Corporate Taxes, Accounting, and Profit Trends: Continued
Corporate Profits and Population
The Cold Light of Reason
Examination of Federal Reserve flow of funds accounts shows that there was no reason to expect that corporate profits would continue to expand at the rate of the early 1990s.
Although before-tax profits rose 8.7% per year during the 1990s, household disposable income increased only 5.2%, while consumption of goods and services rose only 5.7%.
Continued acceleration of corporate profits defied commonsense.
Why should profits continue to increase faster than household income and spending?
Nonfarm nonfinancial corporate before-tax income increased 6.7% per year, on the average, from 1952 to 1989, while household disposable income increased 7.9% a year.
This suggests that over long periods, corporate profits (for the entire country) should be logically linked to improvements in household income.
Since corporations cannot indefinitely increase profits without a correspondingly more prosperous clientele, the slow growth in disposable household income in the 1990s foreshadowed an eventual end of the boom.
Falling Corporate Tax Rates
Much of the improvement in after-tax corporate profits during the 1990s was due to falling taxes.
Effective corporate tax rates (calculated from the flow of funds accounts) dropped from 33% in 1990 to 27% in 1999.
The average effective corporate tax rate in the 1990s was 29.6% compared with an average rate of 40.6% in the years 1952 to 1989.
However, companies did not pass tax savings to consumers, but instead increased profit margins.
For the trend of declining corporate taxation to continue, company taxes would need to drop to twenty percent by 2015 and to zero by mid-century.
There was no basis for such an expectation.
Illusions of Wealth in a Bubble
The artificial pumping up of stock prices by corporate buybacks gave the public the illusion of wealth, reducing the incentive to save.
During the Great Bubble, Americans helped boost corporate profits by borrowing more and saving less.
Americans helped boost corporate profits by borrowing more and saving less.
Household debt increased at an annual rate of 9.8% during the 1990s, compared with the lower 5.2% annual increase in household income in the same period.
The unusual rise in personal debt contributed to the 8.7% annual increase in before-tax corporate profits during the 1990s.
During the 1990s, the annual increase in household savings (income less consumption) fell to only 2.2%, compared with 7.8% during the years 1952 to 1989.
A growing portion of corporate earnings was related to profits held in offshore subsidiaries. During the 1990s, on average, offshore operations accounted for 15.7% of before-tax earnings, compared with 6.2% during the years 1952 to 1989.
Globalization of American business brought greater dependency on conditions in emerging markets.
Crises in Mexico, Russia, and Asia during the 1990s influenced U.S. corporate income. Offshore profits as a percentage of earnings fell from a peak of 24% in 1991 to 13% by 1999.
Declining corporate income taxes and higher margins had driven the growth of profits in the 1990s and could not continue for long.
The drop in profits after 2000 was unavoidable since household spending and income had been growing at a slower rate than profits.
Growth of corporate profits over the last two decades of the century was not so great as to justify price-earnings ratios that exceeded long-term norms.
Claims of extraordinary profits were unfounded.
The Last Straw: Phony Accounting
Furthermore, not only was there reason to doubt that earnings growth was sufficient to justify the extreme stock price levels of the 1990s, but there were grounds to question the accuracy of reported income.
Accounting scandals at Enron, WorldCom, and other public companies in the early years of the twenty-first century suggest that some earnings growth was fictitious.
Corporate managers, whose remuneration was linked to earnings, were motivated to use permissive accounting standards to embellish financial reports.
Corporate managers were motivated to embellish financial reports.
Executives of major U.S. corporations were paid in stock options dependent on share prices.
Accounting rules allowed cash to be diverted to inflate stock prices and support executive options without being recorded as expense.
Executives had reason to overstate profits, although such puffery was harmful to long-term shareholders. With flexibility provided by Generally Accepted Accounting Practices (GAAP), no one knew for certain the degree to which income was inflated.
Some have estimated that during the Great Bubble, corporations overstated income by as much as fifty percent. Because of the steady erosion of the value of money, a portion of corporate profits did not represent a real gain to investors.
For increased earnings to be good news, profits must grow faster than inflation and growth must be sustainable.
Despite the claims of the Federal Reserve regarding low inflation rates, there is reason to doubt the usefulness of the Consumer Price Index as a deflator for those in the investor class. (See the essay,"Fiddling the CPI")
Are There Enough Profits to Go Around?
Corporate profits do indeed define the wealth of shareholders.
Under Workers' Capitalism, progress should be measured not in terms of total corporate profits, but as profits per capita.
For a nation to be stock rich, corporate profits must increase each year at least at a rate that matches the increase in the investor population. Otherwise, there will be fewer earnings per investor and the portfolio of the average stockholder will decrease in intrinsic value.
When the number of investors grows faster than corporate profits, the supply of equity investments (measured in terms of available corporate profits) fails to keep up with demand, prices rise, and average investment merit falls.
In the last half of the 20th century, the number of shareholders in the United States increased more than ten times, much faster than the expansion of corporate profits.
After 1950, the number of American shareholders grew much faster than corporate profits.
However, let us ignore the increased distribution of equity holders and simply ask,
"If the distribution of shareholders was the same in 1950 as in 1990, would the average shareholder be better or worse off?"
This would answer the question, "Were profits really that good in the 1990s?", without the distortion of the enormous increase in the percentage of Americans owning shares.
To correct for illusionary gains caused by inflation, we need to adjust total profits for changes in the Consumer Price Index (although we have reason to suspect the accuracy of this measure.)
Further, we need to use before-tax profits to eliminate the distortion due to the long-term decline in corporate tax rates.
We come up with the following graph:
The blue line indicates that from 1958 to 2002, American nonfarm, nonfinancial before-tax corporate profits, in real terms, on a per capita basis, fluctuated around a level trend line.
The graph shows that per capita real profits varied, with peaks in 1966, 1978, and 1997.
Although real per capita profits rose in the 1990s, the rate of increase was similar to that of the years 1961-1966 and 1970-1979.
The peak in 1997 did not even bring per capita real earnings to the 1979 level – the bad year of Jimmy Carter’s stagflation.
Although real per capita profits increased during the Great Bubble, the improvement did not justify higher price earnings ratios than in 1978, 1966, or 1955.
Essay: continued >
