Crawl Across the Ocean

Monday, March 21, 2005

Corporate Profits

Back on January 20, I analyzed a TD Economics study which was complaining that, despite significant increases in GDP/capita, Canadian's after-tax income hadn't increased much in the last 25 years.

I figured that the GDP growth had to be going somewhere and wrote:

"Anyway, the next question is what about the difference between 25.5% growth in GDP/capita and 9.3% growth in after-tax income. Since GDP is a measure of total income for the country, any growth that didn't go to people would have to either go to corporations or to the government. While the study notes this, it doesn't say anything further about the change in corporate income over this period - which seems pretty odd. Maybe corporations caused some of this gap and maybe they didn't, but if figuring out the source of the gap is the point of your study, wouldn't you want to look into it?"

At the time, I didn't really have any data on corporate profits so I left it at that, but I recently ran across the Feb 12-Feb 18 issue of the Economist which had a couple of articles (subscribers only) on corporate profits as a % of GDP. Here are the relevant quotes:

"UBS, a Swiss Bank, estimates that in the G7 economies as a whole, the share of profits in national income has never been higher. The flip side is that labour's share of the cake has never been lower."

and

"Over the past three years American corporate profits have risen by 60%, wage income by only 10%."

not to mention,

"there is another factor that might have raised the return on capital relative to labour in a lasting way, namely the integration of China and India into the world economy, along with their vast supply of cheap labour. To the extent that this increases the global ratio of labour to capital, it will lift the relative return to capital."

Now to be clear, I have no problem with corporations making profits or even much of a problem with corporate profits increasing as a % of national income (the one drawback being that given the unequal distribution of share ownership, this leads to greater inequality), I'm just putting this out there for the record so when you hear right wing folks blaming high taxes for the low dollar, the high dollar, the lousy weather, the breakdown in family values, the poor quality of television programming and the fact that after tax income hasn't grown at the same rate as GDP growth, you can point out that - at least for that last one - there's more going on than high taxes, and that corporate profits taking a bigger piece of the pie is a big reason why wage growth has been slow in recent years.

As a long term goal going forward, it would be ideal for all members of society to earn income from a mix of wages and share ownership so we could end the artificial divide between owners and workers but that's probably a long way off.

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posted by Declan at Monday, March 21, 2005

7 Comments:

  • I'd like to see some more data specific to Canada, but here's a thought.

    Corporate profit is a measure of reduced investment. A corporation has two choices with "extra" money: they can reinvest, or they can declare profit. Usually there is some combination of the two. Generally though, higher profit taking means that CEOs in general are either more pessimistic about future profit (take the money now), or they believe investment is already maximized.

    In the case of the oil companies, there's probably a good dose of the second. But given the corresponding low investment in Canada, that tells us that CEOs in G7 companies are inclined to take their profit now, thank you very much.

    Wonder if that has anything to do with the emergence of China and India?

    By Blogger Ginna, at 12:45 PM  

  • "I'd like to see some more data specific to Canada, but here's a thought."

    I don't see why Canada would be different from the G7 but I agree all the same. The best I can find is:

    "The share of corporate profits in total GDP has expanded significantly, to almost 14 percent - the highest since Statistics Canada began collecting this data." -

    from the CAW in September, 2004.
    (http://www.caw.ca/news/factsfromthefringe/issue88.asp)
    It begs the question of when Statscan started collecting the data, and it would be nice to see the StatsCan data itself but still.

    "Corporate profit is a measure of reduced investment."

    Huh, wouldn't investments go on the balance sheet and not affect profitability? The whole point of accrual accounting is to declare profits when they happen and not when you choose to 'take' them.

    If there's any reason to discount the profit figures, it's because companies are doing some iffy accounting and are saving up for a big writeoff some year.

    By Blogger Declan, at 1:51 PM  

  • Great stuff! keep it up.

    By Anonymous Anonymous, at 3:08 PM  

  • 14% GDP as profit does not sound too extreme to me, but maybe that's because I am in the process of starting my own business.

    The point of accrual accounting is to declare *revenue* when it occurs, not profit. Profit by definition does not *occur* until the time you take your snapshot, e.g. year end or quarter end.

    Here's the key: taxes and dividends

    Profits are taxables, investments (in general) can earn tax credits and are expenses in some way (capital, labour etc.).

    Corporations who declare large profits are under intense pressure from shareholders to distribute the profits, so the money many not be available for future investment purposes. Therefore, if you forsee a large investment in equipment, R&D, or labour, it's best to identify it immediately, and reduce the profit.

    This is not a game, nor an iffy accounting practice.

    Investments, by the way, are expenses. The balance sheet is the accounting equation: assets = liabilities + shareholder equity.

    Financial statements track revenue, expenses and therefore profit.

    By Blogger Ginna, at 5:47 PM  

  • OK, we're off topic, but that's OK.

    "The point of accrual accounting is to declare *revenue* when it occurs, not profit."

    You have to declare both revenue and expenses in the period they occur. And since profit = revenue - expenses...

    "Therefore, if you forsee a large investment in equipment, R&D, or labour, it's best to identify it immediately, and reduce the profit."

    If the expense hasn't happened yet, you can't use it to reduce your current profit - that *would* be an iffy accounting practice.

    "Investments, by the way, are expenses."

    If you invest in an asset (actually that is redundant - the distinction between investing and plain old spending is that spending qualifies as an investment if it is spent buying assets), the asset goes onto your balance sheet and the transaction has no impact on your revenue, your expenses, or your profit.

    "Corporations who declare large profits are under intense pressure from shareholders to distribute the profits, so the money many not be available for future investment purposes. Therefore, if you forsee a large investment in equipment, R&D, or labour, it's best to identify it immediately, and reduce the profit."

    The shareholders own the corporation. Mangement's job is to work on their behalf, not to work against them.

    By Blogger Declan, at 10:21 PM  

  • "Great stuff! keep it up."

    thanks!

    By Blogger Declan, at 7:05 PM  

  • Sorry for the late comment, but Blogger comments kicked me out a few times last week. Third time's a charm!

    Okay, say I'm the CEO of a small to medium-sized high-tech company, with 300 employees. We manufacture, um, power supplies. We have twenty products, of varying ages. This year sales have been really great, and we are nearing the end of the third quarter with a good amount of cash on hand.

    Now, I have a few choices at this point.

    A) If I think the good times will continue, at the end of the quarter, I can declare that things are going well, and I forsee big profits this year and next. I assume this will mean my shareholders will want a piece of the pie, and expect to pay out dividends, thus reducing next years' cash on hand. My share price will probably go up. Everybody wins now, and we revisit the situation next year.

    B) If I don't think the good times will continue, I can issue say so in the statements, and expect to keep the cash as a "war chest". I therefore declare profits, but no dividends in the near future. My share price will probably drop, and shareholders will be unhappy.

    C) I can go to the board, and say "look, I think the future looks good, which makes this the perfect time to start a 2-year R&D project, launching the next generation of power supplies". What that means in the short term is that my cash on hand is reduced immediately through investments in infrastructure (computers, desks, test equipment, software), and now and ongoing in labour. The project will reduce the cash on hand for the next 24 months, but I expect to come out the other end with some highly marketable products, which will carry the company forward. No dividends, and maybe not even an immediate share jump, but definitely in the long-term interests of shareholders.

    Maybe in 2 years it will be time to invest even further if the good sales continue.

    Now, if I am very optimistic about the medium to long-term future, C is the obvious choice.

    If I am only optimistic about the immediate future, but have my doubts about farther out, I will choose A. If I think the economy is going to hell in a handbasket, I will choose B.

    There's no "working against shareholders", or iffy accounting - you make decisions based on your belief in the future. If I am confident a significant investment in R&D is in the immediate future (3-6 months), I would be negligent if I paid taxes on the profits, and then turned around and invested the money left over in infrastructure and an increased workforce.

    Bringing this back to topic, I repeat my original point. Large and sustained corporate declared profits mean the majority of CEOs are choosing option A. Take the money, don't worry about significantly growing the business right now.

    Some of these are in mature industries, where large growth in not likely in any case. But most are not, which tells me that as a group, corporate heads are pessimistic about the medium and long-term future.

    By Blogger Ginna, at 11:08 PM  

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