A new metric for intangibles

A recent article in the McKinsey Quarterly proposes a new metric for measuring investments in intangibles: profit per employee:

* Today’s approach to measuring financial performance is geared excessively to the capital-intensive operating styles of 20th-century industrial companies. It doesn’t sufficiently account for factors such as the contributions of talented employees that, more and more, are the basic source of wealth.
* Financial performance—observed through balance sheets, cash flow reports, and income statements—is and always will be the principal metric for evaluating a company and its managers. But greater attention should be paid to the role of intangible capital and the ways of accounting for it.
* The superior performance of some of the largest and most successful companies over the past decade demonstrates the value of intangible assets.
* Companies can redesign the internal financial performance approach and set goals for the return on intangibles by paying greater attention to profit per employee and the number of employees rather than putting all of the focus on returns on invested capital.

The full article is available at the Massachusetts Manufacturing Advancement Center website.
The article is based on a forthcoming book Mobilizing Minds: Creating Wealth from Talent in the 21st-Century Organization by Lowell L. Bryan and Claudia I. Joyce. The book focuses on the issue of organization design in the Intangible Economy. As the authors noted in a recent interview:

We believe the time has come for corporate leaders to view organizational design as a strategic imperative and high-return, low-risk opportunity for investment. The classic definition of “strategy” is a plan for actions to be taken with which to gain competitive advantage. Using this definition, we believe corporate leaders need to invest more energy than they have invested in the past in taking actions needed to create the strategic organizational capabilities that will enable their companies to thrive. We are convinced that in the digital age, if you want to create wealth, there is almost no better use of the CEO’s time and energy than making the organization work better. So if corporate strategy is about preparing the corporation to gain competitive advantage, designing a more effective organization is certainly central to this endeavour.
. . .
We believe that nearly all organizations are replete with opportunities to streamline and simplify the use of hierarchical authority to remove unproductive complexities – while simultaneously increasing that authority’s effectiveness.
The approach we advocate involves redesigning a company’s hierarchical order, thereby improving management’s ability to use hierarchical authority to power a company’s performance. The effort centres on defining a “backbone” or central management structure; and developing general line management or clear decision authority and accountability for operating performance. By a “backbone line structure” we mean a chain of command that puts authority to make tactical decisions close to the front lines. By “frontline manager”, we mean someone with the authority to set aspirations, define tasks and roles, assign people and hold them accountable, mobilize resources, and make decisions for frontline workers.
We have used military analogies to illustrate both aspects of the model. In terms of a backbone line structure, in the military, there is no ambiguity about who a soldier’s commanding officer is, we believe the corporations should move more toward this model, than the traditional multiple bosses matrix approach. We also believe that the frontline manager should have more authority and accountability to make decisions at the front line, as do front-line military officers.

Sounds like an interesting read. But I am especially interested with their notion of using profit per employee as the metric of choice. That is an important step toward getting out financial measures right in the I-Cubed Economy.

Tax breaks

Speaking of tax breaks, here is an interesting story from today’s New York Times Tax Break Used by Drug Makers Failed to Add Jobs:

Two years ago, when companies received a big tax break to bring home their offshore profits, the president and Congress justified it as a one-time tax amnesty that would create American jobs.
Drug makers were the biggest beneficiaries of the amnesty program, repatriating about $100 billion in foreign profits and paying only minimal taxes. But the companies did not create many jobs in return. Instead, since 2005 the American drug industry has laid off tens of thousands of workers in this country.
And now drug companies are once again using complex strategies, many of them demonstrably legal, to shelter billions of dollars in profits in international tax havens, according to their financial statements and independent tax experts.
In one popular accounting move, companies declare their foreign markets as far more profitable than their American businesses — even though drug prices are typically higher in the United States than anywhere else in the world.
Drug makers are not the only American multinationals using tax loopholes to declare large portions of their income beyond the reach of the Internal Revenue Service. The Brookings Institution estimates that multinational companies are using overseas tax shelters to lower their payments to the Treasury by about $50 billion a year.

Interestingly, this investment distorting tax incentive is only discussed in the Treasury Department’s background paper on corporate taxation (see previous posting) in an Appendix on taxing international income.
The story goes on to talk about this relates to the issue of transfer of intellectual property offshore:

Tax experts like Michael J. McIntyre, a law professor at Wayne State University in Detroit, say the drug makers are taking advantage of antiquated rules that work better for manufactured products like steel and automobiles.
Under this system, when companies transfer products between divisions in different countries, they must account for the sales internally through “transfer pricing.” But they have significant discretion in how they set prices for these transactions.
That turns out to be especially so for high-margin products like drugs, which in pill form cost only a few cents each to make once they have been invented, but can be sold for several dollars apiece. The hefty profit margins result in part from patents that can protect the drugs from competition for years. And by transferring those valuable patents overseas, companies can declare that their profits should follow the patents overseas as well.
Under the rules of transfer pricing, if a company moves patents or other so-called intangibles from its United States division to a foreign subsidiary, the foreign unit is supposed to pay the American division a fair-market price. But outsiders have a difficult time determining if companies have properly assessed the value of patents, trademarks and other intangible properties.
To further complicate matters, some corporate subsidiaries in tax-haven countries, like Singapore and the Netherlands, now directly finance research in the United States. So they own the patents without ever having to “buy” them from their American parents, Mr. McIntyre said.
“They don’t even have to push it offshore,” Mr. McIntyre said. “It’s already offshore. And once it’s offshore, they strip the income from the onshore activity.”
In theory, companies are only deferring taxes on the profits they shelter overseas, not permanently avoiding tax. If they bring the money back to the United States to distribute to their shareholders, they still have to pay American taxes on it.
But those rules were temporarily suspended when President Bush signed legislation in 2004 to let companies return overseas profits at a rate of 5.25 percent, far below the official tax rate of 35 percent, if they moved the money back by 2006.

The story concludes with a suggestion:

Some experts now say the current system of taxing overseas profits should be scrapped. Even the companies that take advantage of loopholes might benefit if the system were changed, because they could save money on tax planning and have more certainty that the I.R.S. would accept their returns, said Michael C. Durst, a former I.R.S. official who is now special counsel to the law firm Steptoe & Johnson.
The simplest solution, Mr. Durst said, would be shifting to a system in which companies would assign a portion of profit to each country where they made a sale, relative to the size of the sale. Instead of trying to tax profits made overseas, the United States government would simply take its share of the profits on American sales. Such a system would be harder for the companies to game, Mr. Durst said.
But he and other tax experts say that any effort to close loopholes, to be politically viable, might have to be combined with a lowering of the corporate tax rate from its current 35 percent. And no one expects any legislation of that sort, at least not before the next election.

That is an interesting suggestion. The key will be looking at all the loopholes, not just a few tax incentives like the R&E tax credit.

Tax conference background (advocacy) paper

In preparation for Thursday’s short conference on tax policy and competitiveness (see earlier posting), the Treasury Department has released a background paper that makes the case for ending special tax breaks and reducing the corporate tax rate. According to a story in today’s Washington Post (Reconsidering Corporate Tax Breaks), the paper is not meant to be the final word:

Treasury Secretary Henry M. Paulson Jr. said in an interview that the paper is not intended to state a position so much as to open a public discussion about how to streamline taxes and regulations to help U.S. companies compete.

However, the paper is rather forceful in its tone. As the paper states:

Other countries continue to reduce their corporate tax rates, leaving the United States still further behind.
. . .
Our current system for taxing businesses and multinational companies has developed in a patchwork fashion spanning decades, resulting in a web of tax rules that can harm the competitiveness of U.S. companies.
. . .
However, our tax system disrupts and distorts a vast array of business and investment decisions, leading to an inefficient level and allocation of capital through the economy.

There are other worrisome parts to the paper. For example, in the section on “Distortions caused by tax incentives” focuses almost exclusively on the research and experimentation tax credit and the domestic production provisions. What about all the other tax incentives?
I was especially interested in the section on tangible versus intangible assets:

Income from investment in intangible assets (e.g., R&D and advertising) generally receives more favorable tax treatment than does income from investment in tangible assets (e.g., plant and machinery). Investment in intangibles might be excessively encouraged by the tax system, relative to investment in tangible assets.
As discussed above, the cost of purchasing a tangible asset generally is written off (depreciated) over time to compensate for its decline in value due to wear and tear. In contrast, the cost of investment in intangible assets generally is deducted immediately (expensed). Expensing can give a substantial benefit to intangibles over tangible assets. For example, because of expensing, corporate intangibles face an effective tax rate that is close to zero, whereas corporate depreciable assets face an effective tax rate of around 30 percent.

While immediate expensing of intangibles may confer some tax advantage, I’ve seen no evidence to suggest the result is an over-investment in intangibles. In fact, the accounting side of the expensing on intangibles tends to push management toward treating intangibles as an operating expense to be minimized rather than a long term investment.
Likewise the section on physical versus human capital is interesting:

Investment in acquiring skills and abilities shares much in common with investment in more traditional physical assets. Investment in human capital can be thought of as an intermediate input that can be used to produce a final good. Much of the economic cost of acquiring abilities and skills is incurred in the form of earnings that are foregone during the period of training or schooling. Because these foregone earnings are not taxed (i.e., imputed and includable in income), this treatment, in effect, allows an immediate deduction for such investment. Similar to the discussion above on the tax treatment of investment in physical capital, in economic terms, the “deduction” for investment in human capital (i.e., the nontaxation of foregone earnings) equals the tax on the cash flow from the “expected” normal return on the investment, which eliminates the tax on this part of the return (in present value). To the extent that future earnings exceed the expected normal return – perhaps because of luck, innovation, or successful risk taking – the tax on these higher than expected normal returns will exceed the tax value of the initial deduction and would be taxed (in present value).
Investments in physical capital and human capital are treated very differently in our current tax system. Physical capital is typically depreciated over the life of an asset, while human capital is effectively expensed or deducted immediately because of the non-taxation of foregone earnings. This disparate treatment between physical and human capital discourages investment in physical capital relative to human capital. More uniform treatment would reduce this distortion. [Footnote: Of course, more uniform treatment could involve either expensing or applying economic depreciation to all investment (i.e., human and physical capital).]
The current income tax also offers a number of other incentives for investment in human capital. These include the tax exclusion of scholarships, fellowships, and the value of reduced tuition; education tax credits; deduction of student loan interest; tax advantaged education saving accounts; deductibility and exclusion of employer provided education expenses; deductibility of tuition; and allowing students beyond the normal age cut-off to qualify as eligible children when computing their parents’ earned income tax credit and their parents’ dependent deduction.

Again, I see no evidence that all these supposed tax incentives are resulting in an over-investment in human capital and an under-investment in physical capital. What I do see is a preemptive argument against the idea of a knowledge tax credit.
The paper also mounts a spirited defense of the practice of shifting intangible assets offshore:

Multinational corporations have developed a large number of valuable intangible assets such as patents and trademarks that allow them to earn supra-normal or infra-marginal returns on the tangible capital that is necessary to exploit the intangible. The decision on where to locate the production of a particular highly profitable good or service is usually a discrete one in which a certain amount of plant and equipment is required. The decision on how much to invest in any given country therefore is based not only on the effective tax rate on marginal investment, but also on the taxation of the infra-marginal returns.
A U.S. subsidiary abroad has to pay a royalty to the parent company for the use of the U.S. developed intangible. However, the evidence suggests that a substantial portion of the return to the intangible asset remains in the location where it is produced. Furthermore, under the current U.S. tax system, most foreign royalties are shielded from U.S. tax by excess foreign tax credits flowing from more highly taxed income. Multinational companies therefore have a strong incentive to locate the production of any new valuable products and services in low-tax countries. Lowering the corporate tax rate would make the United States a more attractive location.

Interesting, since they just stated that the US tax system benefits investment in intangibles over tangibles. So why is there then an incentive to shift production of intangibles offshore? And not a word about the issue of transfer-pricing, especially of intangibles — which then IRS Commission Mark Everson labeled in Congressional testimony last year as “a high-risk compliance concern”:

Taxpayers, especially in the high technology and pharmaceutical industries, are shifting profits offshore through a variety of arrangements that result in the transfer of valuable intangibles to related foreign entities for inadequate consideration.

and which, this past April, IRS “estimates that inadequate consideration has resulted in material underreporting of taxable income by U.S. Corporations.”
What is also notable in the paper is what is missing. For example, missing from the paper is any discussion of any form of border-refundable tax that many other nations use to boost exports. Also missing is any discussion of payroll taxes.
I would like to think that the Thursday conference will be an open discussion of the issues. The background paper, however, is a set up to a preconceived solution: lower the tax rate. That may or may not be good tax policy. One would not know that from the one-sided advocacy brief that is being used for the background paper.

Dualing polls on globalization

Today’s FT has a poll showing that globalization is viewed a having a negative affect in all the rich countries — two to one negative to positive in the US (with about 45% not sure). But over on Dani Rodrik’s weblog: Globalization: we love it, we love it not…, he contrasts this with another recent poll that shows 60% of Americans think globalization is mainly good.
Sounds to me that the general public — just like the experts — are still grappling with what this thing called globalization really is.

Still a digital divide

Binary America: Split in Two by A Digital Divide – washingtonpost.com

Less than a mile and a half from the Citadel, the site of the Democratic presidential debate tonight, sits Cooper River Courts, a public housing project. Forget the Web. Never mind YouTube, the debate’s co-sponsor. Here, owning a computer and getting on the Internet (through DSL or cable or Wi-Fi) is a luxury.

Enough said

Trade adjustment assistance for service workers

Congress is finally looking to correct a major flaw in our trade adjustment assistance program, according to a story in today’s Washington Post – Aid May Grow for Laid-Off Workers:

Under a Senate bill to be introduced today, computer programmers, call-center staffers and other service-sector workers who make up the vast majority of the nation’s workforce would for the first time be eligible for a generous package of income, health and retraining benefits currently reserved for manufacturing workers who lose their jobs to international trade.

This is long overdue. The problem stems from the original belief that services, unlike goods, could not be traded over international boundaries. That belief by economist was never actually true but it didn’t matter because so few services were actually traded. The situation has changed dramatically with more and more services now subject to international competition. (By the way, in the mid-1980, I worked on a report at the Congressional Office of Technology Assessment on International Competition in Services: Banking, Building, Software, Know-How….)
But my friend Howard Rosen, who heads up the Trade Adjustment Assistance Coalition, is quoted in the story as saying “This is not going to be a slam-dunk.” If giving computer programmers who have been laid-off because of globalization the same benefits as auto workers laid-off because of trade is not a slam-dunk, then our entire trade policy is in serious trouble. If we can’t provide even this band-aid, what can we do?
As I have said a number of times in this blog, we need a new trade policy (see here, here, here, here and here). How can we come up with a new workable trade policy if we can’t take a simply step of acknowledging that services are, in fact, traded and therefore we need to treat service workers the same as manufacturing workers?
Keep an eye on this one – as it is likely to be a flashpoint in the trade policy debate.

Centre for Jurisdictional Advantage

The concept of “jurisdictional advantage” is one that Athena Alliance (and this blog) has followed for some time. Earlier this year, the Rotman School of Management at the University of Toronto announced the creation of a new research center on the topic:

“The Centre for Jurisdictional Advantage and Prosperity will enhance the province’s prosperity by taking an integrative approach to the study and creation of jurisdictional advantage. Currently, the study of how jurisdictions, including provinces, become magnets for companies to start-up, locate and grow, and for talent to study, live and work, has been fragmented across many diverse fields. This disconnected knowledge has been less helpful to policy-makers and businesses than is required,” says Rotman Dean Roger Martin. “The Centre will remedy this by attracting and bringing together the best group of scholars in the world to study jurisdictional advantage in order to create new and valuable insights that will benefit Ontario and the world at large.”

And last week, they announced that Richard Florida will be heading up this new Centre (Creative Class Thinker Joins Rotman School of Management).
Over the years, Athena Alliance has been fortunate to be associated with key members of the Rotman School. Dr. MaryAnn Feldman gave the original jurisdictional advantage paper at an Athena-Wilson Center symposium. and Dr. Florida presented his book, The Flight of the Creative Class, at another symposium. Dean Roger Martin spoke to an Athena sponsored Congressional briefing on innovation.
We wish Dr. Florida and the new Centre all the best in their work.