Confronting corporate welfare

In the crusade to trim federal spending, it's business's turn to face the knife. But which funding programs? And how far should we go?

On November 22, 1994, Robert Reich, then U.S. Secretary of Labor, issued a challenge to Washington's public policy "think tanks" to identify business subsidies he characterized as "federal aid to dependent corporations."(1) Along with the many social welfare programs being targeted for reduction or termination by the incoming Republican-controlled 104th Congress, Reich believed that "corporate welfare" subsidies would provide considerable fuel for deficit reduction. Reich challenged congressional Republicans to terminate inappropriate federal government involvement in the workings of the U.S economy.

Secretary Reich's call to action was answered the following year with corporate welfare "white papers" issued by the libertarian Cato Institute, the centrist Progressive Policy Institute, and the liberal Center for Responsive Law and Essential Information. The reports' findings and recommendations were stunning. The Cato Institute identified 125 federal programs that subsidize business to the tune of $85 billion annually. The Progressive Policy Institute found 121 spending and tax subsidies benefiting specific industries that, if eliminated or reformed, would save $265.2 million over five years. Not to be outdone, the Center for Responsive Law and Essential Information's report uncovered 153 federal business welfare programs totaling $167.2 billion in taxpayer subsidies for Fiscal Year (FY) 1995.

How did corporate welfare endure under a Republican congress and a Democrat president? According to Cato Institute analysts Stephen Moore and Dean Stansel, it came out of the budget debate relatively unscathed. Of the $19.5 billion budgeted for the 35 least defensible programs identified by the Cato Institute, Congress cut only $2.8 billion (or 15 percent) for FY96. Moore and Stansel found that many programs were reduced nominally or not at all. Meanwhile, although President Clinton called Secretary Reich's proposal an "attractive idea," he clearly articulated that he did not endorse cutbacks in benefits to business. In fact, Moore and Stansel found that the Clinton administration actually proposed increased spending in the 35 least defensible programs. And the White House vetoed Republican budget bills because Republican reductions in corporate subsidies were deemed too large.

Defining Corporate Welfare

The condemnation of corporate welfare across the political spectrum may lead one to believe--incorrectly--that the definition of this concept is universally understood. But as we will see, the ideology of each public policy think tank or public interest group colors the definition of what constitutes "corporate welfare."

The Cato Institute defines corporate welfare as special government subsidies or benefits that are targeted to specific industries or businesses. It can take the form of direct government grants, loans, insurance, or subsidies provided to businesses; trade barriers designed to protect U.S. firms in particular industries from foreign competition at the expense of American consumers; or a loophole in the tax code carved out solely for the benefit of a particular company or industry. However, tax provisions that are universally available to all companies and industries, such as allowing faster write-off of capital equipment or a general tax cut for business, are not included in the definition.

The libertarian interpretation of the federal tax code differs markedly from liberal interest-group interpretations of federal corporate tax policy. The liberal definition of what constitutes corporate welfare often includes universal business tax provisions that are deemed inequitable, especially when comparing the corporation's "ability to pay" with the tax burden placed on other segments of American society.

The Progressive Policy Institute defines corporate welfare as subsidies that benefit specific industries, with the proviso that there may be offsetting social or economic policy reasons for preserving certain subsidies. The definition includes direct spending subsidies, direct and indirect tax subsidies, trade protections, and anticompetitive economic regulation as the conceptual elements of corporate welfare.

The Center for Responsive Law and Essential Information includes the following elements in its definition: (1) direct payments to companies; (2) provision of public goods and services without adequate compensation from companies; (3) federal purchases from companies of goods and services at more than market value; (4) federal tax breaks for businesses; and (5) business exemptions from laws.

A real-world example of a corporate welfare consensus is found in a "Dirty Dozen" list of federal subsidies and programs jointly issued in June 1995 by the three institutions. The list--which affects agriculture, defense, and construction industries, among others--constitutes the core elements of corporate welfare targeted to specific industries and firms: direct subsidies, tax breaks, regulatory exemptions, and trade protection. The three institutions unanimously recommended that this list of programs and subsidies be eliminated or significantly reduced from FY96 and future budgets. Anticipated savings over the subsequent five years were estimated at between $16.2 and $18.5 million.

The value of private businesses in the United States

The vast majority of businesses in the United States are privately held, and approximately 99 percent meet a common government definition of "small." However, we know surprisingly little about the market values of these organizations. In this paper, we estimate the market value of privately held firms in the United States from sources on earnings, assets, and reported market value of multiple forms of business entities, including corporations, partnerships, LLCs, and sole proprietorships. We discuss various theoretical and practical methods of valuing assets, including those arising from economics, neoclassical finance, portfolio theory, and tradition. Concluding that most of them are not appropriate for valuing private firms, we use insights from dynamic programming and ratio analyses from traditional technique to produce a new estimate based on reported taxable earnings, net worth, and tax filing status. Using this approach, we estimate that privately held U.S. firms had earnings that exceeded those of publicly held firms in two recent years by a significant margin. Moreover, the market value of these firms exceeded that of publicly traded firms. We also conclude that policymakers, perhaps grossly, underestimate the true scale of "small" and privately held firms in the economy.

Keywords: valuation, small business, private business

**********

The market values of publicly traded companies are tracked on a daily basis by millions of investors, and "the stock market" is the subject of intense and nearly continuous media exposure. However, privately held companies employ the majority of workers in the United States, and produce the majority of the output. We know surprisingly little about the market values of these organizations, especially when compared with their publicly held counterparts. Such ignorance places policymakers, investors, and workers at risk when they make vital decisions about the economy in general and their individual roles within it. In particular, this lack of knowledge compromises the ability to make informed decisions in all the following matters: entrepreneurial management decisions; lending decisions where private firms (or firms that may become private) are involved; investment decisions by portfolio managers; pension decisions by both pensioners and pension fund managers; actuarial projections that involve private firm investments; public policy debates over "social security" and other assets available over the long term to fund retirement income; economic development policies for states and regions; and national tax and economic policy.

Ignorance of the market value of privately held companies also undermines many of the practices of modern finance, in which the stock market is used as a proxy for the total value of investment assets. In particular, the Capital Asset Pricing Model (CAPM) and other descendents of the mean-variance framework rely heavily on a simplifying assumption about investments: that the stock market serves as a valid proxy for the universe of equity investments available, and therefore the risks and returns of publicly traded stocks are the relevant focus of portfolio decisions by these investors. This will be discussed further below.

In this paper, we assemble data from a variety of sources on the assets, revenue, and earnings of privately held firms. Using these data, and employing a mixture of techniques, we estimate the market value of privately held firms in the United States, which may be the most important economic statistics for which there are no direct empirical data. We also demonstrate a methodology to revise this estimate in the future, and offer some suggestions for improving it.

In Section 1 of this paper, we assemble data on the number of business entities operating in the United States, define "privately held" companies, and distinguish them from other "business" entities. We also review stylized facts about "small" businesses. In Section 2. we survey the numerous classes of entities that file business tax returns, and categorize them into publicly held firms, privately held firms, and nonfirm business entities. In Section 3, we review the few available indicators of the value of businesses in the United States, including the Flow of Funds, stock market indices, and the Survey of Consumer Finances. Finally, in Section 4. we use all the foregoing material to estimate the market value of private firms, using several methods. We also compare our estimate with available direct and indirect estimates of the value of public and private firms. Section 5 closes with conclusions, some possible extensions, empirical tests of the findings, and limitations. We also include an appendix that surveys the valuation methods.

1. Information on Privately Held and Publicly Traded Firms

Most news media provide daily news about the major stock markets in the United States. However, the "stock market" includes only a small fraction of the firms in the United States. These are generally, though not always, larger and longer-established firms that have chosen the corporate form of organization for the advantages it offers to professionally managed firms that need capital investments on a large scale. As we will demonstrate below, far more firms, with larger earnings, are outside this well-publicized subset of American businesses. We start our analysis of privately held firms by looking at the available data on firms and their value.