Corporate Profits and Relationship to Investment

Abstract

Profits play a crucial role in business investment and the equity market. The former has a major impact on long-term GDP growth and in business cycle analysis. The equity market, on the other hand, affects both investment and, via the wealth effect, consumer expenditure. But profits are one of the most volatile variables in the economy. Accordingly, they play a key role in long-term growth trends and in business cycle analysis. Until very recently a prevalent view was that the long-term decline in profitability that took place from the late 1960s to the early 1980s had been reversed. Such a decline was associated with the heyday of trade union power and the interference of Keynesian-type demand management with laissez-faire economics. Defenders of such policies attributed the decline to the two oil shocks that redistributed income and wealth from the oil-consuming to the oil-producing countries. There was a strong belief that neoliberalism invigorated the power of the market mechanism and managed to reverse the long-term decline in profitability.

The corporate profits discussed here are not shareholder reported earnings. They are the profits that are based on National Income and Product Accounts (NIPA). This measure of profits is designed to gauge the economic profitability of current operations. It excludes a number of one-time charges that appear in shareholder reports and, importantly, records options as an expense, albeit at the time of the exercise. Although this treatment of options is not ideal, it is arguably superior to their treatment in shareholder reports, where options are generally not treated as expenses at all. NIPA profits closely approximate those obtained from reports submitted for tax purposes, and, for obvious reasons, corporations tend not to inflate taxable earnings.