Income Inequality is an Insidious Risk but Investors Can Measure It

Income Inequality is an Insidious Risk but Investors Can Measure It

by Jaishree Singh, MSPH

November 26, 2020

Editor’s Note: The Sustainability Investment Leadership Council (SILC) is pleased to publish the following blog post by ESG Researcher Jaishree Singh, MSPH. Please contact Michael.Kraten@SaveTheBlueFrog.com with questions, comments, or suggestions about our blog, or to ask questions about our organization.

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What is Income Inequality & How Does It Affects Business?

According to a 2020 report by The Investment Integration Project (TIIP), institutional investors are reckoning with income and wealth inequality—not only because it’s a moral issue, but also because it’s “bad business.” The report found that income inequality adversely affects investment portfolios through several channels, such as: poor employee productivity, social distress, and unstable financial markets. The more unequal societies become, the more likely they are to experience uprisings, extremism, and isolationism when it comes to foreign affairs. [1][2] In short, financial and social systems are deeply connected. Income inequality stresses these systems, which causes market volatility and diminished returns. Therefore, investors must use ESG frameworks to screen companies that present social risks related to their employees and community.

How Do We Measure Income Inequality?

Global Bodies

Groups like The World Economic Forum (WEF), OECD, and the World Bank use the Gini coefficient to measure inequality or the factor by which the richest people earn more than the poorest in a given country. [3] According to the WEF, income inequality has risen since 1990 in many countries. [4] The U.S. has the most inequality out of the top G7 nations (e.g. UK, Italy, Japan, Canada, Germany, France). [4][5]

But the fact that inequality has decreased in other countries, like Portugal and Scandinavia, suggests that rising inequality isn’t inevitable as economies become more advanced. [4] The Gini coefficient, which ranges from 1 (perfect equality) to 0 (total inequality) is measured using the disposable income per person in a household. [5][6] Other statistics such as: national population, GDP per capita, and 10-year average GDP growth help contextualize the Gini coefficient. [7] S80/S20 compares the income/person of the top 20% to the bottom 20%. [5][6]

ESG Frameworks

Investors who incorporate environmental, social, and governance (ESG) frameworks into their practice might recognize income inequality as falling somewhere between “S” and “G.” The “S” refers to metrics that impact employee wellbeing and the broader community while “G” refers to management ethics.[7] A 2018 U.N. PRI report found that ESG investors recognize that positive company performance on S and G factors influence their “employee relations.” Good employee relations improve valuations in that satisfied employees are likely to stay with the company and contribute human capital for longer. Parnassus Endeavor Fund tracks “employee relations” when selecting portfolio companies, which they believe helped them achieve superior returns (12.2%) to the S&P 500 (8.9%) between 2005-2018. [8]

A 2020 report by the World Economic Forum discussed 50 ESG metrics associated with sustainable value creation, 34% of which can be associated with income inequality. [7] Under the theme of promoting “global prosperity,” the WEF listed metrics such as: rate of diverse employment, investments in employee training and health, R&D, taxes paid, investments in community infrastructure, and “vitality index” or the amount of gross revenue generated from recent products, indicating a trend toward greater innovation. [8] On the “G” side, the company discussed metrics such as: the compensation gap between company CEOs and their average worker, racial/gender diversity on the board, propensity toward corruption, inclusion of risk/opportunity metrics into business processes, delivery of company purpose/mission, and achievement against strategic milestones.[7]

Investment Bodies

Investors are increasingly turning to organizations that examine corporate ESG behavior. JUST Capital, a non-profit created by billionaire Paul Tudor Jones II and Deepak Chopra ranks companies by how well they treat their workers and broader community.[9] The organization has unique metrics that account for factors like income inequality, consumer safety, community development, environmental protection, and business ethics. For each category of factors, JUST surveys the American public in order to create KPIs for each.

JUST defines income inequality along several metrics, such as: paid parental leave, paid time off, diversity and inclusion, gender pay equity, day care services, flexible hours, career development, and tuition reimbursement. According to a recent JUST report, disclosure isn’t just a win for workers, but for companies. In 2018, only 65 out of 890 public U.S. companies disclosed income equity data, but those companies experienced a 1.2-3% three percentage bump in ROE compared to companies that didn’t disclose this data. [10]

Generational Poverty

The growth in U.S. income inequality can be traced back 40 years to when wages began to stagnate for most Americans. Specifically, the U.S. economy doubled but only the top 1% of wage earners saw their income grow. From 1970 to today, the bottom 50% of earners still make about $16,000 annually while the richest 1% now make $1.3 million (from $400,000). American CEOs now earn 300 times more than an average worker, compared to 20 times more in 1965. [1]

Today, more than 43 million Americans live below the poverty line, leading to food insecurity, unsafe housing, lack of access to healthcare, and depleted savings. These cascading effects exacerbate desperate circumstances for those in poverty: 1 in 5 children, disabled and mentally ill individuals, and populations of color (1 in 4 African Americans, 1 in 5 Latinx). [1] Even within the middle-class, white families grew their net worth significantly compared to black families—a gap of $100k in 1992 to $154k in 2016. This pushes 70% of middle-class black children into poverty as adults. Racial income divides are expected to drive more than $1-1.5 trillion in GDP losses between 2019 and 2028, diminish economic agency among minorities, and increase rates of cyclical “generational” poverty. [11]

The U.S. and other OECD countries have observed a rise in “generational poverty,” or poverty that affects 2 or more generations. [12] These circumstances extend the time in which families spend meeting immediate needs (e.g. food, housing), delaying education, squandering savings, and remaining marginalized. [1][13] According to a 2020 U.N. report, it would take 5 generations for children living in low-income families to earn their country’s average income.[12]

How Income Inequality Arose – Changes in the Definition of “Work”

Multiple drivers led to stark income inequality in the U.S., but changes in the “nature of work” has posed perhaps the greatest influence. More jobs today are part-time and without benefits, such as those within the “sharing economy” (e.g. Airbnb, Uber, independent contractors). Also, automation, robotics, and computer software might replace 47% of American jobs in the coming years (e.g. particularly repetitive, clerical tasks like in transport, office administration, manufacturing). As a result, “middle-skill jobs” will begin to disappear in favor of higher-skilled jobs. [1][14]

Not everyone in the middle-class can afford to “upgrade” their skills when affluent Americans are more likely to be accepted to elite colleges and training programs. Also, Congress has not increased the $7.25 minimum wage to keep up with inflation; its value has dropped 16% over the last 50 years. Labor union participation is at its lowest point (~10%) in the last 40 years. It might be due to increased intimidation from managers. [14] MIT Economics professor, David Autor, says that “some inequality is needed but dynamism shouldn’t turn into dynasticism.” In other words, market incentives reward risk taking and hard work, thus creating some inequality. But too much inequality in favor of “winner take all” keeps the rich at the top, shoving 99% of us to the bottom and underground. [15]

How Investors Can Address Income Inequality

In order to address these risks, investors can integrate new criteria into their investment decisions: good employee relations, fair corporate tax policies, and alternative compensation models. [2] First, investors must demand that corporations disclose information in accordance with the Human Capital Management Coalition and the Workforce Disclosure Initiative, such as: employee wages, benefits, training, retention, and union relations. Mending employer-employee relations will improve company morale, productivity, and retention. [2]

In the 1990s, corporations only paid 2% of GDP in taxes; in 2003, they paid 1.2%.[2] In 2018, Amazon, Delta Airlines, General Motors, and IBM actually earned rebates instead of paying federal taxes. [16] Investors should support federal policies that require corporations to pay their fair share of taxes and allow the government to redistribute this wealth. [2] Finally, investors should use proxy voting to pass alternative compensation models. [2] CEO pay rates are wildly out of balance with the average worker, but also the way these figures are calculated must be changed. Instead, company workers across the hierarchy should all be rewarded for making decisions that benefit the entire ecosystem of stakeholders (e.g. suppliers, community, environment), not just the stock price. [2]

Income inequality is a serious investment risk. Investors have the power to change this paradigm and protect their portfolios through proper screening, advocacy, and proxy voting. Corporations have long relied on savvy accounting to avoid accountability and taxation. [12]

In the face of the 2020 election, investors should understand that 99% of Americans drive the economy, but their voices are being drowned out. Private and corporate wealth have helped elect politicians that prioritize non-sustainable business at the cost of the middle class, thus perpetuating this system. [12] It’s in investors’ interest to elect candidates that dismantle this system in favor of a more equitable economy.