Bruce Bartlett
With the recent announcements by WorldCom and Xerox that billions of dollars have suddenly disappeared from their previously announced earnings, investors are now focusing as much on the quality of corporate profits as their size. Economists are also wondering whether the rash of restated earnings is corrupting national economic data, such as for the gross domestic product. It appears that the problems of investors are more serious than those for the economists. That is because investor data come from corporate reports mandated by the Securities and Exchange Commission, while the Commerce Department's data on corporate profits, which are used to calculate GDP, come from tax returns. The distinction is important because the accounting is quite different in company reports and on tax returns. These distinctions are perfectly legal. Normally, however, they are not important, except when someone tries to exploit them for short-term gain, as WorldCom appears to have done. What WorldCom did is take advantage of the difference in accounting for capital and operating expenses. The former would include equipment and buildings that will last and produce profits for many years. The Internal Revenue Services requires that they be depreciated over their useful lives and not deducted all at once. The latter, such as salaries to workers, are used up in the production process and can be deducted immediately. Normally, companies fight with the IRS to be able to "expense" or write-off as much of their costs in the year in which they occurred. Bigger write-offs mean lower taxes. Thus companies tend to resist depreciating investments that they can get away with expensing, while the IRS tries to force companies to depreciate just about everything, thereby raising their tax bills. What WorldCom did was to turn this situation upside down. Instead of trying to expense capital, it capitalized expenses. It took operating expenses that should have been deducted from profits immediately and treated them like capital to be written off over a period of years. The effect was to artificially lower their costs, thus increasing their reported profits. Companies usually don't do this sort of thing because anything that artificially increases their profits also increases their taxes. The interesting question, therefore, is what did WorldCom report on its tax return? My guess is that it did the opposite of what it did on its financial statements and reported its expenses as expenses and not as capital. In effect, the company tried to have its cake and eat it, too -- reporting inflated profits to investors and real profits to the IRS. For this reason, it is likely that the IRS data on corporate profits are pretty firm relative to the softer numbers on financial statements. This is good news because the GDP data are calculated from tax returns and not from financial statements. Consequently, we can rely to a much greater extent on the profits data published by the Commerce Department than those calculated from financial statements, such as those reported by Standard and Poor's for the 500 largest companies. Normally, S&P 500 profits move up and down symmetrically with those reported by the Commerce Department. Since the Commerce data cover all U.S. corporations and not just the top 500, its figure is always much larger. In most years, S&P 500 profits equal about 40 percent of total profits in the U.S. economy. But in 1999 and 2000, they got up to 50 percent. Last year, they fell to just 32 percent, but have rebounded to 52 percent in the first quarter of this year. If the first quarter data hold up, it suggests that corporate profitability is stronger than the stock market currently believes. However, the data are likely to be revised significantly in coming months. Complete tax data are only available to the Commerce Department through 1999, and the first data from 2000 are just coming in. Revised corporate profit data will be available from the Commerce Department later this month. I believe that a very useful reform would be to require major corporations to release their tax returns to the public. This would give financial analysts and investors important data on company operations and prevent the kind of games that WorldCom played. It will require a change in law, but in the current political climate that should not be too hard. Alternatively, organizations like the New York Stock Exchange could require the release of tax returns as a condition for listing. Companies will complain bitterly about privacy and the loss of competitive advantage. But at a time when all corporations are deemed guilty until proven innocent and investors are desperate for numbers they can trust, I think it is a small price to pay. In the meantime, there is nothing to stop a company from voluntarily releasing its tax returns as a sign of good faith. I would certainly be much more willing to buy stock in such a company, and I'm sure that many other investors would, too.

Bruce Bartlett

Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.

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