Where it all began
British Economist Hector McNeill is the leading international developer of the Real Incomes Approach to Economics.
He is the Director of SEEL - Systems Engineering Economics Lab
The work leading to the Real Incomes Approach to Economics providing the potential for securing sustained non-inflationary economic growth, started in Rio de Janeiro almost 40 years ago.
The lead researcher and developer of the Real Incomes Approach economics programme since its inception in Rio de Janeiro, Brazil, in 1975 is Hector McNeill.
This work was initiated to analyse the macroeconomic and microeconomic implications of the severe impact of significant rises in international petroleum prices on the Brazilian economy. This started out as an enquiry into why Keynesianism, and the then promoted Monetarism, could neither avoid nor resolve economic and financial shocks arising in commodity or financial markets without imposing further arbitrary prejudicial impacts on significant segments of the economic constituencies.
Hector started this work making use of the resources at the Getulio Vargas Foundation located in Botafogo, Rio de Janeiro. McNeill studied economics at the Universities of Cambridge, England and Stanford, Palo Alto, California.
He also completed post-graduate studies in Systems Engineering at the School of Engineering at Stanford University. While in Brazil he was a lead researcher in natural resources at the National Commission for Space Activities (now INPE) in São José dos Campos, São Paulo leading work into coffee leaf rust and the economic impacts of frost attack on coffee. He led a UN FAO project at the Brazilian Coffee Institute to design and implement the world's first automatic crop inventory system. At the Secretariat of Agriculture in São Paulo he contributed to the "McNeill-Serra" river basin water balance simulation model that was subsequently tested by the Institute of Geology verifying the generation of accurate results. He also worked at the Ministry of Planning Foundation Institute for Geography and Statistics as member of the team establishing SUPREN (The Superintendency for Natural Resources & the Environment) and was the Environmental Economist and project Task Manager for the World Bank on the G7 Rainforest Trust Fund in Amazonia. He contributed to a major study (PROGNOS-GTS) on the potential impacts on IT on the European economy and became a Senior Scientific Officer at the European Commission in Brussels with the Information Technology & Telecommunications Task Force organizing initiatives in the application of advanced IT applications including 5th Generation systems. More recently he has worked in the field on investment projects in transition economies in Europe and funded by the European Commission. Besides his work on Real Incomes he is currently lead developer of an online process project cycle management system for the private and public sectors.
Brazilian economic prospects
The needed transition from the Real Plan to a plan for Real Incomes
Petroleum price hikesDuring the period 1967 to 1974 when Antonio Delfin Netto was Minister of Finance, Brazil passed through a period unprecedented growth, a period often referred to as the economic miracle or the "Oba-Oba" period. At the time one of the more sensitive dependencies of the Brazilian economy was the need to import almost all of its petroleum. In 1974 the price of crude oil quadrupled leading to a failure of an anti-inflation policy that up until that point in time was succeeding.
This is an update on the previous article with the same title outlining what I consider to be the potential of the Real Incomes Approach to economics in significantly improving the status of the Brazilian economy and helping generate growth and a more equitable distribution of real incomes. This can bring Brazilians and their country to assume the status internationally that such a natural and human resource rich country should assume. This is not just something of benefit to Brazilians it is something a troubled world needs to increase the influence of countries with positive and non-aggressive foreign relations within the global theatre.
Unfortunately the government is being given bad economic policy advice which is veering towards austerity rather than growth. Ministers are talking haplessly in terms of a "slow down" in the economy as if nothing can be done. Applying the conventional monetary and fiscal policies will not achieve the necessary reversal of the current downward trend.
There is a serious diversionary activity distorting a transparent focus on the poor economic advice being given to the Brazilian government in the form of the increasing reference to corporate scandals and corruption. It is as if Brazil is the only country afflicted by weaknesses in human nature, corrupt politicians and tax officials.
However the Brazilian government can take robust actions to create a significant impulse for growth based on a Real Incomes policy. To achieve this there is a need to terminate the common denial that anything is amiss with conventional economic theory, monetary and fiscal policies when the evidence is staring us in the face. There is no underlying political motivation here. I have to emphasize this is a criticism of what I once believed, having studied economics as good universities and working in international organizations concerned with economic development for over 40 years. There continues to be denial amongst many economists and politicians concerning the failures of economics in general. I was first alerted to this fact in Brazil in the mid-1970s but this denial persists until the present day. This means economists are often advising governments to participate in grandiose social experiments in the hope that they will work. However, their continued failure is creating prejudice for the economic and social constituencies. To some degree this is the result of a lack of awareness concerning alternative and logical economic theories and policy options and, in particular, the Real Incomes Approach. If the economics profession is to help contribute to a better future for our societies we need to specify what we are trying to achieve. It is then our professional responsibility to identify viable and functional solutions that satisfy the needs of individuals, society in general and thereby supporting the state fashion a better future for all.
The result was the development of slumpflation, that is, recession associated with inflation and rising unemployment.
Economists in denial over flawed economic theory and policies
When I tried to analyse the situation and apply the economic theory and policy options I had learned at the Universities of Cambridge and Stanford I became extremely frustrated by the fact that the theory did not enable a rational analysis and the range of policy instruments could not solve the crisis without imposing severe prejudice on the economic and social constituencies. Up until that point I had felt that I fully understood economic theory and policy so I found this impasse traumatic. I even came to the conclusion that I could not have understood what I had been taught. However, I also noted that leading economists were not coming up with convincing solutions and it dawned on me that macroeconomic theory was seriously flawed and policy approaches therefore inadequate.
A battle of economic schools followed during this period of slumpflation with Keynesians losing out to monetarists whose so-called solutions, in terms of the associated prejudice imposed on the social constituencies, were no better than Keynesianism. I therefore sat down to review macroeconomic theory in June 1975 and by June 1976 I had completed a first draft of a paper entitled: "Price Performance Fiscal Policy - A Real Incomes Approach".This was my first attempt to point out theoretical flaws and propose policy options. At that time what came to be known as supply side economics was emerging as a parallel development to my work on Real Incomes. When I reviewed this approach I saw that it was a modified fiscal policy which did not have much to do with the supply side. This caused me to realize that I had committed the same error as the supply side economic developers by making my initial policy proposal a fiscal variant as opposed to a genuine supply side policy.
Following the period of international petroleum price hikes the Brazilian economy drifted enduring difficult conditions through the rest of the 1970s and 1980s. A legacy from the period of high growth in the 1960s was an inadequate distribution of income. By 1993 inflation had risen to an unsustainable level and finally in 1994 Fernando Henrique Cardoso introduced economic reform as Finance Minister at the end of the Itamar Franco government and continued his efforts as President of Brazil from 1995 to 2002. During this period the Real Plan was introduced designed to refinance state budgets, raised the retirement age and introduced policies to reduce income disparity. The Real initially gained value against the U.S. dollar as a result of the large amount of capital inflows in late 1994 and 1995. It then began a gradual depreciation process, culminating in the 1999 January currency crisis, when the Real suffered large devaluation, and fluctuated wildly. Following this period (1994–1999) of a quasi-fixed exchange rate, an inflation-targeting policy was instituted by new central bank president Arminio Fraga, which effectively meant that the fixed-exchange period was over. There were frequent central bank interventions to manipulate its dollar price.
The Real Plan has been stretched far beyond its usefulness simply because, as in the cases of conventional monetary policy (here I refer to the global context), there has been no effective incentive for increasing productivity and as this becomes evident the monetary authorities have tended to state, "we have done all we can, it is now up to fiscal policy!" The reality is that neither conventional monetary or fiscal policies can help in securing effective and substantive rises in productivity. The outcome tends to be a devaluation of the currency without any corresponding augmentation in productivity so that export competitivity stagnates and so does national real income.
Until economists and the "policy-makers" they advise accept this simple reality, economic and social constituents will continue to be exposed to standards of living well below the potential, especially in such a human and natural resources-rich country as Brazil. This destructive denial and inaction on the part of economists needs to stop.
Because of the apparent lack of awareness of the Real Incomes Approach to economics and the policy options it provides, there has been a continued assumption that the currency’s appreciation gained through the application of high interest rates was crucial to keep inflation under control. In practice this attracted foreign capital and a consumer led period supported by a supply of cheap imported products to meet the domestic demand. This forced domestic producers to sell at lower prices in order to maintain their market shares and the drop in inflation created a growth in demand. One complex conclusion was that increased imports helped prevent demand-side inflationary pressures that would upset the stabilization plan. This is one interpretation that only remains valid under that policy regime. However the margins of Brazilian companies were low making adequate investment for the future a major challenge.
| What is supply side?|Supply side needs a better specification or definition. It needs to represent the actions taken at corporate level making use of the range of options that are controlled and managed by the management of economic units in the interests of their business and customers. This needs to operate within a policy framework that provides adequate incentive and freedom to make effective resource allocation decisions to enhance productivity and efficiency. A legal framework is required to ensure that the enthusiastic pursuit of objectives of any one company or group of companies cannot prejudice the interests of others. Policies need to provide a practical framework so as to permit managers to exercise decision-making to secure optimized resource allocations at the level of the firm, in accord with their specific conditions, markets and access to resources.
Supply side policies can only operate successfully if the correct determinant model of the economy is applied in order to gain a precise predictability of the impacts of policy instruments. This means substituting the Aggregate Demand Model (ADM) of the economy used by conventional policies by the Production, Accessibility & Consumption model (PACM) (see "The PAC Model of the Economy").
Why "conventional" supply side goes wrong
So-called supply side policies fail because all attempts to date assume that they can operate according to the Aggregate Demand Model of the economy which relies on the profit motive to gain traction. Because of the profit paradox, however, it is difficult for firms to optimize resources allocation and remain competitive on a sustained basis resulting in a loss of policy traction (see "The profit paradox").
Many supply side policies, so-called, are supported by subsidies, that is, grants and low interest finance to encourage investment. However, in many cases funds are received without adequate conditionality. Under conventional project cycle management, the ability of an investment project to attain expected results can only be assessed by donors after funds have been spent. This results in such subsidies being regarded, in many cases, as income as opposed to commercial investments. Currently, conditionality is applied ex ante on the basis of assessments of project design or ex post on the basis of an evaluation of outcomes. What is required is that any subsidy should arise from actual project performance and policy planners have been unable to achieve this basis for operation.
The Real Incomes Approach policy provisions are, however, designed to possess a zero risk conditionality by maintaining a real time audit with incentive payments arising, ex post, according to actual price performance assessed in real time. Thus benefits accrue to companies when they contribute to the augmentation of real incomes of customers. In addition the benefits do not come from government revenue but come from the corporate cash flow so there is no subsidy involved. (see "The Price Performance Levy")
In practice the supply side economics experiment in the USA failed because there were no incentives for companies to sustain their innovative activities and funds drifted into assets and high executive and shareholder returns and low income groups did not share in the growth in national income. (see "Some evidence on the failure of supply side economics").
With the new government under President Luis Ignacio da Silva (Lula) during the period 2003 to 2011, some of the family grant programmes for poor families were continued but government expenditures increased squeezing out other programmes and approaching the capacity of revenue, in spite of the tax burden increasing from something like 25% of GDP in 1994 to around 36% now. Government provisions are approaching 40% of the national income.
When the global crisis of 2007 appeared Brazilian banks did not suffer the way others did because of an adequate capitalization and sound asset holdings. The consumer led growth has declined and Brazil could end up in a state of slumpflation. Exports have declined since 2006 but the Central Bank maintains a lower target for inflation of 4.5% which I would consider to be far too high. This is equivalent to a currency depreciation of 40% each decade. Bank interest rates make it impossible for some Brazilian firms to invest
One of the peculiarities of Brazilian economics is what is referred to as inertia inflation. This is based on people raising unit prices on the assumption that costs are going to rise by some fixed percentage each month or even day. Thus inflation was bolstered purely by expectations. This is what resulted in the runaway inflation before the Real Plan was introduced. However the broad approach to macroeconomic policy in Brazil is entirely conventional placing faith in interest rate setting by the Central Bank and fiscal rectitude or what people are now referring to as fiscal consolidation.
Ex-president Ignacio da Silva places the Presidential sash on Dilma Rousseff outside Planalto Palace in Brasilia, Brazil, on Jan. 1, 2011
Worldwide the cumulative evidence does not provide any confidence that this approach can succeed in anything other than the short to medium term in "tackling" inflation simply because of the differential impacts on the real incomes of economic and social constituents. All conventional monetary policies fail to acknowledge that inflation is caused exclusively by the pricing decisions of each economic unit in response to actual input cost variations and the variations in revenue associated with different unit prices according to the price elasticity of consumption (pEc). The fact that inertia inflation exists and existed in Brazil is evidence of the ineffectiveness of policy. It is more than evident that policy needs to discourage inertia inflation strongly, not by raising interest rates and investment input costs but by providing a positive incentive for companies to invest while containing or reducing output prices.
Except for isolated cases of some outstanding Brazilian companies, the Brazilian economy lacks growth in productivity and efficiency, there is a growing deficiency in qualified personnel in technical professions and it needs to tackle, yet again, income distribution. In reality the growth model, based on the Real Plan cannot contribute much more; it is spent.
In former times Brazilian policy-makers applied the age old solutions such as privatization and lowering tariffs and the like. This is a rather complex process that I have witnessed on several occasions in several countries and these do not have the positive impacts that people imagine. The basic impact is a transfer of assets from national accounting balance sheets to private balance sheets. This involves a significant degree of asset stripping and concentration on asset values for sales opposed to the identification of stable productive outcomes. In any case, at the moment, these are not in the offing, they aren't an option.
What is happening now
The problem with conventional economic theories and policies
In a recent interview in this series I outlined the problems of economic theory and practice (see Macroeconomics - the problems) and associated with these problems is a mindset which most economists develop as a result of formal economic training. We all tend to end up with dialogues taking place that use an economic vernacular consisting of terms and associated semantics which excludes, to some extent, an adequate, precise and practical consideration of many fundamental issues of importance. This has resulted in a certain conditioning of the perspectives we have and the shaping of economic models and this causes much of what is expressed in terms of the Real Incomes Approach to be somewhat counter-intuitive. This can be traced to the notion of aggregate demand and the profit motive (see The profit paradox) and the wide application of often contradictory economic indicators (see Why Real Incomes?).
Under the new administration, re-elected President Dilma Rousseff is giving support to the policies of her Minister of Finance Joaquim Levy and the Central Bank governor, Alexandre Tombini. Levy has set about maintaining Brazil's credit rating by cutting welfare spending and raising taxes. In the meantime Tombini has raised interest rates to 13.74% with the objective of attaining a 4.5% inflation with inflation currently at around 8%. These are conventional book-balancing and counter-inflationary policies which are associated with a time delay in resolving the issue of low productivity. In other words the needed rises in productivity are compensated by devaluation of the Real and prejudicial impacts on the economic and social constituencies. Monetary policies the world over are increasingly discouraging real investment in technology and human resources thereby delaying the solution to the crucial question of raising productivity. This failure of monetary policy is not specifically a fault of the Brazilian government or their economists but it is a more general fundamental matter of denial concerning the fact that defective theory and derived policies that are being applied worldwide by governments and many times under the auspices of the leading international organizations including the IMF and the World Bank.
Brazil has a well honed tradition of emphasis on monetarism with Eugênio Gudin, Otávio Gouveia de Bulhões, Roberto de Oliveria Campos and Delfin Netto and others being contributors to this tradition. However, our common experience during the last 70 years and especially since the late 1970s with the emergence of monetarism and financialization as the dominant macroeconomic policy realities is that there are systematic failures in monetary policy associated with the profit paradox and the legal basis for accountancy norms. So-called supply side economics is also ineffective in its original form or as ad hoc subsidy-orientated initiatives. Monetary policy has not been successful on protecting the long term value of the currency. The operation of fiscal policy has not been impressive because of currency devaluations and inefficient operation of government services. Lastly there has been a failure to secure sustained investment in technology and human resources so as to improve productivity. Conventional policies have been associated with the imposition of conditions that generate differentials between the social and economic constituents generating winners, losers and those unaffected by policy. Conventional policies fail to secure a positive systemic consistency (see "Positive Systems Consistency").
Temporary problems & amazing promise ...Drought in the centre south of Brazil has affected agriculture as well as river flow and reservoir volume, lowering the source of cheap hydro-electricity energy. This has caused inflation in food, fibre and feedstocks as well as energy. These should be temporary issues.
Prospection work uncovered one of the worlds largest oil reserves in the Tupi Basin off Rio. Access to them requires very deep well structures. After 7 years development Petrobras is raising this high quality petroleum.
It is estimated that even at the current low world oil prices the Tupi operations are marginally profitable because of superior technology and techniques.
If Brazil had access to the Tupi Basin reserves in the 1970s one wonders where Brazil would be today.
Brazil now faces the specific and urgent problem of encouraging all economic sectors to improve their efficiency through better resource allocation, the introduction of improved production methods and innovation through investment in technology and human resources. Interest rate policy does not have any particular impact on these needs and when it comes to government revenue and budgets there is a need to look to how productivity can bring about economic growth so as to generate more revenue as well as to use this more effectively. At the moment budgets, that are too low, face cuts. The inadequate size of the budgets is a direct result of the profit paradox encouraging widespread tax evasion and avoidance and the application of conventional but wholly inappropriate government revenue-seeking methods that depress productivity options (see "The profit paradox"). At the moment some suggest that interest rates should be lowered to devalue the Real. This is not a sound solution.
The profit paradoxThe profit paradox is a situation where the declared motivation for economic activity, profit, actually results in the misallocation of resources and lower productivity. This is caused by profit being the basis for assessing corporate performance while at the same time being the target for corporate taxation. The legally-based accountancy and audit norms classify wages as a cost leading to any decision to maximize profits to be associated with constraints on wage levels. Government revenues depend in part on corporate taxation so this legal obligation creates a generalized situation where business owners hide their incomes and profits in a widespread epidemic of tax evasion and avoidance. This has resulted in government revenue falling, even under the Real Plan and in wage earners facing falling real incomes (see "The profit paradox").
"Creating difficulties to sell solutions"
In the 1960s I was enjoying a cafezinho in a botequim in Copacabana with an acquaintance who was a corporate tax inspector. This fellow had a palatial house and I innocently asked him about housing finance. He replied that part of an inspector's job was to "Create difficulties in order to sell solutions". In other words all tax payers were subject to pressure and willing to pay to avoid having to pay the legal requirement. He also said, this being the situation, it was often not necessary to create difficulties since corporate accountants simply made generous payment proposals up front - usually very generous.
It would seem from some reports that Brazil continues to face serious issues on the corporate tax evasion and avoidance fronts amounting to multiples of the apparent national budget. The mechanisms deployed involve corruption in the fiscal legal authorities and in some cases tax inspector involvement.
It is also apparent that Brazil's tradition of attempting to use the formal mechanisms of monetary policy and fiscal policies is inappropriate since these can not raise productivity or avoid the profit paradox complications. There is a need to move from the profit motive to the real incomes motive - see Why Real Incomes?
The need to substitute the Real Plan by a Real Incomes policy
What is required is the application of policies which deploy policy instruments that can secure a careful trade-off between exchange rates and rising productivity so that the Real holds its value or even rises while productivity delivers lower unit prices nationally. This will result in enhanced purchasing power, real income growth and consumption. Associated impacts are a higher income multiplier resulting from lower unit prices (see "The Real Growth Multiplier") and a growth impulse that better distributed incomes (see "Growth Impetus"). Real income levels are a key indicator of economic success because they represent the outcome of the trends in nominal incomes, productivity and unit output prices (see "Why Real Incomes?"). Implicit in the use of real incomes as a policy success indicator is that there should be no inflation. The combination of a stabilized purchasing power of the Real and rising productivity expressed in unit prices quoted in the Real would also result in public services and provisions requiring a reduced nominal sum thereby alleviating the pressure on central government budgets (see "Public service provisions - a note"). This transformation of public service funding can be consolidated by bringing all government services under the same Real Incomes policy regime (such as Price Performance Policy (PPP)) as the private sector and subject to the same incentives.
The Real would become more attractive to foreign investors not only as an asset but also for buying into investments in Brazil as well as purchasing exported products and services.
Brazilian policy-makers need to take stock of what has been a very poor track record of monetary policy in relation to medium to long term productivity and income status. The continued reliance on the conventional monetary and fiscal policy duo demonstrates a failure to accompany the advance in the state of the art of economic theory and practice with the Real Incomes approach being an example of a practical and transparent option that is ignored.
PPP, a suitable Real Incomes option
The best way to boost productivity and the real incomes of Brazilians is to introduce a Real Incomes policy based on a Price Performance Policy (PPP). PPP eliminates the problems of the profit paradox and disruptive government revenue-seeking both of which distort investment productivity and shift the levels of productivity to below what is feasible.
PPP is a productivity approach to growth that should unify the interests of business ownership and the people employed by companies so as to build up a sense of necessary cooperation in advancing their mutual interest in raising their real incomes. Rather than impose interest rates with a view to control inflation or attract foreign capital, interest rates need to be left free to attain levels that reflect more closely the productivity of economic activities as opposed to arbitrary monopolistic interventions by the state (with or without central bank "independence"). As a result there would be increased investment and growth.
In order to combine raising productivity with inflation control it is necessary to remove the elements of the profit paradox that distort economic activities and reporting. Joseph Schumpeter made an important observation that profits are the guarantee of future activities and employment. Taking this literally profits can be substituted by investment in technology and human resources. If one eliminates profits it become necessary to establish another basis for measuring return on investment. The most obvious candidate is income, or rather, real incomes gained from economic activities.
PPP provides a new economic paradigm that can be applied to the management of all types of economy and states of economy. The approach is specifically designed to achieve a positive systemic consistency (see "Positive Systemic Consistency"
- remove the systemic failures created by the profit paradox
- are more effective than conventional supply side economics
- are more effective in currency value management than conventional monetary policy
- are more effective in increasing the efficiency of operation of fiscal policy
- provide a direct and sustained incentive for investment in technology and human resources
Of fundamental importance to Brazil is that the Real Incomes Approach can fashion policies that secure:
The PAC Model of the economy - the policy environment
- increasing productivity
- sustained reduction in inflation
- sustained growth in real incomes
- a more equitable distribution of real incomes across all income categories
The Real Incomes Approach does not make use of the aggregate demand model (ADM) of the economy upon which is based Keynesianism, monetarism and supply side analyses and policy predictions. The Real Incomes Approach is based on the Production, Accessibility & Consumption (PAC) Model of the economy (see "The PAC Model of the Economy"
) which is a more rational supply side representation. The impulse for consumption and inflation control and income multipliers can be explained in terms of the PAC Model (see "The Real Growth Multiplier"
and "Growth Impetus"
A short description of the method of PPP without reference to theory can be accessed here: "Bare Bones Price Performance Policy"Notable aspects of the policy
In the context of the Brazilian situation with relatively complex and onerous corporation taxes the Real Incomes policy Price Performance Policy is quite distinct from conventional policies through the elimination of corporate taxes and, in addition, having the following key differences:
No corporation tax
- corporation tax is widely abused as a result of the profit paradox and resources allocation is distorted by considerations of corporation tax. Companies can achieve far higher levels of productivity if corporation tax is eliminated with the bulk of this cash flow being added to investor, owner and employee salaries and personal income tax paid on the basis of pay as you earn (PAYE).
A Price Performance Levy (see "The price performance levy") is paid by companies according to their actual Price Performance Ratio
(See "The price performance ratio"
)- This Levy can have a base rate of a nominal sum, say 20% i.e. set at a rate to provide a positive incentive for companies to lower their Price Performance Ratio to lower the Levy, if possible to zero.
Managers can allocate resources in response to exogenous input price rises to alter the price performance and reduce the Levy, even to zero
- improvements in price performance are compensated by Price Performance Levy discounts that are treated as bonuses, paid pro rata to all people associated with the company with corporate performance being based on the generation of income of personnel (ownership, shareholders, managers and employees) against investmentElimination of the profit paradox
- by substituting profits in accountancy norms by investment in technology and human resources and transferring corporate returns to the real incomes of those associated with each firm resource allocation can achieve higher rates of returnManipulation of PPR
- because profits have been substituted by investment in technology and human resources, modified accountancy norms (see below) enable management to manipulate the PPR downwards (See "The price performance ratio"
) by raising unit costs in association with stable or lower unit output prices
Companies do not contribute to government revenue
- Where Levies are paid, these do not count towards government revenue, but are reserved for the future use exclusively in investment in technology and human resources by the company
These procedures do not involve any subsidy since the funds involved all come exclusively from current corporate cash flow and this enables conditionality of payment to be against actual performance. This avoids the typical problems of failure associated with lack of effective control of conditionality associated with supply side subsidy initiatives. The public sector is subject to same PPP regime as the private sector
- this introduces the same incentives for increased productivity within public service operations thereby attaining operational performances equivalent to the private sector and reducing the cost of provisions.
The policy incentive
In order to encourage management to make decisions on resource allocation optimization to secure unit price moderation or reduction there is a need to provide a positive economic incentive. Under the profit motive moderating unit prices in the face of rising unit costs will lower unit margins and raises risks. However, the elimination of this motivation by substituting profits by investments in technology and human resources and substituting the profit motive by a real incomes motive can reduce these constraints and reduce risk on the basis of the identification of optimized resource allocations. Thus an incentive that lowers the risk of unit price reductions can help companies gain market penetration and increased income. This would secure simultaneously the microeconomic and macroeconomic objectives of enhanced real incomes both of those who own and those employed by companies as well as their customers.
The degree to which a company achieves price moderation can be measured by the price performance ratio (PPR) (See "The price performance ratio"). The PPR value achieved by any economic unit is established directly by management decisions and actions. Rather than bear down on companies with centrally-established rate for interest and taxation these instruments can be substituted by a positive productivity incentive in the form of a Price Performance Levy (PPL) (see "The price performance levy"). This can be applied by selecting from a very large range of optional formulae. By way of example a power function can be used where the main variable that determines the value of the Levy is the PPR. Thus the PPL can be of the following form:
PPL=L(PPR)2 . . . . . (1)
PPL is the levy applied to the company
L is the base rate Levy,
PPR is the price performance ratio.
Assuming a base rate Levy of 20%, Table 1 shows the range of values of the PPL according to the PPR achieved by a company.
Price Performance Levies associated with different Price Performance Ratios
|PPR||Base rate Levy||PPL||Bonus|
As can be seen under a fixed policy-related base rate Levy of 20%, management can allocate resources so as to come up with the PPR they desire and thereby pay a Levy varying from 20% to zero. Naturally managers will try and avoid paying the Levy and the only way to do this is lower their PPR by improving demonstrable productivity. Companies can easily manage their PPR values by carrying out incremental investments in technology and human resources which will raise unit costs in addition to any rises associated with purchased unit input variables. However, the resulting gains in efficiency must be recorded in the form of moderated unit output prices. In other words the benefit to the economy becomes real and demonstrable. The amount of PPL avoided that is based on increased productivity and sales is a bonus category
Source: The Real Incomes Approach - The main theoretical principles & policy options
How PPP worksAs outlined in "The Real Incomes Approach - The main theoretical principles & policy options") (a summary can be found here "Bare Bones PPP") the operation of Price Performance Policy requires modified accountancy categories.
In the article Schumpeter and Keynes by Peter Drucker, a section describes Joseph Schumpeter's view on the role of profits as the foundation or guarantee of future activities and employment. The significance of this view arises from the fact that Schumpeter's role for profits, bears little relationship to their currently perceived role but, in my view, it presents a key to straight thinking; an imperative. By limiting the role of profits to that identified by Schumpeter it is possible to alter the accountancy norms, on a rational basis, so as to terminate the contention between business success and wages as well as to ensure government revenue rises to realistic levels. This requires changes in accountancy regulation details. The corporate taxation and accountancy framework are so divisive that significant efficiencies can be realized by eliminating corporate taxation from the decision analysis model. This is not to say government revenue raising is not an essential requirement in a modern economy but corporation tax is a very inefficient and disruptive way to raise government revenue. The objective is to facilitate resources allocation so as to achieve the highest feasible return to operations supported by investment in technology and human resources. By eliminating corporate tax considerations we are left with six basic categories of quantifiable accounting aggregates:
As mentioned, the profit category can be redefined as investments in technology and people (in the Schumpeterian sense). So the accounting categories can be expanded to seven:
- Corporate revenue from sales
- Income of individuals associated with the company
- Current operational costs
- Corporate revenue from sales
- Income of individuals associated with the company
- Current operational costs
- Investment in technology
- Investment in human resources
Margins in excess of distributed real incomes and operational costs represent funds that can be invested in innovation or expanded operations, saved or used to purchase assets.
|M = CR - (dY + oI) |
Where M is the margin
CR is corporate revenue
dY is distributed income
oI is operational inputs
The margin net of the Price Performance Levy is given as follows:
nM = M(1-PPL) |
Where nM is the net Margin
M is the Margin
PPL is the Price Performance Levy (expressed as a decimal e.g. 12% = 0.12)
This formula can be altered to embed the two accountancy categories of investment in technology and human resources as follows:
M = CR - (dY + oI + dT +dH)|
nM = M(1-PPL)
Where nT is the incremental investment in technology
dH is the incremental investment in human resources.
The Price Performance Ratio (see "The Price Performance Ratio"
) dominates the formulae that estimate the PPL (see "The Price Performance Levy"
). A company can lower the PPR by moderating output prices in response to rises in unit input costs. The unit output price response can be made more competitive by reducing the PPR and minimizing the PPL by making marginal investments in technology and human resources. This will raise unit input costs but this will secure the PPR and PPL desired.
This adjustment will require a reduction in margin so the unit prices need to be set at the level that maximizes corporate revenue (CR) and/or the margin (M). The optimized unit output prices will be established as the price reduction that maximizes revenue and/or margins which will be determined by the price elasticity of consumption (pEc) that results in the best degree of market penetration combined with revenue compensation.
Sustainability depends to a large extent on the degree to which investment is geared towards a creative transformation that improves efficiency and productivity through investment in technology and human resources so as to maintain a sustained income and employment (see "The PAC Model of the economy"
Hector McNeill is the director of SEEL-Systems Engineering Economics Lab.
IBRE - The Brazilian Institute of Economics
The Economist Newspaper
The Real Incomes Research Programme Archives (1975-2015)
SEEL (internal notes)
Updated June 8, 2015: Final section.
Updated June 17, 2015: reduced length of some sentences and added reference links within text. Added box "Temporary problems & amazing promise ..."
Updated 22nd June, 2015. Some parts rewritten but sense maintained. Several cross-references added.
Updated 23rd June, 2015: added sections entitled: "The PAC Model of the economy - the policy environment"
plus cross-references and "The mechanics"
Updated 26th July, 2015: Completely reviewed and updated.
Updated 23rd August, 2015: Minor modifications to improve clarity; sense unaltered.
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