SEPTEMBER 01, 1979 by JOHN SEMMENS
Mr. Sammons is an economist for the Arizona Department of Transportation and is studying for an advanced degree in business administration at Arizona State University.
A widely forecast recession did not occur in 1978. The Carter Administration stood practically alone in its insistence that there would be no recession. So, when the year ended with healthy gains in reported corporate profits there was much rejoicing, right? Well, not quite. It seems that while prosperity is a circumstance to be much sought after, profits—one of the symptoms of prosperity—are a "catastrophe" that the body politic cannot abide.
There is no rejoicing. Instead, the occasion serves to stimulate demands for mandatory profit controls from union potentates, while the President seems intent on providing an opportunity for in-house economists to grope for new meaningless phrases to describe and defend government economic policy.
The most amazing aspect of the whole spectacle is that so much inspiration could be generated by an event which never occurred. There was no increase in corporate profits in 1978. When adjustments are made to account for the effects of inflation, net profits actually declined by 4% rather than increasing by 16%, as the reported figures seem to imply.’
This discrepancy between reported and real profits is one of the less ambiguous government accomplishments of recent years. On the one hand, a manipulative monetary policy has facilitated a phantom doubling of nominal profits over the last decade. On the other hand, a tax code which makes no provision for the declining value of each dollar, allows the government to confiscate ever larger portions of the nation’s wealth. It is the old story of crime and punishment. Only in this case, while it is an agency of the federal government which robs the holders of money of their purchasing power, the punishment is dished out to the productive sector of the society.
Such a policy, though it may be temporarily expedient in the aggrandizement of government power, has significant negative effects on the general welfare. The progressively worsening bouts of stagflation, with each episode more unnerving than the last, are a manifestation of the future that such a policy portends.
It is possible, one must suppose, that the originators and executors of this counterproductive treatment of business profits are unaware of the damage wrought or, at least, that they discount its seriousness. However, a supposition of this sort must border on the absurd, given both the extensive discussion of the issue in academic and business circles, as well as recognition of the need to warn investors of the distortions to a firm’s reported financial condition evinced by the Securities and Exchange Commission.
In May of 1976 the S.E.C. issued ASR 190, which required publicly held corporations to prepare additional financial statements estimating the impact of inflation on reported financial results. Thus, the business firm’s access to equity financing is being stymied from all sides. The Internal Revenue Service, ignoring the effects of inflation in creating imaginary profits, siphons off retained earnings. Meanwhile, the S.E.C., citing the effects of inflation, is warning off would-be investors from providing external sources of equity finance.
Since the counterproductive policy persists, despite its absurdity, we must demonstrate more convincingly its effects and why it is imperative that it be changed.
The most convincing evidence we would cite to illustrate the seriousness of the problem is the lack of progress in the stock market. The Dow Jones Industrial Average, the most famous of stock price indices, has failed to advance much above 1000 in the past ten years. In fact, the DJIA now stands lower than it did ten years ago. This is in spite of a near "doubling" of earnings over the span.
Customer’s men and stock market touts are not the only ones to be mystified by the "sick" market. Looked at from the standpoint of the "value" of the assets owned by the firm, it would appear that shares are undervalued. The ratio of market price to book value is about half of what it was a decade ago. And since the nominal return to equity is approximately the same as it was then (about 12% on the Dow Jones Industrials), the shares must be worth twice as much, right? Wrong, the shares’ price-to-earnings ratios are halved and the number of companies whose shares sell for amounts less than tangible book value is substantial.
An obvious case of market irrationality, it would seem. Unless, that is, one is willing to consider an alternative hypothesis. What if it is not the market that is out of step with reported earnings, but rather, the reported earnings which are out of step with an "efficient" market? There are sufficient grounds for such a hypothesis in economic theory. At the root of the capitalistic theory of the economy is the presumption that given a reasonable period of time, the market is the most effective and efficient allocator of resources. Now, if a cost level adjustment to the reported financial statements of a sample of firms were made for the years 1967 through 1977 and the resulting figures appeared to more closely conform to the market value of the shares, then would it not be logical to conclude that the sickness is in profits and not the market?
For the purpose of evaluating the above hypothesis, the earnings and market values of the 30 companies which now compose the DJIA were compiled for the ten-year period. Use of these firms is defended on the grounds that combined they account for nearly 15% of the total earning power of all U.S. non-financial corporations. This is a significant slice of the total economic pie in this country.
Using an unweighted average of common stock earnings divided by average market prices of DJIA shares, we find an apparent rise in rate of return from 6.4% to 10.0% between 1967 and 1977. The return on common stock, by this measure, has increased substantially. However, if we adjust earnings to reflect the effects of inflation on the firms’ depreciation reserves for long-term assets, an entirely different picture is revealed. In this case we find virtually no change in the return on common stock. In 1967 the rate was 5.2%, while in 1977 the rate was 5.4%.
"As a consequence of the U.S. tax system, inflation unambiguously reduces incentives to undertake new investment projects, and therefore, business investment spending declines."2 It would appear that the chickens of Keynesian monetary manipulation have come home to roost. American investors can no longer be duped into accepting nominal rates of return which conceal lower real rates of return.
Despite demagogic rhetoric attacking "obscene profits" and "tax loopholes," an examination of real earnings portrays a much different story. Even though inflation effectively reduces income, the tax code makes no allowances for the reduction in real income. As a result, the after tax return to equity takes a beating. In the last decade real after tax return to equity dropped by over 50%, i.e., from over 10% to under 5%. Meanwhile, the effective tax rate on real income has soared to over 70%. Far from escaping "fair" taxes and piling up "windfall" profits, American corporations are being progressively bled dry.
This rising effective tax rate has been cited by numerous studies of the tax consequences of inflation. The important consequence, of course, has been the powerful disincentive for capital investment that is created. The real reduction in return that occurs when cash flows can recover only the original historical cost of fixed assets leads, quite naturally, to a more negative assessment of investment pay-offs, and therefore, to less investment.
Ostensibly, the accelerated depreciation schedules that the IRS allows are supposed to offset the tax effects of inflation. While this may have been an adequate resolution of the problem 20 years ago when inflation rates were more modest, it does not provide much help today. An article in the Federal Reserve Bank of St. Louis Review found that the presence of a negative inflation effect was independent of depreciation methods used.3 A similar conclusion was reached by Richard Kopcke.4 Whether one used straight line or sum-of-the-years digits depreciation under high inflation rates, the difference was minor, i.e., with an equipment life of 10 years and an inflation rate of 9% per annum, the difference in present value of the streams of cash flow under the two depreciation methods was only 1%.
Neither is the investment tax credit adequate to overcome the penalty resulting from taxation based on historical cost recovery depreciation allowances. A study by Parker and Zieha showed that under inflation rates of recent years, even an investment tax credit of 10% was not sufficient to offset the negative incentives of the basic tax codes.
The Real Crime
A look at the earnings performance of the 30 DJIA companies will serve to indicate the magnitude of the disincentives produced by the taxation and inflation combination. After adjustment for inflation, every company has experienced a decline in return on equity between 1967 and 1977. For the entire period, profits were overstated by 29 to 55%, (using weighted and unweighted averages respectively). A year to year comparison reveals the growing distortion in reported figures. In 1967, nominal earnings were overstated by only 8 to 16%. However, by 1977 nominal earnings were overstated by 66 to 116%.
These phantom earnings are, of course, taxed as if they were real. In 1977, out of a pre-tax net income of $39 billion, $28 billion went to cover tax liability, $10 billion was paid out in dividends, and only $1 billion was retained to facilitate company growth. The ratio of taxes to real retained earnings in 1977 was 28 to 1. For each dollar these firms retained for future expansion, $28 had to be set aside for government consumption. This compares to a calculated ratio of $3 in taxes for every $1 in retained earnings in 1967.
Excessive taxation is the real catastrophe, not corporate profits that are "way too high." The retained earnings of the 30 companies used in this study amounted to less than .3% of the total assets of these firms. Since it requires at least $80,000 in real capital (adjusted for the effects of inflation on replacement costs) to support each job, the total employment-generating capacity of these firms from internal sources was 13,000. If this phenomenon can be said to be typical, then the total number of jobs that could be generated by the retained earnings of all U.S. nonfinancial corporations in 1977 was fewer than 90,000. This equates to an employment growth rate of one-tenth of one percent.
These figures may shed some much needed light upon the great mystery of modern economic orthodoxy: the simultaneous occurrences of high inflation and unemployment. Keynesian monetary manipulation assumes that more inflation means less unemployment, and vice versa. This theory relies heavily on the presumption that nongovernment investors are dopes. This, of course, is the fatal flaw in the system. Independent economic actors will seek to protect themselves against the losses resulting from investments penalized by inflation.
Job-Creating Programs Consume Available Capital
The progressively worsening results of monetary manipulation have been compounded by the implementation of various public job creating programs. If $80,000 in capital can provide only one job in the private sector, then $80,000 ought to be able to make work for at least five persons if it is simply spent by the government on salaries. Such a simplistic solution ignores the lesson told in the golden goose fairy tale. Private capital normally earns a return in excess of its cost. Over an extended period, the $80,000 in capital would not only regenerate itself, but provide an increment for the expansion of the enterprise and employment. In contrast, the government program which consumes the $80,000 to create five jobs is exhausted within one year. Repeated resort to consumption-based job creation must inevitably erode the long-term employment opportunities of the economy.
There can be little question that inflation and taxation lead to a lower rate of capital formation. Output is reduced, but the question is: by how much? One researcher called the total social welfare loss resulting from the current tax treatment of earnings on capital "astounding." His estimate of the yearly welfare loss was $50 billion. The chief victims of this loss are working people. The punishment of capital and the reduction of returns on capital also reduce the returns on labor. Consequently, upward mobility and an improving standard of living are hampered by the poor returns on capital investment. These consequences are no less real merely because they are unintended. Policy makers would do well to remember this point the next time they seek to punish corporate "profiteers."
The persistent reliance on inflationary policies has created what may be the most difficult problem to reverse—inflationary psychology. The penalties inflicted on thrift and productive investment have nurtured an "eat, drink and be merry for tomorrow we die" philosophy. It was Keynes himself who said "in the long run we’re all dead." True to his word, Keynes is dead, leaving the rest of us to reap the harvest sown by policies based upon his theories.
The "long run" of 1935 is here today, with all of the distortions and disincentives that Keynes’ early critics predicted. More and more, we see purchases made in order to avoid higher prices later. This rush to acquire hard goods increases the proportion of malinvestment. The earlier one commits to a specific investment, the less certain one can be of the future. This in itself would tend to lower return on fixed assets, even were inflation to be ended.
Further, manpower and resources are diverted to nonproductive pursuits. The deterioration of monetary assets impels an increase in money velocity and paper financial transactions, as firms and individuals seek to minimize cash balances. This creates a demand for financial services in great excess to what would be necessary under a more stable monetary unit. These transactions consume resources that might serve more productive ends. In addition, managerial talent must be directed, at least in part, toward coping with the problems of inflation and its tax consequences. This diverts talent from dealing with matters that could be of more substantive benefit to our material well-being.
Possibly the most damaging effect of the inflation-taxation policy is the destruction of truth in both financial reporting and policy discourse. The disintegration of the monetary unit goes a long way toward invalidating corporate annual reports. Even worse, this distortion pollutes the price system and upsets the balancing and allocating functions performed by this system.
But the lowest blow of all is the contribution this policy makes to the deterioration of public policy debate. The whole "advantage" of a deliberate provocation of inflation is the element of deceit based upon the "money illusion." The money illusion concept is an illustration of Keynes’ contempt for the intended victims of government manipulation of the money supply. People are not astute enough, Keynes reasoned, to perceive the erosion of purchasing power in the monetary unit. As long as the nominal dollar amounts of their incomes remained unchanged or higher, they would not react to protect themselves from the effects of inflation of the money supply. Disciples of this "money illusion" theory attempt to trick the economic units in society into pursuing actions they would not ordinarily take. This makes dissemblers of our public policy spokesmen. How can a political system based upon democratic decision-making operate when the citizens must be fed lies as a matter of course in the implementation of national economic policy? One critic even goes so far as to claim that the whole process is intentionally dishonest—not for the people’s own good, as apologists might argue—but for the express intent of increasing the government’s tax take.’
The Ultimate Punishment
We have examined the effects of inflation and taxation on corporate profits. There can be little doubt as to the negative consequences. Corporate profits are, as a result of inflation, overstated. Since the tax code makes no allowance for inflation, profits are then overtaxed. Real earnings are substantially reduced.
The penalties against earnings from capital investment have, naturally, discouraged such investment. This portends a rather dire future for the United States economy. Discouragement of investment shrinks the capital stock. If the effect on the 30 DJIA companies we have examined is representative, then the economic growth capacity of private business in the United States is less than 1/3 of the rate of population growth. If the long-term standard of living is to rise, or at least avoid a decline, more capital must be created. This is precisely what the government’s policies on inflation and taxation are preventing.
Perhaps the greatest irony of the manipulative monetary policy has been the rising value of that "barbarous relic"—gold. At the same time that stock prices and the return on productive assets have declined in real terms, the price of gold has surged. The inflationary monetary policy spawned by Keynesian economic theory has done more to promote the resurgence of the "barbarous relic" than all hoarders and speculators could ever have hoped to achieve. Which only goes to show that in the long run, crime does not pay.
1"Profits ’78—Inflationary Razzle-Dazzle", Citibank Monthly Economic Letter (Apr., 1979), pp. 5-10.
‘John Tatom and James Turley, "Inflation and Taxes: Disincentives for Capital Formation," Federal Reserve Bank of St. Louis Review (Jan., 1978), pp. 2-8.
‘Richard Kopcke, "The Decline in Corporate Profitability," New England Economic Review
(May-June, 1978), pp. 36-56.
5James Parker and Eugene Zieha, "Infla‑
tion, Income Taxes and the Incentive for Capital Investment," National Tax Journal (Vol.
XXIX, No. 2, 1976), pp. 179-189.
6Michael Boskin, "Taxation, Saving, and the Rate of Interest," Journal of Political Econ‑
omy, (Apr., 1978), pp. 3-27.
‘Harry Johnson, "A Note on the Dishonest
Government and the Inflation Tax," Journal of Monetary Economics (July 1977), pp. 375-377.
Plunder by Fraud
The world is not sufficiently aware of the influence that sophistry exerts over it.
When the rule of the stronger was overthrown, sophistry transferred the empire to the more subtle, and it would be hard to say which of these two tyrants has been the more disastrous for mankind.
Men have an immoderate love of pleasure, influence, prestige, power—in a word, wealth.
And, at the same time, they are driven by a powerful impulse to obtain these things for themselves at the expense of others.
But these others, who constitute the public, are impelled no less powerfully to keep what they have acquired, provided that they can and that they know how.
Plunder, which plays such an important role in the affairs of the world, has but two instruments: force and fraud, and two impediments: courage and knowledge.
FREDERIC BASTIAT, Economic Sophisms