Whose Income and Whose Value?

1. Whose Income and Whose Value? Shyam Sunder, Yale University Rethinking Capitalism Bruce Initiative at the University of California at Santa Cruz April 7-9, 2011 Sunder: Income and Value

2. Capitalism? • Some dictionary definitions: • an economic system in which investment in and ownership of the means of production, distribution, and exchange of wealth is made and maintained chiefly by private individuals and corporations, especially as contrasted to cooperatively or state-owned means of wealth. • …an an economic system in which the means of production are privately owned and operated for profit. • …characterized by a free market for goods and services and private control of production and consumption. • …characterized by the freedom of capitalists to operate or manage their property for profit in competitive conditions • …political/economic system which encourages capitalists Sunder: Income and Value

3. Why Do We Call It Capitalism? • One possibility, rarely discussed: • Because we choose to do accounting from the point of view of the supplier of financial capital • Look at the accounts and financial reports as currently prepared • Let us look at an example Sunder: Income and Value

4. Microsoft Corp. (MSFT) Income Statement (in millions, except per share amounts) Year Ended June 30, (Audited) 2010 2009 2008 Revenue $ 62,484 $ 58,437 $ 60,420 Operating expenses: Cost of revenue 12,395 12,155 11,598 Research and development 8,714 9,010 8,164 Sales and marketing 13,214 12,879 13,260 General and administrative 4,004 3,700 5,127 Employee severance 59 330 - Total operating expenses 38,386 38,074 38,149 Operating income 24,098 20,363 22,271 Other income (expense) 915 (542) 1,543 Income before income taxes 25,013 19,821 23,814 Provision for income taxes 6,253 5,252 6,133 Net income $ 18,760 $ 14,569 $ 17,681 Cash dividends declared per common share $ 0.52 $ 0.52 $ 0.44 Sunder: Income and Value

5. Our Accounting Model • Accounting reports are modeled for the capitalist perspective of the firm • Treats all factors of production (other than the equity capital) as costs • Focus on net income to the shareholder • Residual income would subtract the cost of equity capital focuses on surplus • Corresponding focus on shareholder value as the stock variable of interest • This accounting choice has consequences • It not only determines the data we have but also shapes the nature of discourse on the performance and consequences of the economic system • Harder to talk about things we do not have data about Sunder: Income and Value

6. Imagine an Alternative • Look at the enterprise from the points of view of all factors of production simultaneously • Measure contribution of resources from each agent (opportunity cost of resources supplied) • Measure outflow of resources to each agent • Income of each agent is the difference of his/her receipts and contributions • The sum of this income across all agents is the wealth generated by by the enterprise • Capitalize the individual and aggregate flows to determine value to individuals and in aggregate Sunder: Income and Value

7. Accounting for Enterprise Resource Flows Sunder: Income and Value

8. What Do We Know from Microsoft Accounts? Sunder: Income and Value

9. National Income Accounts • National income may be defined provisionally as the net total of commodities and services (economic goods) produced by the people comprising a nation; • As the total of such goods received by the nation’s individual members in return for their assistance in producing commodities and services; • As the total of goods consumed by these individuals out of the receipts thus earned, or • As the net total of desirable events enjoyed by the same individuals in their double capacity as producers and consumers. Simon Kuznets Sunder: Income and Value

10. Effect of National Income Accounts on Perspectives and Management of National Economies • “…National income is the end product of a country’s economic activity, reflecting the combined play of economic forces and serving to appraise the prevailing economic organization in terms of its returns.” • Development of national income accounting and its implementation by Simon Kuznets in the twentieth century, transformed how we think about and manage national economy • Let us think about the limitations of financial reporting and its possible transformation Sunder: Income and Value

11. Extensive Income and Value • Extensive income (and value) as the sum of: • To the shareholders • To customers • To Vendors • To employees • To creditors • To government • To community, etc. • Inducement from the firm – O.C. of contributions Sunder: Income and Value

12. Income/Value to Investors • Residual income and corresponding shareholder value created • Focus of current financial reports • Apply similar perspective to other participants in the firm Sunder: Income and Value

13. Income/Value to Customers • Customer’s “investment” in the form in the form of search, learning, negotiation, payments, settlement of disputes • Expected PV of benefits from goods received should exceed the PV of investments • Includes immediate transaction as well as the consequences of the transaction for resource flows associated with any future transactions (reduction in time, cost, search etc. for later transactions) • In a perfect product market, consumer’s surplus from the firm is zero (may be +ve from industry, and the economy) Sunder: Income and Value

14. Value to Government • Various levels of government provide mostly non-priced services plus some priced goods • Resources from taxation • Value of the firm to the government from providing priced services is the same as for vendors • Value of the firm to the government from providing non-priced services is taxes plus fees minus O.C. of resources spent on providing services • Major challenge to put this into practice Sunder: Income and Value

15. Value of the Firm to Community • Local, national and global • Most exchanges in form of externalities • Value of the firm to the community is the sum of net externalities plus the net payments Sunder: Income and Value

16. Justification for Shareholder Value Criterion • Assume neoclassical model of the firm (all surplus goes to the owner, income/value to all other agents is zero both before and after the event): no need to calculate and report the effects on any other class of agents • Capital markets are said to be efficient, at least more perfect than the other factor markets • Contradiction between the two assumptions Sunder: Income and Value

17. Who Gets the Goodies? • Agents who transact in relatively perfect markets might be expected to obtain prices closer to their O.C. • U.S. capital markets said to be more perfect than others • Suppliers of capital should be expected to get close to their O.C. • Surplus/value of the firm should accrue mostly to agents who transact through less perfect markets • Yet, we tend to assume that the surplus goes to the shareholders • At least that is how we do our accounting Sunder: Income and Value

18. Need Analysis of Extensive Income and Values • For policy, need analysis of income/values to all participating agents, not limited to shareholders • Would not have the data without analysis of extensive income/value of the firm Sunder: Income and Value

19. Use of Shareholder Value As Guide for Policy • What is the theoretical justification for using shareholder value for policy • Law of the Instrument (Kaplan): Use whatever data is available • Extensive income/value measures are currently unavailable Sunder: Income and Value

20. Concluding Remarks • Income and value concepts driven by the perspective of capital alone have their limitations, and contradictions • For important classes of policy matters, we may need extensive concepts of income and value • Lessons from national income accounting Sunder: Income and Value

21. Thank You. Shyam.sunder@yale.edu www.som.yale.edu/faculty/sunder Sunder: Income and Value