Corporate Profits
Yes I am playing with FRED. My thoughts about the graph after the jump.
First isn’t that a long name for a time series ? Profit measurement is controversial. Non-accountants such as myself are afraid to even go there.
Wouldn’t you have guessed a larger ratio ? So much effort seems to be directed at making that number high but it is 0.07 of total domestic income. Where does the rest of capital’s share of value added go ? OK I will try to answer. First a significant fraction of capital’s share of gross income is not net income at all — it is the cost of depretiation of capital (about 15% of GDP). Second some of it goes to creditors of corporations (bond owners and banks) as interest not to shareholders as profits. Indirect taxes aren’t negligeable — some of the value added which doesn’t go to employees goes the the IRS. Finally “corporate” — a large section of the economy but not all of it.
The ratio is amazingly stable (except for the great depression of course). In particular, it didn’t trend up during the period in which the income share of the top 1% shot up. Also it declined and reached a post depression minimum during the Reagan Bush years. Like all the other evidence, the graph suggests that Democratic presidents are good for business. During the perid in the graph, the corporate income tax was effectively slashed from a major source of revenue to the current sick joke. This means that pretax profits used to be a much higher of gross domestic income than they are now.
The ratio is procyclical (of course) but in an odd way with peaks of corporate profits’ share midway through expansions. This very much fits a Phillips curve type story with sluggish wages and wage inflation accelerating during an expansion.
The recent increase seems tiny compared to all the fuss, during the recovery the share increased by 0.6% of GDP.
Is there any relationship between “profit” on this graph and what companies report as profit on taxes?
Count me among those who are skeptical of the corporate profit figures. I don’t really understand the accounting either, but it seems to me that most corporations have largely figured out how to reinvest their profits in the company without having them treated as taxable profits.
For example, say that a company was going to spend $100 in a given year improving its software in order to be more competitive long term and $200 on all other expenses. In that year, it makes $400 in revenue. Is its profit $100 or $200? How do we reliably determine whether that $100 spent on improving the software is retained profit being reinvested or whether it is just a cost of doing business? If the money invested in building up the product can be treated as an expense, then corporations would have a huge incentive to just reinvest all of their profits to avoid all taxes, right?
Anyways, that is probably just my ignorance on display, but any help getting my head around it would be appreciated!
Actually that is where capitalization of software comes in. In particular that kind of software is a capital asset and the company recovers depreciation on it. This is where accrual accounting differs from cash accounting. It is just like if a company buys an expensive widget, they don’t in general expense the item, rather they capitalize it and depreciate it over the number of years involved. (This is because the cash flow statement is not used to determine profits) When I worked in the IT department of a big company software with a life of over two years had to be capitalized and depreciated (along with tangible items).
The rules say that software has a 4 year life so in you example you would have a depreciation of $25 from the development. But depreciation is deducted before profit is calculated So it would not show up in the profit. So in your example the profit is $175. (before taxes)
Essentially the idea is that you deduct the percentage of the asset
that is used up from revenues in determining profit and loss.
Thus an income statement (simplified)
Revenue 400
expenses 200
depreciation 25
profit 175 before income taxes
Income Tax 61.5
After Tax profit 113.75
(I assumed straight line deprecation in the example but other methods exist)
You have still spent the money to acquire the software (already, or according to a schedule of payments which may differ from your depreciation expense schedule). Depreciation/amortization is a process to match the timing (normally along a straight line) of revenues with spending on capital assets that are theoretically in use in the process of earning those revenues. Tax dep/amort is a political football with no relation to any normal accounting concepts, and pretty much arbitrary and almost always accelerated methods (assets become “useless” faster under tax accounting than normal financial accounting).
Matching of the timing of revenue recognition and expense recognition is one of the lowest level core concepts in non-cash accounting (accrual accounting).
Depreciation isn’t “fake” it’s a timing shift.
Great. Thanks guys, that makes sense.
Okay, There is a series of Corporate Profits After Tax with Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj) and a series of Corporate Profits After Tax (without IVA and CCAdj).
They pretty much track each other and if you squint your eyes and look at the graph a little sideways in the way economists do you could convince yourself that the one with is lagging the one without.
But explain this to me, I transformed both to % of GDP. And I got what we have been told that corporate profits have done, doubled since 1980 as a percentage of GDP. From about 5% to over 10%. I don’t know how to insert graphics into comments, but here is my FRED graph,
http://research.stlouisfed.org/fred2/graph/?id=CPATAX
Does increase in corporate profits as a % of GDP actually mean an increase in company profits as a % of GDP, or does it mean that there is a shift to corporate structures in the mix of businesses earning profits?
To clarify that thought a little more, if I am the only owner of a business, I can either incorporate it, or I can choose to not incorporate it. If I don’t incorporate it, then it is a “sole proprietorship” and the income comes directly into my own personal tax return, and is probably indistinguishable from any other individual earned income. The same is true of a partnership or limited partnership business, and in some cases even a limited liability company.
Professional corporations, corporations, etc, are themselves taxpayers. So the business form can influence the % of GDP of corporate tax filer profits, even though the % of GDP of total business profits may remain the same, just by trends in the business form of businesses.
We know that there has been significant retail consolidation, and the same is probably true of manufacturing, and there may also just be a general trend towards companies being formed as corporations or other taxable entities instead of pass-through entities.
Further given that most business confers limited liability as a benefit, i.e. you can’t go after the business owners assets in many cases if the business is an LLC, LLP or full corporation, it makes sense for any business to incorporate. As noted LLCs and LLPs pass thru, taxes as do chapter S corps. I recall reading that most corps in the US are chapter S corps not chapter C corps that pay taxes. However an S corp must file form 1120 and send K-1s to its shareholders (limited to a max of 100)
The data for the FRED chart used in the post comes from the BEA’s NIPA Table 1.10 Gross Domestic Income by Income Type. Table 1.10 has separate lines for Proprietors’ Income (partnerships, LLCs and S corps?) and Rental Income of Persons (real estate partnerships?). This is a link to Table 1.10 :
http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&910=x&911=0&903=51&904=2003&905=2013&906=a
The companion Table 1.11 displays the data as a percent of GDI.
The S corp is the business organization form used very widely for franchises. There is only one McDonald’s Corp ( c corp) but there are over 3000 McDonald’s franchisees (s corp).
The capital consumption adjustment is the difference between the changing value of capital assets and the accounting depreciation of those assets. Playing with this number is one of the oldest games with the books. You can even out good and bad years or you can keep paying dividends for decades, issuing the last checks the day before the bankruptcy filing.
So Robert can you add a second graph with interest income? I am very interested, because I speculate that the increasing size of the financial sector, is because the financial sector de-facto owns (mostly as collateral) an increasing share of the economy.