Corporate Profits and Relationship to Investment

Abstract

Reported earnings in the second half of the 1990s showed a dramatic improvement in profitability, which was interpreted as the reversal of the long-term decline in US profitability. However, National Income Accounts did not confirm this argument at that time, which financial markets ignored entirely. The ‘governance crisis’ that ensued confirmed that creative accounting was mainly responsible for that interpretation. Consequently, the question of whether the US economy is still characterised by long term declining profitability is pertinent. A further question is whether this decline might reverse itself with the current recovery. The alternative interpretation would be that any improvement might be temporary in view of the US long-term trend of shifting production overseas. We address these issues in this chapter.

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 expensed 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.