Executive Summary
The Securities and Exchange Commission (SEC) recently approved a rule requiring firms to disclose information about materially relevant human capital. What should these new disclosures be, and how effective will such metrics be at influencing firm behavior? In the 1950s, many large firms issued voluntary disclosures about their investment in human capital. These pie charts, which indicated how each dollar of revenue was spent, provided a simple and powerful way for shareholders to understand how a company invested in its various stakeholders through taxes, wages, and dividends. The authors find that the disclosure was popular during an era when managers felt they were responsible to all stakeholders — not just investors. But as the shareholder primacy view of capitalism took hold, the disclosures fell off. The authors argue that it’s time to bring them back.
Capitalism is in the midst of a once-in-a-generation reckoning as the general public and corporate executives alike question the old model of shareholder primacy and call for corporations to identify a purpose that serves all stakeholders, not just investors. In response to this shifting perception of the role of the corporation, the Securities and Exchange Commission (SEC) recently approved a rule requiring firms to disclose information about materially relevant human capital so that investors and other stakeholders can get a sense of the role employees play in creating the risks and successes of their firms. But important questions remain: What should these new disclosures be, and how effective will such metrics be at influencing firm behavior?
It is vital that we find the right answers to these questions. Disclosures that are not carefully constructed can backfire, potentially leading to outcomes worse than the status quo. For instance, a 2016 study by Alexander Mas found that mandated CEO pay disclosures in 1934 did not have their intended effect of lowering executive compensation. Instead, lower-paid CEOs used the public information to negotiate higher salaries, while all but the most egregiously overpaid executives experienced little to no change in compensation. If new disclosures are created to elevate non-shareholder interests, they should be carefully examined to ensure they are working as intended.
But while the past holds cautionary tales, it also provides examples of disclosures that could provide a roadmap for effective future reporting. In the 1950s, many large firms issued voluntary disclosures about their investment in human capital — such as the one from General Motors (GM) below. The pie chart, which indicates how each dollar of revenue is spent, provides a simple and powerful way for shareholders to understand how GM invested in its various stakeholders through taxes, wages, and dividends — and GM was not alone in reporting this type of data visualization.
Source: General Motors, courtesy of Ethan Rouen, Harvard Business SchoolWe examined the annual reports of the 88 companies that have been included the S&P 500 since its 1957 inception and found that, at some point, a third of these companies reported this type of pie chart, often on the first two pages of the annual report. By 1980, this type of disclosure had all but disappeared.
Our analysis shows how this disclosure, and the information it reported, declined in lockstep with the shift toward the view that the firm’s sole obligation is to its shareholders. We find steep declines in the prevalence of these charts in the years leading up to the 1970 Friedman article, and another steep decline in the late 1970s.
The decline also coincided with firm resources being increasingly directed toward the firm itself and not to employees and other stakeholders. As the prevalence of the disclosure declines, the shares of revenue going to employees and taxes decrease, but the shares going to other operating expenses and the financing of the firm increase.
Perhaps the most surprising part of our analysis came when we examined how reporting the pie chart affects firm behavior. We used a difference-in-difference framework to examine changes in the share of revenue allocated to wages before and after a company stopped reporting the chart, while also controlling for variables such as firm size, capital structure, and profitability. We find that, before 1970, firms that reported the chart paid a higher portion of revenue into wages. In other words, they prioritized employee interests more than comparable firms that did not report the chart.
After 1970, however, the effect completely reversed. Firms that reported the pie chart later, when shareholder primacy was becoming the prevailing viewpoint, paid a lower share of revenue into wages than comparable firms. Moreover, while the shares of revenue going to wages and dividends were uncorrelated before 1970, they became extremely negatively correlated afterward, indicating that the two groups — employees and shareholders — were put more in competition for firm resources with each other after 1970.
While these findings may sound counterintuitive, they are consistent with the shift to shareholder primacy that occurred around 1970 and emphasize how the effect of disclosures depends on the viewpoints of the people reading them. If investors believe that a company’s only responsibility is to increase profit, disclosures will be used as a roadmap for cost-cutting by slashing wages, taxes, and socially responsible expenditures. Indeed, our results suggest that, in the current environment, reduced transparency and allowing for more managerial discretion may actually be better for stakeholder interests than overzealous disclosure.
Taken together, these results underscore the complexity of creating disclosures that motivate managers to take into account a broader set of stakeholders when making decisions. But that complexity does not mean that companies and regulators should give up.
Instead, disclosures ought to be examined carefully to ensure they are working properly. Publicizing the information more broadly, instead of putting it in investor-focused disclosures, could also make these disclosures more effective in aligning corporate and non-shareholder interests. And continuing to question the role of businesses in our society and expect that they work toward a broader social good might eventually create a climate in which disclosures can be used by shareholders themselves to make companies behave more responsibly. Mandating corporate disclosure is a powerful tool for change, but regulators should exercise caution as they do so, keeping in mind who will be reading the new information and how it might be misused.
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September 29, 2020 at 09:22PM
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Companies Used to Share How Each Dollar of Revenue Was Spent - Harvard Business Review
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