Rethinking Shareholder Primacy in the New Innovation Economy

There is growing evidence that incentives that reward short-term interests of corporate shareholders can skew management decisions away from long-term investments in research and development and worker training. Over time, this behavior can degrade the shared ecosystem for innovation and hamper the nation’s economic competitiveness and security. This analysis challenges the concept of the longer-term efficiency of “shareholder primacy”—a prevailing theory in corporate governance, which holds that shareholder interests should be prioritized relative to all other corporate stakeholders—because these interests are often realized by harvesting the current crop without sowing the seeds for the next season. This assessment also strengthens the view that corporate actors as well as the public have a shared interest in the long-term health of a robust innovation commons and that incentives facing corporations should be aligned with these goals.

Indeed, policies that reward the maximization of shareholder value over the short term have encouraged the wholesale offshoring of production in leading industries to lower wage economies and decreased domestic investments in a skilled technical workforce. These actions have resulted in an uneven geographic distribution of the economic benefits of scientific research and innovation. Despite the spectacular growth of innovation clusters in some U.S. communities, this prosperity has not been felt across many of the nation’s regions—widening the gap between those highly performing clusters and the “rest.” At a macro level, the data is at best inconclusive as to the extent that the United States’ largest and innovative firms have benefited U.S. households in general.

Further, some analysts point to this widespread disenfranchisement with the high technology drivers of the U.S. economy in explaining a decline in the nation’s social and political cohesion. They highlight the fraught U.S. political environment, growing environmental threats, and rising racial tension as evidence of this phenomenon.

Reevaluating Shareholder Primacy

These troubling developments are prompting a reevaluation. The mantra of shareholder primacy, which has captured the U.S. business community’s mindset over the past 50 years, is now being reconsidered as firms think beyond what the stock market wants today and toward a framework that rewards building a more sustainable, innovative corporation that invests in its employees and surrounding community.

In a significant move, in 2019 the Business Roundtable, backed by nearly 200 American CEOs, announced the adoption of a new Statement on the Purpose of a Corporation which declared that firms would shift away from a solely shareholder-focused posture to one in which shareholder value is balanced with a focus on long-term value creation via investing in employees, communities, and other stakeholders. This shift also reflects a realization that investment in stakeholders through higher levels of corporate, social, and environmental engagement create better innovation outcomes and profitability for firms.

Policymakers are also questioning the primacy of shareholder value as a defining pillar of corporate governance. Senator Marco Rubio (R-FL) argues that the concept of shareholder value is weakening the country and leaving an opening for geopolitical rivals like China to assert a greater role in global affairs and technological leadership. In a 2019 report titled American Investment in the 21st Century, Rubio states “Our adversaries are wasting no time in securing their own economic futures. . . . We need to build an economy that can see past the pressure to understand value-creation in narrow and short-run financial terms, and instead envision a future worth investing in for the long-term. Our future strength, security, and prosperity depend on it.”

Milton Friedman’s Legacy

The “invention” of shareholder primacy was popularized by Milton Friedman, an influential post-war macroeconomist. From his perch at the University of Chicago, Friedman sought to cast human selfishness as the key to maintaining the primacy of the United States’ free enterprise system. Offering this opinion in the New York Times, Friedman wrote in 1970 that executives who pursued a goal other than making money were “unwitting puppets of the intellectual forces that have been undermining the basis of a free society these past decades” and were guilty of “analytical looseness and lack of rigor.” Most influential, however, was his claim that “a corporate executive is an [employee] of the owners of the business, namely the shareholders.”

Though never codified, shareholder primacy came to define the corporate philosophy of the last several decades. However, with a mixed record of success that many agree no longer fits the current times, the popularity of shareholder primacy reached its zenith in the last decade and has been in steady decline since.

Shareholders versus Stakeholders

In a March 2022 Senate hearing “Examining the Impact of Shareholder Primacy: What it Means to Put Stock Prices First,” Stanford University economist Joshua Rauh stood by Friedman’s legacy. Citing data that shows how in the past 50 years the rise of shareholder primacy has coincided with U.S. real per capita GDP increasing 132 percent to almost $64,000 per person—the highest for all nations of a population of at least 10 million people—Rauh noted that “most benefits of U.S. stock returns accrue to U.S. households” because “they own 38% of the U.S. stock market directly and about an additional 28% through mutual funds and ETFs (exchange-traded funds).” Further, he noted that those with a pension fund own another 11 percent of the stock market—the benefits of which also accrue to households. Simply put, just over 68 percent of households are shareholders, either directly or through pension funds, business ownership, or ownership of non-residential property. Moreover, more than 80 percent of the companies that go public in the United States have negative earnings, yet they raise billions from investors and venture capital every year. If anything, Rauh concluded, such macro data highlights a lack of short-term thinking regarding immediate shareholder return.

Yet, the story on the ground is different. Although many Americans do hold shares in the nation’s firms, they do not exercise the prerogatives of ownership in a meaningful way. Owning shares formally entitles the holder to a stake in the firm’s decisions, but this power is severely diluted because most individuals own only a tiny stake in a particular company, invest in diversified portfolios, and buy and sell stock based on limited knowledge with, often, the goal of realizing short-term gains.

Given this asymmetry, firm managers are incentivized to push up the short-term price of their shares, often by stripping the value of longer-term, shared resources. Rules that tie share prices to managerial compensation and bonuses further intensifies this effect, prioritizing short-term gains over long-term investments in social, environmental, and innovation capital.

Firm managers may also attempt to maximize share price in the short term by outsourcing labor to low-wage economies. Rather than investing in raising the efficiency of the local workforce, they may rely on short-term contracts to avoid the costs of paying employee benefits. The recent rise of the “gig economy” is a concerning example of this effect.

Moving Beyond Politics

Ongoing quibbling over corporate environmental, social, and corporate governance investments (ESG) obscure and politicize the more fundamental issue of aligning corporate interests with national priorities in long-term competitiveness, national security, and welfare. The aforementioned March 2022 congressional hearing on shareholder primacy question was, for example, diverted to examine the claim that abandoning shareholder primacy would give managers the power to arbitrarily invest corporate money towards particular partisan social and environmental goals, rather than towards profit-maximization for those American households who own shares and expect a reasonable return on that investment.

Yet, it is important not to confuse what some call the “feel-good capitalism” tied to the ESG phenomenon with the deeper issue of “stakeholder capitalism.” The latter reflects a basic recognition that shareholder primacy incentivizes short-term gains over long-term investments. Devoting serious attention to a more integrated system that includes input from nonprofits, boards, customers, employees, lenders, regulators, and others might guide corporations to make sound long-term investments that ensure the wellbeing of U.S. innovation and manufacturing ecosystems and the workforce and local communities that depend on the vitality of these shared resources.

Alexander Kersten is a deputy director and fellow with the Renewing American Innovation Project at the Center for Strategic and International Studies (CSIS) in Washington, D.C. Sujai Shivakumar is director and senior fellow of the CSIS Renewing American Innovation Project.

Commentary is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2022 by the Center for Strategic and International Studies. All rights reserved.

Alexander Kersten
Deputy Director and Fellow, Renewing American Innovation Project
Sujai Shivakumar
Director and Senior Fellow, Renewing American Innovation Project