Chart taken from the CCPA report, Ascent of Giants: NAFTA, Corporate Power and the Growing Income Gap, by Jordan Brennan (April 2015).
If we are interested in addressing the trend of growing wealth inequality in Canada, we should be paying more attention to domestic merger and acquisition (M&A) activity. These transactions are a unique mechanism for generating wealth inequality and therefore one more good reason why we should close tax loopholes that primarily benefit the wealthy.
To provide some context, 2015 saw $374.1 billion worth of M&As take place involving Canadian companies, which made it the most active year for M&As in the last seven. Of this amount, about $102.9 billion (just under a third) involved transactions between Canadian firms. To put it another way, in 2015 Canadian business owners who sold their business to another owner collectively earned revenue equal to about 5% of nominal GDP.
How do mergers and acquisitions generate inequality? I believe the best way to answer this question is to discuss why M&As are profitable. On a theoretical level, there are two main reasons for this.
Firstly, the new merged business may be more efficient having combined the resources of two previously existing companies, allowing it to make and sell products at a lower cost. In general, efficiencies include any innovation, arrangement or enhancement directly resulting from a transaction that improves productivity and profitability. Creating efficiencies can be a good thing, theoretically, if they make the best use of precious resources to create a higher quality of life for citizens.
Secondly, and less favourably, the new business coming out of an M&A may be profitable because the merger removes a competitor from the market. With less competitive pressure, the merged business can charge a higher price (or provide a lower quality product for the same price). With less competition the merged business can make more money at the expense of people with no choice but to purchase the product at a higher price.
Canadian regulators of merger activity would likely tell you M&As are profitable solely because they generate efficiencies. In the interest of consumer welfare, our government has a regulatory system that is meant to prevent M&As that are profitable because they reduce competition. M&As over a specific size (value) require the approval of the Competition Bureau, and this tends to be granted if the deal is not likely to significantly lessen or prevent competition. In the words of a former director at the Competition Bureau, “the very fact that so few mergers are contested by antitrust authorities [on the grounds of being anti-competitive] illustrates the prevalence of cost savings in motivating transactions.”
In fact, unlike most countries, Canada makes special exemptions for mergers that generate efficiencies. According to the Competition Act, if a merger will likely hurt consumers by reducing competition the merger will still be approved if the efficiencies surpass and offset any potential harm. This exemption is called the “efficiencies defence.”
However, a fascinating working paper released by the U.S. Federal Reserve in October provides a different perspective. It suggests that M&A regulation is, on the whole, ineffective. In general, merged firms earn profit primarily through reduced competition and generate few efficiencies. This finding is particularly shocking given stringent M&A laws in the U.S. that do not permit a Canadian-style efficiencies defence.
In my view, it is likely the profitability of any given merger or acquisition is influenced by multiple factors, and to varying degrees. Regardless, the two main mechanisms for generating profit through M&As are culpable of generating inequality.
If an M&A is profitable the shareholders gain from that profit. To own shares in a company requires surplus wealth (e.g., surplus income not used for housing, food, education, etc.). Shareholders therefore tend to be among Canada’s highest income earners, but generally include those who are wealthy enough to have savings. Profitable M&As therefore make the rich richer.
More specifically, shareholders of the firm that is acquired (the “target”) receive most, if not all, of the gains from an M&A. The number of target shareholders is generally smaller than the number of shareholders in the acquiring firm, so the wealth generated by M&As is concentrated in the hands of a relatively small group of people. Executives at the merging companies may also receive bonuses upon completing a transaction. The profit of the merged firm is then greater than the sum of the profits of the two firms pre-transaction because it has reduced its operating costs.
M&As also create losers. In the case where a transaction reduces competition shareholders profit by extracting wealth from consumers through higher prices (or by offering a lower quality product at the same price). Realizing efficiencies can also harm workers: laying off “redundant” staff post-transaction is very likely the most common type of efficiency. From a utilitarian perspective, society is better off because, in theory, labour will be redirected to a more useful purpose, i.e., fired workers will move on to other jobs where they are wanted. But this is no solace to workers facing shrinking average wages from new jobs created, as reported by Statistics Canada this summer.
Even if M&A profits come from genuine improvements in the merged business or its products/services we should be concerned that people are adequately compensated for any hardship they endure. Likewise, while it may be reasonable for investors to expect a greater return on riskier investments, surely there are ways to ensure the gains enjoyed by the relatively wealthy are equitably distributed to those who lost out from the deal.
A progressive taxation policy could be a reliable way to correct for the wealth inequality generated from M&As. Unfortunately, Canada’s current tax system is not up to the task.
Taxation of personal income earned from corporate profits is far lower than it is for employment income (as discussed elsewhere in this issue of the Monitor). Not only are marginal rates for this kind of income significantly lower, but there are a multitude of tax expenditure programs (i.e., tax loopholes) that reduce the effective tax rate on income from stocks and other investments.
Some of the worst tax breaks relate to M&A profits: pension income splitting, the dividend gross-up, the stock option deduction, and credit for partial inclusion of capital gains. A recent report from the CCPA, Out of the Shadows, finds that in 2011 the government spent about $9.7 billion to pay for these four tax expenditures alone, which benefit almost exclusively Canada’s highest income earners.
Admittedly, it would be difficult to get an accurate estimate of the value of forgone taxes directly attributable to M&A activity. However, the CCPA report clearly illustrates that our current taxation system is not compatible with the goal of preventing the growth of wealth inequality due to M&A activity. No matter how you slice it, M&As transfer wealth to the wealthiest individuals in our society, often at the cost of those with fewer means.
My intention here is not to demonize all mergers and acquisitions, simply to point out a progressive redistributive tax system—to compensate for the upward movement of wealth through M&As—is in the interests of the overall health of society. Some efficiencies (e.g., layoffs) create pressures on individuals, family life and Canada’s social safety net. The links between poverty and higher risks of illness—with the costs this creates for health systems—are well documented.
The architects of the Competition Act were very aware that in order for laws regulating business conduct to be effective they require complementary economic policy in other realms. The intersection of Canada’s domestic M&A regulations and taxation policy is an example of the need for policy synchronization, as alluded to in the 1969 interim report on competition policy. But clearly more work needs to be done drawing the connections between today’s expanding wealth inequality and existing Canadian policy. Do we need to reconsider Canada’s “efficiencies defence,” for example?
The federal government committed in its 2016 budget to reviewing Canada’s tax system, including current tax loopholes, some of which relate to business takeovers. This review is a valuable opportunity to make a measurable impact on preventing the growth of inequality, including that generated through M&As.
Robin Shaban is a public policy researcher and former Andrew Jackson intern for the CCPA’s national office. She is also a former officer of the Competition Bureau and has a master’s degree in economics from Queen’s University in Kingston, Ontario.
This article was published in the January/February 2017 issue of The Monitor. Click here for more or to download the whole issue.