Thinking About the Living Wage

Yesterday (16/01/2016) Jeremy Corbyn made a speech to the Fabian New Year Conference in which, during a section on fairness, he stated

Another proposal would be to bar or restrict companies from distributing dividends until they pay all their workers the living wage. Only profitable employers will be paying dividends, if they depend on cheap labour for those profits then I think there is a question over whether that is a business model to which we should be turning a blind eye.

The idea that companies could be barred from paying dividends is certainly a headline grabber - it plays straight into the hands of those who see Corbyn as an anti-capitalist throwback obsessed with statist intervention.  This is annoying because - as I hope I'll come on to explain - there's the kernel of a good idea buried behind the frankly bonkers wording used.

Imagine a parallel universe in which a Labour leader was savvy enough to realise that the language he uses shouldn't be tuned to his existing supporters but to the wider electorate. In this universe they could have said:

Another proposal would be to ensure that those companies that can afford to pay the living wage, do. One mechanism that might be used to determine who those companies are could be that they pay dividends. After all, dividends are used to reward external shareholders and are paid from retained profits - maybe paying employees enough to achieve a minimum acceptable standard of living should be a precondition of shareholders earning a return.

Now, this is still a fairly radical proposal but at least it avoids the incendiary and frankly impractical idea that the UK government could "bar" companies (many of whom are of course global concerns) from paying dividends.

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As a technical aside: limited companies are already "barred" from paying dividends unless they have accrued a retained profit on their balance sheet. Because profit and cash aren't the same thing, it's quite possible for a company to have the cash to be able to pay a dividend but be "barred" from doing so because they don't have sufficient retained profit

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Now I'm no Corbyn fan (had you guessed?) but let's try and cut him some slack here. This wasn't positioned as a concrete policy proposal and he was addressing a left-wing think tank so it might be a good idea to brush over the unfortunate choice of wording and to - without necessarily having to get into a tank to do so - think about the underlying idea.

The principle being explored here is that maybe a higher minimum wage requirement could be imposed on those companies who can afford it. A perhaps more business friendly corollary of this would be to suggest that the National Minimum Wage should be increased but companies who can't yet afford to pay it could be exempted.

The question of course is how we define those businesses who "can afford it". Corbyn is saying "if you can afford to pay a dividend, you can afford to pay a living wage to all your employees".  Before we can explore this idea further we need to clear up some widely held confusion about the term "living wage" (at least if my Twitter timeline is anything to go by).

We assume Corbyn is referring to the Living Wage, a figure calculated annually by the Living Wage Foundation and which some employers voluntarily adhere to. This is not be be confused with the "National Living Wage" which is a simply a cynical re-branding of the National Minimum Wage for people over the age of 25.

To try and clarify, let's look at the levels set for employees outside London:

National Minimum Wage (as enforced by HM Government, under advice from the Low Pay Commission):

• Currently: £6.70 for employees aged 21 and over
• From April 2016:
• £6.70 for employees aged 21 - 24
• £7.20 for employees aged 25 and over (branded as the "National Living Wage")

Living Wage (as defined by the Living Wage Foundation)

• Level when Osborne announced the above "National Living Wage": £7.85
• Current level (set in Nov 2015): £8.25

If you're confused by this, you're meant to be - it's why Osborne cynically co-opted the term "Living Wage" and applied it to what is actually just a new tier of the Minimum Wage. The "National Living Wage" is not and never was the "Living Wage" as defined by the Living Wage Foundation.

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It's worth pointing out that - because it's defined on the basis of the take-home pay required to have a minimum acceptable standard of living - the Living Wage is a function of prevailing tax conditions as well as the cost of living. The point being: had the proposed tax credit cuts gone ahead, the Living Wage (as defined by the Living Wage Foundation) would have needed to be raised yet further. Even if Osborne had changed the National Minimum Wage (for people over 25) to the level of the Living Wage as then defined by the Living Wage Foundation (he didn't), by proposing tax-credit cuts at the same time he was raising what the true Living Wage would have become.

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The first obvious point to make here is that the Low Pay Commission were given a remit from Government to advise how to set “NMW rates that helped as many low-paid workers as possible, while making sure that we do not damage their employment prospects”. It's implicit in this remit that all companies would have to pay the National Minimum Wage, so the NMW has to be influenced by the base level affordability for poorer performing companies (there's no point raising the minimum wage level to the point at which it puts many companies out of business and creates mass unemployment).

There are other factors of course (such as international competitiveness) but let's assume the Low Pay Commission are doing their job well and the Minimum Wage is set at or near the highest level that companies on the whole can bear. Given we already vary the minimum wage by region and age*, why not tier it by corporate ability to pay - why shouldn't some companies be held to a higher minimum wage standard than others?

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* From April we will have different NMW rates for employees aged under 18, 18-20, 21-24 and 25+. Quite why it's deemed acceptable to pay a 24 year-old less than a 25 year-old for doing the same job is beyond me, but that's maybe a debate for another day.

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It's reasonably easy to argue for companies to have higher minimum wage thresholds in extreme cases: surely a company that pays its senior executives millions of pounds and generates super-normal returns for its investors shouldn't at the same time be paying some of its employees so poorly that they are living below what might be considered a "minimum acceptable standard of living"?

If you're thinking "but it's ridiculous for some companies to have to pay a higher minimum wage than others", remember this will happen from April 2016 with the new "National Living Wage" (inside vs outside London) and historically corporation tax rates varied by level of corporate profit (profits under £300k used to be taxed at "small profit rates") and there are initiatives like small business rates relief that mean we discrimate in favour of smaller companies already.

So if you accept the principle that it makes sense for some companies to be held to a higher minimum wage standard than others, how do we determine if a company should be required to pay a higher tier minimum wage?

1. Distributing Dividends

Now I'm sure Corbyn and his advisors understand this very well [turns to camera 3, raises eyebrow] but it's perhaps worth explaining how dividends work:

Take a typical small owner-managed company: the owner can choose to pay themselves a salary and/or (if retained profits exist) pay a dividend. Assuming the owner holds 100% of the shares (receives all of any dividends paid) the levels at which it's appropriate to switch between salary and dividend depend on the prevailing tax rates

• Pay a salary and incur employees' and employers' NI and Income tax
  or
• Retain profit, pay corporation tax on that profit, pay a dividend and pay tax on that dividend

So far so straight-forward. Now let's say the company seeks to expand and so our owner-manager introduces external shareholders to give the business funding (somebody puts a chunk of cash into the business in return for a share of the business's equity).

This external shareholder is not an employee and can only see a return on his investment through dividend payments (or selling on his shares ... but the person he sells on to can only see a return on his investment through dividend payments (or selling on his shares ... but the person he sells on to ... etc.)).

This simple fact underpins a very important principle of corporate finance: equity is only worth the future value of the dividends the equity holders will receive.

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Because of the time-value of money (£1 today is worth more than a £1 in ten years time) we'd technically say the equity is worth the Net Present Value (NPV) of all future dividend payments, where the discount rate applied to calculate that NPV reflects the risk profile of the investment.

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Let's say things really take off and the business needs access to more financing on an ongoing basis (or the owner wants to cash in some of his equity value) so he floats the business on the stock market. People buying shares in his company (either at the Initial Public Offering, through later Rights Issues or from other shareholders) will only receive a return on their investment from future dividend payments (or by selling on to other investors ... who will only receive a return on their investment from future dividend payments (or by selling on to other investors ... who will only receive a return on their investment from future dividend payments etc. ) )

I'm aware I'm labouring the point here, but it's absolutely crucial to this debate: a company (its equity) is only worth the money that the holders of that equity will receive and - other than by liquidating the business - that can ultimately only come in the form of dividend payments. Dividends are not some frothy excess - a company's equity is only worth it's future dividend prospects, they underpin the value of all stocks, the value of the entire stock market.

Of course pension funds are very large share owners so anything that affects the value of future dividend flows affects equity values and jeopardises pensions.

[I'm surprised that the ONS stats suggest only roughly 3% by value of UK equities are held by pension funds] 

This is why barring dividend payments is a non-starter and Corbyn looks naive to even suggest it. The reality here is that nobody could expect large successful companies to stop paying dividends - but the government could impose on them a higher NMW figure (it's worth noting that over 2,000 companies who are already accredited Living Wage employers would be unaffected). The threat of barring dividend payments makes this proposal sound dafter than it is - it's simply a suggestion that companies who pay dividends should have to adhere to a Living Wage policy.

The question then becomes: how appropriate is the "have ever paid a dividend" mechanism for defining companies who should be able to afford to pay the Living Wage?

The positive argument for this mechanism is that it protects vulnerable businesses and favours start-ups. If you've yet to retain enough profit to pay a dividend you're probably one of those businesses that the Low Pay Commission is implicitly protecting when it decides how high it can go with the current Minimum Wage. The question of whether we should favour start-up companies over incumbents is a complicated one, but if you believe we should (to encourage an entrepreneurial economy) then the "have you paid a dividend yet" mechanism has merit.

But is it appropriate that all companies that haven't paid dividends should avoid this higher minimum wage requirement?

A company that is fully owner managed (where all the shareholders can receive salaries and bonuses) may have no pressing need to pay a dividend. Eventually founders retire and/or family members who don't work in the business inherit shares, at which point there becomes pressure to pay dividends - but if it's been able to self-finance growth the company could be very large before this happens.

Mutual structures (like partnerships or co-operatives) are employee-owned models that (broadly speaking) don't pay dividends. Take the John Lewis Partnership as an example: the ordinary shares yield no dividend as they are owned by the JLP Trust which pays eligible employees a partnership bonus. [I know there are JLP preference shares which do yield a dividend but let's not get bogged down in that].

Even putting aside the employee owned models, some companies may wait a very long time before paying their first dividend. If a successful company can reinvest their profits for a greater return than their investor's cost of capital then they maximise shareholder value creation by reinvesting rather than returning money to shareholders (who also incur tax charges in the process).  Of course - per the logic above - this can't go on for ever; but companies that to date have never paid dividends include Amazon, Ebay and Google. Apple Inc didn't pay its first dividend until 2012.

I think by now you'll have got the point: there are many large successful companies that would avoid the requirement to pay the Living Wage if it was based purely on whether or not they have paid (or yet want to pay) a dividend.


2. Alternative Models (some thoughts)

Two out of Three

There's an interesting model in place already that's used by Companies House to determine whether or not a company should file full accounts. In this case the rule is that a company is defined as "small" (and therefore exempt from the requirement to file full accounts) if it satisfies at least two of three criteria

• Aggregate turnover must be £6.5 million net (or £7.8 million gross) or less
• The aggregate balance sheet total must be £3.26 million net (or £3.9 million gross) or less
• The aggregate average number of employees must be 50 or fewer

The conditions for being required to pay the Living Wage could be a similar "at least two out of three criteria" model with something along the lines of;

• Have ever paid a dividend
• Highest paid executive's salary greater than £250k?
• Retained profit on balance sheet of over £1m?

It's a model worth considering if you accept the principle that those who could pay the Living Wage should.


Carrot instead of Stick

If a company is making profits that get taxed and some of those taxes are going to provide state support to their employees ... why not cut out the middle man and simply tax the company less on the basis that they pay their employees more? Theoretically a "zero sum game" might be possible here where shareholders earn exactly the same dividends and employees receive the same net income, but all that income comes directly from the employer as wages rather than partially via state benefits. Unfortunately finding a mechanism to achieve this in practice is probably impossible.

Personally I think the principle of rewarding companies for paying all their staff the Living Wage or more is a non-starter. Some companies will be in sectors where they have few or no staff below the Living Wage simply by the nature of their industry (professional services firms for example) - they would be rewarded for carrying on business as usual. If instead (as Labour proposed at the last election) you reward companies who move from having some employees below the Living Wage to being a Living Wage employer, you are effectively penalising their competitors who may have already voluntarily put in place a Living Wage policy before the incentive was offered.

The alternative might be to raise the NMW for all employees and for the state to create a mechanism for redirecting the money saved (in lower benefit payments) to those companies that need support as a result of the higher NMW. By definition these companies are unlikely to be paying much (if any) corporation tax, so some other mechanism other than corporation tax relief would need to be found.

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This is a fascinating and important topic that deserves considered debate, so it's unfortunate that Corbyn has chosen to wade in using poorly chosen language and ideas that - at least at first glance - appear not to have been properly thought through.