Though the stock market is hitting new highs, many people are less than impressed. It’s commonly believed that the Federal Reserve’s $85B per month spending on mortgage backed bonds is all that is holding things up more than reality. That was backed by the big rally after Bernanke announced the program (aka QE3) would not “taper” in the near future, but continue.
But the truth is that corporate profits are at levels that they have never been before, meaning that there is underlying value in the stock market that is driving the rise. More importantly, corporate profit margins (profit over gross revenues) are also at unknown highs. It points to not only how we get out of the job shortage that is the reason the Fed keeps buying, but also the most obvious ways to close the budget deficit – and gives a little more definition to the boomtimes that probably like ahead in the 2020s.
Before we get into the details, the background is essential. The Bureau of Economic Analysis (BEA) has been keeping track of corporate profits since the 1930s. We’re not entirely sure how things went before that, and most people only use their data since WWII. The share of the total economy that appears as corporate profits (after taxes) is shown below in their data from 1947:
Corporate profits were never above 10% of the economy before 2006, and the current 10.8% is a record by a wide margin. Since WWII the average has only been 6.3%. But what does this mean?
Corporations can do several things with their money. They buy another business, give it to the shareholders as a dividend, or they can spend it on more employees and equipment to grow their existing business. All of those are legitimate, deductible expenses – “profits” are more or less money that they are sitting on as cash. A lot of profits is actually a bad thing, in a way, because it means that businesses are slow to invest in what they do. If they prefer to realize it as profits, and subject it to corporate taxes, it’s a sign of a lack of faith in the economy or themselves.
Dividends are another matter, of course, and usually only happen when shareholders demand them. But it’s the other way that money stops being “corporate profits” and becomes “personal income”.
One of the things that Barataria has been watching for in 2013 is the wave of hiring by big corporations that will come once they start having faith in the economy and its potential for growth. As earnings from 3Q13 come in we’re seeing about 7.5% increase over 3Q12, which is huge. By just about any measure, corporations do have a lot of money. And as shown in this chart below, using data from Zacks Investment Research, margins are also at historic highs:
Typically, a high margin shows a business that is worth investing in. That means that people are hired, the business expands, and the margins gradually fall back down to a more normal level – but the overall income is higher. Not so right now. Net margins well over 8%, which used to be rare in the non-finance world, are now almost expected – and they are projected to keep climbing. Note also that finance, which was once much more profitable than anything else, is now much closer to “normal”.
What will it take to restore confidence? Again, while this is hardly a time for austerity (just ask the Federal Reserve!) a reputable path towards a balanced budget in 2017 would help a lot. That would be about the time stimulus would not be as necessary, especially if corporate profits are unleashed into a wave of hiring and expansion. If this would be so good for business, it only makes sense that corporate taxes, now at a historic low as a share of revenue, would be the best place to look for balancing the budget in the first place.
Higher corporate taxes would discourage realizing profits and encourage spending them on expansion. While that may sound really difficult to get past Republicans, combining it with tax deductions for dividends (the other way money passes into income) and a dramatic simplification (reducing the cost of compliance with the tax code) could make it palatable.
No matter what, it is clear that we are in a very different era for corporate profits, and they should be treated differently than they have in the past. It’s very much worth thinking through as a matter of tax policy – and how the flow of that cash can become the logical replacement for the buying program that the Fed wants badly to start tapering off as soon as it can.
This post was written by Erik Hare and originally published on Barataria. Follow Erik on Twitter: @wabbitoid.
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