As the stock market struggles to maintain a sustained rally, the
critical question is whether we are seeing a rebound in corporate profits.
Ultimately, stock prices are based on profitability. Therefore, stock prices
are not going to rise unless and until profits do.
More fundamentally, profits are what make the U.S. economy run.
It is why people invest, start businesses, hire workers and take risks. Even
those on the far left admit this. As Robert Kuttner, editor of The American
Prospect, recently noted, corporate earnings are "one of the most important
indicators of a thriving economy."
Unfortunately, the rate of profit in the U.S. economy has been
trending downward for decades. According to a new report from the Commerce
Department, the rate of return on corporate capital averaged better than 10
percent in the 1960s. But in the 1990s, it was one third lower, averaging
6.3 percent. Even at the height of the 1990s economic boom, profits peaked
at just 7.8 percent in 1997. By contrast, profitability reached 12.1 percent
in the 1960s.
Thus it appears that there is less fuel for the stock market
today than there was a generation ago. In the long run, this will mean less
investment, lower productivity, fewer jobs and a lower standard of living
than we would have if corporate profits were higher.
Fortunately, after-tax profits have not fallen as much as
before-tax profits. Whereas gross profits have fallen by about a third since
the 1960s, after-tax profits have only fallen by about a quarter. In the
1960s, after-tax profits averaged 5.9 percent; in the 1990s, they averaged
4.3 percent. Last year, after-tax profits were down to just 3.3 percent.
It is not entirely clear why the tax wedge between before tax
and after tax profits has declined. On the one hand, the corporate tax rate
has fallen from about 50 percent in the 1960s to 35 percent today. But on
the other hand, corporations no longer get the Investment Tax Credit.
Previously, firms could deduct 10 percent of investments in capital
equipment directly from their tax payments in the year in which the
investment was made.
A more likely explanation for the relative decline in corporate
taxation is that companies changed the way they operate so as to reduce
their tax liability. The most important change is that corporations today
raise far more of their capital from borrowing than they used to. Since
interest payments are tax deductible, whereas dividends are not, this
reduces their taxes.
Others point to the growth of so-called tax shelters. Evidence
for this has been found in the growing gap between the profits corporations
report to the Securities and Exchange Commission -- known as book income --
and those reported to the Internal Revenue Service. According to a recent
IRS study, the difference between total book income and net taxable income
rose from $92.5 billion in 1996 to $159 billion in 1998.
Of course, there are legitimate reasons why corporations would
report different profits to the IRS and SEC. Indeed, the law requires them
to do so. But there is a suspicion that companies are aggressively
exploiting tax saving opportunities to the detriment of the U.S. Treasury.
Alternatively, however, companies may be overstating their book income in
order to boost their stock prices, as companies like Enron and Worldcom did.
In other words, the gap between book income and taxable income
may not be the result of tax shelters, but because profits were being padded
on financial statements. Further research is clearly needed to sort out the
issue, but there is no reason to assume that tax shelters are the only
Of greater importance, in terms of the economy, is that all
measures of corporate profitability have fallen over time. Indeed, to the
extent that companies have been able to offset some of the decline in gross
profits by using the law to reduce their taxes, it has moderated the decline
in after-tax profits.
At the end of the day, after-tax profits are what matter,
because that is what is left over to finance investment and pay the
dividends upon which stock prices are based. Since it is not clear what the
government could do to raise the overall level of profitability, it must
necessarily concentrate on cutting taxes so as to raise after-tax profits.
Treasury Secretary Paul O'Neill believes strongly that the
corporate income tax should simply be abolished. He has said that he may
make some proposals in this area after the election. Some Democrats are also
coming around to the idea that corporate taxes should be cut. Former Clinton
economic adviser Gene Sperling, for example, has called for reinstating the
Investment Tax Credit, which was abolished in 1986.
Hopefully, O'Neill's initiative will lead to a serious policy
debate on the role and importance of corporate profits in the economy and
ways in which tax policy can boost them.