Global Policy Forum

The Free Rider Principle: How Privilege Is Subsidized


By Jamie Morgan

January 15, 2003

In the West we have a cult of celebrity and a culture of blaming the victim. We marvel at the conspicuous consumption of the continually narrated lives of people who exist in a permanent state of fantasy and privilege. At the same time we are encouraged to denigrate those who live on the state. Perversely, their meagre lot as a permanent underclass is referred to as 'benefits' and 'welfare'. The real question is who benefits from our obsession with fame and blame? Real wealth and power tends to be inconspicuous. Business is faceless but we are encouraged to think of it as benign - the source of our employment, of our products, of our lifestyles. As such we tend not to notice how we actually subsidise business to the detriment of society. Business should be our obsession when it is an example of what economists call the 'free rider principle'. Two examples introduce the principle: how we subsidise multinationals, and how we subsidise the business elite.

How we subsidise multinationals

The 4 major accountancy firms charge about £500 an hour to provide business with advice on how to limit their 'exposure' to tax. By its very nature, nobody knows exactly how much tax is avoided by business. Estimates for the UK vary from the Inland Revenue's figure of £20 billion to £85 billion per year. Either sum would more than plug Gordon Brown's expenditure gap in his pursuit of a better health system. According to Oxfam, developing countries lose out on about £33 billion per year in tax revenues. This is around three quarters of the total Western development aid budget for a typical year. How does this happen?

Multinational corporations often pursue a policy of 'vertical integration'. This means that they merge or take over other firms that provide the products that they sell or that go into their own production process. A coffee factory in Britain, for example, buys a plantation in Brazil. This provides the corporation with the opportunity to engage in Transfer Pricing, which makes it possible to minimise tax liabilities in both countries. The subsidiary's product is sold cheaply to an intermediary shell company in a 'tax efficient location' such as the Cayman Isles. The low price means that reported profit on sales in country A are therefore negligible (reducing corporation tax). The shell company then sells the product on to the main firm at a high cost. High prices mean that the apparent profit on the sale of the final product in country B is therefore low reducing corporate tax liability there also. There is of course little or no tax to pay in the Cayman Isles.

It is worth remembering that the corporation isn't just providing a product for consumers. It is also a consumer of the infrastructure of the industrialised nations where it sells its wares. But it is, wherever it can, avoiding contributing to the upkeep of that infrastructure - to the transport network, the health system that maintains a productive workforce, to the education system that produces a productive workforce. A greater proportion of your wage is therefore required to make up some of the difference (as we know it is never all made up). You are poorer because they are greedy. Not only that, your society is denied better service provision because they are greedy.

Since that greed disguises itself it actually becomes a way of undermining all aspects of your life. Nation states argue that globalisation prevents them from holding multinationals to account - higher corporation taxes, more stringent regulation of tax avoidance, more labour rights etc. will simply make firms relocate. Firms meanwhile, argue that global competition forces them to demand lower corporation tax, fewer labour rights etc. (which they call 'a level playing field of business friendly policy'). Both ends of the argument work against you and in the direction of everything organisations like the WTO stand for. Less tax for them is more tax for you, a business friendly policy means longer hours for you, means job insecurity and the possibility of a whole host of problems - stress, ill health, less time with one's family, family dysfunction and ultimately social dysfunction. Both ends of the argument are essentially justified by the credo that it is an aggressively competitive world. Part of the proof of that is that firms can post lower profits at both ends of their production process. The accounts show that the firm can't 'afford' more. Perversely, not paying tax in the UK can lend authority to the argument that business is unable to contribute more to society and treat you better and that nation states could do something about it. The transformation of you from human to hamster on a corporate wheel is a by-product of this perversion. As is the argument that firms can no longer afford your pension, though they are taking more and more of your life. These changes are rather banally termed the reapportioning of risk.

In poorer nations, reapportioning is part of the justification of globalisation. The Kuznet thesis in economics argues for 'trickle down'. As the rich get richer the poor benefit as wealth moves down through the system. If a poor country opens itself up to international competition and to foreign direct investment it will eventually become wealthier. Transfer Pricing undermines this argument. Whilst in the West, multinationals avoid contributing to the maintenance of the infrastructure of society in the rest of the world they avoid contributing to the construction of the kind of infrastructure they need for a complex industrial economy. This is what tax avoidance means. Who takes up the slack? Organisations precisely created to generate infrastructure financing - mainly the World Bank and state budgeted overseas aid departments such as Claire Short's in the UK. Who pays? In the case of the World Bank the host nation itself. Not only is it denied tax revenue from the multinationals, it borrows in lieu of the revenue it is denied in order to create the conditions the firm needs to produce. In doing so it becomes subject to the governance conditions of the loans, limiting its capacity to put its people before profit. Balanced budgets and business friendly flexible working conditions prevail. Tax avoidance therefore creates the conditions that tie poorer nations into a situation of debt that creates a dependency on the very firms that avoid paying any tax they can. Without what they do pay default would become more of a possibility. Multinationals therefore gain greater leverage in how they operate in poorer nations precisely by avoiding tax in a way that generates debt. No conspiracy is required for such an outcome, simply an economic structure that tends in this direction.

Then of course there is the case of Western government 'aid'. This is typically tied to bilateral trade agreements. Since firms are avoiding tax contributions in the West, it is financed to a disproportionate degree by the ordinary worker's taxes in the West. The trade itself is also guaranteed in a way that makes a mockery of risk for the firms that benefit from these trade agreements. The UK Export Credit Guarantee Department (ECGD) effectively insures firms against defaults on trade payments. Ethics is rarely an issue here. The ECGD backed £117m worth of trade with Zimbabwe last year. It also backs arms and 'defence' contracts. In 2001, British Aerospace sold a $40m military air traffic control system to Tanzania that it didn't need and couldn't afford - whatever its non-democratic government might think. $40 million is a third of the nations health budget. One in three is also the proportion of malnourished children in Tanzania. When firms default, the UK government picks up the bill. Contractors know that your taxes insulate them from harm whilst their practices continue to be harmful.

Ultimately, multinationals are subsidised at both ends of a system that they gain from. They don't pay their fair share of tax in the West or the rest of the world. Your taxes make up some of what they don't pay in the West. Your taxes make up some of what they don't pay in the rest of the world through 'aid'. The host ('developing') nation accounts for the rest of it. And the logic of the system is to justify the oppressive face of globalisation. In the West that logic is expressed as inevitability - blind economic forces of competition. Elsewhere it is about tying new countries into the imperatives of the system making them subject to those same 'blind economic forces.

What privilege really looks like

Wealth and power tend to hide in plain sight. Publicly listed companies must publish their accounts, and shareholders can attend annual general meetings and put questions to the board. What firms do, who and how they pay for what they do are always potentially accessible.

Neo-liberal economics conditions us to think of wages in terms of labour markets. We are told that people are paid what the market says they are worth. The theoretical justification of this is the concept of diminishing marginal revenue product. This simply means that each new employee adds a certain amount to the total output of the firm. This is their productivity. Each product can be sold at the market price. If the amount they produce multiplied by the price it is sold at (i.e. the revenue they bring into the firm) is higher than the cost of employing them, hiring them adds to total profit. It is assumed that adding more labour to a fixed amount of factory (or capital) will cause, after a certain amount of employment, the productivity of each successive employee to fall or diminish (there are only so many people who can reasonably work on the machines or at the desks).

According to neo-liberal economics, therefore, one can only logically employ up to the point where the revenue generated by the last employee equals the cost of employing them. Otherwise the firm would make a loss. In economic theory wages can never be higher than this level, which is effectively set by how productive labour is. The more productive labour is the higher wages can be with more employment. When a firm sheds labour the inverse argument is made - they are unproductive and employing them is not cost effective. An unproductive unit of labour is a loss and the competitive pressure to make a profit demands that they be 'rationalised'. This is the 'discipline' of the market. Whatever else one thinks about this theory (and critiques abound), it has been ideologically powerful in pushing through the kind of flexible labour market reforms that have contributed to the reapportioning of risk. But on top of this labour market sits another one, a privileged labour market with quite different rules.

Since the share price peak of 1999 about £650 billion has been wiped off the value of shares in the UK. In 2002 alone, the share value average measured by the FTSE 100 fell by about 25%. As anyone with a pension or an endowment mortgage will tell you, this kind of falling (bear) stock market is deeply worrying. The stock market is the main site of investment by the funds that hold your money. A bear market makes you poorer. But what about the fund managers? During the good times (a bull market) City workers are renowned for their large earnings. How are they paid when their productivity is effectively negative i.e. the value of your ISA, your pension fund, your endowment investments are falling? In these circumstances they use a system called the benchmark. If the FTSE falls by 25% but your fund by only 24% your fund manager has beaten the benchmark. What does this mean? In terms of his six figure basic salary as a fund manager it means nothing at all. His basic wage is not related to productivity. But it does entail an annual bonus. To be sure, it will be smaller than in a bear market, he may not be buying quite so much property this year but then we all have to economise. In 2000 over 1,000 UK City investment bankers 'earned' over £1 million in bonuses. The numbers receiving such bonuses in 2002 has fallen to around 250 (typically with 60% locked in shares). Bonuses for others have declined to around £280,000. Where does the money come from? Out of the fees charged to the transactions made on your behalf. During a recession you are subsidising their failure. In years when you have become poorer they are rewarded out of your diminished assets. Flying in the face of economic theory, their negative productivity does not result in their wages falling to zero (because at these times their concept of productivity is making money off you not money for you). It simply reduces their bonus. If one followed the logic of neo-liberal economics there would surely be no need for such an incentive to retain a job with a £100,000 salary during a recession but apparently, despite there being more analysts than jobs, such an incentive remains an imperative. A famous economist, J. K Galbraith, nicely summarises this split between how labour markets treat the rich and poor - if you want the poor to work harder, you pay them less, and motivate through desperation, if you want the rich to work harder, you pay them more and motivate through avarice.

Privileged labour markets reward failure because the mark of privilege is the power to set one's own conditions of employment. One sees this also in the phenomenon of the 'golden goodbye'. In a recession most firms do badly because demand for most products tends to fall. But some firms do spectacularly badly in a way that requires fault to be apportioned amongst those who devised the firm's market strategy. Essentially, this is the board of directors. The price of failure for senior executives, however, is quite different than the cost of the firm's failure to its ordinary employees. The collapse of Enron denied ordinary employees severance pay and, since they had previously been encouraged to retain stock in the firm, devastated their savings. In November 2001 just prior to filing for bankruptcy, senior staff awarded themselves $55m in retention bonuses from the diminishing resources of a firm already finding it difficult to generate credit that would allow it to continue trading in the face of its losses.

In April 2000 five third generation (3G) mobile phone network licenses were sold in the UK for £22.5b. This kind of level of investment just for infrastructure rights was extremely unlikely to ever be recouped and must count as a spectacularly poor piece of business strategy by the firms. For this and other reasons Marconi has become a byword for corporate failure in the telecoms industry. Lord Simpson of Dunkeld, its CEO presided over a collapse in Marconi's value from £35b to £150m. If this does not count as negative productivity it is difficult to see what does. Lord Simpson's reward (whilst mass redundancies were being handed out) was a golden goodbye of £1m. John Mayo, Marconi's finance director received £2.8m. Assuming an average annual wage of £20,000, the opportunity cost of this combined £3.8m was 190 jobs.

Failure, however, is simply a high profile indication of the split between labour markets in the real world. When adjusted for inflation (for a fair comparison) between 1970 and 1999 the average annual salary in the US increased from $32,522 to $35,864. That's about 10%. During the same period, the annual remuneration of the top 100 CEOs rose from $1.3m to $37.5m. Divide $35,864 into $37.5m and we find that CEO's earn 1046 times more than the average American worker today. In terms of the neo-liberal justification of wages in labour markets this implies they are 1046 times more productive. One wonders quite what a CEO can be doing to generate revenue at quite that rate. One might look at it as a reward for taking the 'tough decision' to work you harder and pay you less implying that the CEO's productivity is in fact a measure of the productivity squeeze he can place on each worker. In which case, to earn 1046 times the average he must be squeezing an extra $35,864 out of 1046 workers a year or some derivative of the combination of these two figures. Put another way, his reward is some portion of what he extracts from the value of what you earn for the firm that you do not receive. Your income may be growing because the firm is more productive but his is growing because the rate at which yours grows, as a proportion of the growth of the revenue of the firm, is lower than it might be i.e. their income growth is being subsidised by slower income growth for others (irrespective of whether the size of the pie is growing). In effect, if the CEO's income is growing faster than the average worker, one is subsidising his income in a successful firm but in a different way than one subsidises his incompetence in a failing firm.

Consider also that the trend in direct taxation in Western countries has been to reduce the rate of progression. This means that the rate of increase at which higher earners are taxed compared to the average earner has been reduced. This, referring back to Galbraith, is part of the idea of incentives for the rich to work harder (1046 times harder). Combine this with a greater concentration of wealth at the top at the expense of the average and as any numerate person can tell you tax revenue as a proportion of the total wealth of a nation will fall (especially if you take into account that the wealthy employ highly creative accountants). That is, unless, of course, this loss is compensated by more tax at lower levels of the system. These tend to be hidden stealth taxes - on varieties of consumption. Since the poor spend a greater proportion of their total income than the rich they also pay a greater proportion of their income as tax in this way. What this means is that the substitution of regressive taxes for progressive taxation is yet another way in which the rich are subsidised during their working lives.

As the high profile case of Jack Welch former CEO of General Electric (GE) shows, subsidy does not stop at the end of a CEOs working life. In 2000, his last full year as CEO Welch earned, including stock options, $123m before retiring in 2001. The publicly available papers from his subsequent divorce have since brought to light the terms of his retirement. GE pay $80,000 a month for the running of his New York apartment, he has the use of the corporate aircraft ($291,869 per month) and a limousine service, GE also provide box seats at the opera, Wimbledon, as well as major baseball and basketball games. One might wonder whether he can afford such luxury when one considers that his personal fortune is estimated at $900m and that he is held on retainer at GE for 30 days consultancy work per year at a meagre $86,535.

The free rider principle

It is worth bearing in mind that the ideology of neo-liberal economics is antagonistic to the very idea of subsidy. Subsidies protect the inefficient against the discipline of the market. In international trade they are referred to as protectionism and one argument often used against them is that they perpetuate the privilege of a few against the interests of the many. For example, the lack of competition in agriculture maintains high prices for foodstuffs in a country against the interests of the mass of the population. This is a dubious argument in many ways but it is curious indeed that it is not applied to the various ways in which the truly powerful are subsidised. In economics there is a term for getting something for nothing, for not paying your share and benefiting from the expenditure of others. That term is the free rider principle. It was not developed in the mainstream of neo-liberal economics but for theories of public service provision. The context was how to ensure that everybody paid for mutually beneficial services. The classic examples are lighthouses and street lighting, where if I pay for their creation, you can also consume them, but the principle can be extended in degrees to any kind of infrastructure. Part of the problem is dealing with what is termed non-excludability. Once an educated workforce exists it can be tempting to exploit it whilst seeking to avoid paying to reproduce it. The important conclusion reached in welfare economics was that there was no solution to this problem without regulation. The state (and citizens placing informed pressure on the state) has to start taking responsibility for what is a political economy issue of justice and what kind of society we want to live in.

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FAIR USE NOTICE: This page contains copyrighted material the use of which has not been specifically authorized by the copyright owner. Global Policy Forum distributes this material without profit to those who have expressed a prior interest in receiving the included information for research and educational purposes. We believe this constitutes a fair use of any such copyrighted material as provided for in 17 U.S.C § 107. If you wish to use copyrighted material from this site for purposes of your own that go beyond fair use, you must obtain permission from the copyright owner.