIT to return cash of 40% x 5=200% of the investment cost before tax
over the five year period to create a taxable profit of 100%.  Tax at 50%
would provide the investor with a 50% after tax surplus as set out in the
Table below.  This return provides sufficient incentive to bring forth the
investment.  The Internal Rate of Return (IRR) using Discounted Cash Flow
analysis is 15% after tax.   

Now let make the economists metamorphical assumption, mentioned by David
Ellerman, that "we have a can opener" in the form of a ruling from the tax
authorities that they will provide investors with an offer they cannot
refuse.  The offer is that the government will change the basis for paying
tax from the current accural system to a cashflow system on condition that
the investor give up all ownership rights to their investment and transfers
it to the stakeholders after five years.  It is a free choice for the
investors to select.

If the stakeholders included the machine operators, then they obtain a very
real incentive to repair and maintain the machine to maximise its operating
capabilty, operating life and so residual values.  The operators become
"industrial gleamers" who pick over the fields for residual produce after
the farmer has harvested her crop.  By improving mainternance, the
operators would reduce interruptions to production and so could increase
the investors returns.  It could also stop the bulldozer driver allowing
the machine to drop over a cliff  in the second year as considered above to
create a loss for the investors of 40%.  The appropriation of surplus
profits to stakeholders  can create a win-win outcome for investors,
operators and the economy while Democratising the Wealth of Nations.  This
provides the basis for my proposals for a Community Investment Code (CIC)
for the WTO to counter their MAI initiatives.

If the investors chose to accept the offer of the tax authorities to change
the "rules of the game" they would only incur tax on their cashflow returns
AFTER they had recovered ALL their funds invested.  This would minimise the
possibility of a cash loss and its extent.  

With a cashflow system, no tax would be due on a debt free investments
yielding a EBDIT of 40% pa on funds invested until after 2.5 years.  With a
50% tax rate the investor would then pay tax of 20% for the next 2.5 years.
 Because of the time value of money, the Internal Rate of Return (IRR)
increases from 15% to 18% (ie. 20% higher) even with the same investment
surplus value of 50% as shown in the table below:

              Tax & accounting systems
                  Investment cashflows
System        Accrual      Cashflow
Break even   3.3 years   2.5 years
Investment      -$100   -$100
Return year 1     $30     $40
Return year 2     $30     $40
Return year 3     $30     $30
Return year 4     $30     $20
Return year 5     $30     $20
Total return    $150    $150
Surplus   $50     $50
IRR after tax   15%     18%
Year 6 surplus  $20     $20
profits after tax for stakeholders              

If there is a basis for the business to exist after five years and if the
equipment has not worn out, and if the "array of prices" persists, etc.
etc, the after tax cashflows under both systems after five years would be
the same 20% as no depreciation tax shelter would remain in either case if
the 40% EBDIT could be maintained.   All the 40% would then represent
surplus profits with the new stakeholder owners obtaining 20% and the
government the other 20%.

It is only by considering the operating life and ex-post cashflows of
productive assets that we can understand how wealth is concentrated and how
the care of productive assets can be a couple of orders of magnitude in
value more important than labor costs and labor productivity which was the
focus of some recent remarks by David Ellerman.  If operators properly
cared for and maintained productive assets, their life may be extended for
many more years.  The values created for the community by this means can be
hundreds of time greater than the values created by operating the machines
more efficiently on a day to day basis which is the concern of industrial
economists.

My own experience as a time director of the third largest manufacturer of
custom designed industrial gears in Australia showed how gear manufacturing
machines written off over five years more than 20 years ago could increase
in value far more than inflation.  These machines then produced surplus
values in excess of three times their original cost at current values.
However, accounting information cannot identify surplus profits and may not
even reveal the current value of these machines written off more than 15
years ago! 

And finally Michael, the farmer is not foolish, just unlucky.  In our
existing system of independent atomistic enterprises it is a matter of the
survival of the fittest.  Economic growth arises from the fittest in the
community creating more value than is lost by the losers as described at
the end of my last posting.  David Ellerman understands more than most
other people in the world how the risk of entrepreneurship can be
socialised from his study of Mondragon: "The Socialization of
Entrepreneurship: The Empresarial Division of the Caja Laboral Popular",
Industrial Cooperative Association, Boston, 1982.   Because Mondragon
democratised the ownership of surplus values and profit it provided a way
to make economic development self-financing without  external ownership,
control or debt.  

There are alternative ways of achieving this objective.  The utility of the
concept of procreative assets is that it allow us to analyse these
alternatives.  It provides a basis to custom design different institutional
structures to protect the stability of the currency and the financial
system while also allowing a community or nation to introduce
self-financing democratic economic development.  But it is no use
considering these opportunities until the methodolgy of the cashflow
framework used by modern business people is understood.  This posting has
already got too long.

Regards

Shann

At 04:55 AM 30/10/1999 , you wrote:
>Dear Ownership Group,
>
>I would like to respond to Shann's comments below with a few questions to
>help reconcile my own thinking. I must add that Shann has volumes of
>writings that I have tried to catch up with but have not had the time to
>digest sufficiently, so bear with me. 
>First, I am curious about this notion of surplus, especially surplus
>profits.
>Second, I am trying to think how we distinguish between procreative and
>degenerative assets ex ante.
>
>My perspective is colored by my background in finance and portfolio
>management, but I think for valuation purposes financial assets are
>comparable to real assets in that they are claims upon those real assets and
>the cashflows associated with them (financial assets are considered passive
>as opposed to procreative in Shann's schema). 
>
>When I think about deferring consumption and investing over time, my
>decisions are governed by expected values and probabilities that are best
>represented in a risk/return ratio. I diversify to manage the unsystematic
>risk associated with any singular investment (or buy insurance if I can't
>diversify).
>
>The logic, as we know, is if one investment in my portfolio pays off big, it
>will cover any potential losses from other investments. If this investment
>is valued ex post as surplus profits and taxed or appropriated, my
>diversification strategy has been contravened, no? If a priori I know that
>my gains will be constrained while my losses are self-limited, I would
>imagine that the set of feasible investments will greatly shrink. Why would
>I assume the risk? This is why an onerous capital gains tax really
>constrains investment choices.
>
>So, how do we know what is procreative or degenerative beforehand? i.e.
>before we see the positive or negative cashflows? This seems consistent with
>David's objection to valuation based on a particular array of prices at a
>moment in time.
>If a farmer invests in tools and seed, plants a crop and there is a drought
>and he loses the farm, was he foolish to invest in the first place? was the
>machinery degenerative? am I missing something obvious?
>
>from this point of view, uncertainty is a critical factor in decision
>behavior,
>
>Regards,
>Michael

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
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Life long E-mail: sturnbull@mba1963.hbs.edu
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