After-tax profits

Posted: Oct 18, 2002 12:00 AM
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 explanation. 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.