The sickening plunge in corporate profits
Here is the evolution of labor compensation and corporate after-tax profits over the past 9 quarters:
Total labor compensation: $8315.3b. —-> $9049.5b. Up 8.8%
After-tax corporate profits: $1184.6b. —-> $1099.5b. Down 7.2%
So why have workers been doing so much better than corporations in recent years? And why did corporate after-tax profits plunge from $1.3 trillion in 2013 Q4 to $1.1 trillion in 2014 Q1?
I know what you are thinking. “I don’t believe those numbers. Where did you get them?” I got them from the BEA. And I don’t believe them either. And that’s why I don’t believe that nominal GDI fell 1.4% rate in Q1. Because if you look at components of gross domestic income, you get the following:
Compensation plus depreciation (reliable data): Up at a 3.7% rate in Q1.
That’s more than 2/3rds of national income. So basically the unusual (1.4%) plunge in NGDI was a story of plunging corporate profits. I know of no other data confirming that plunge. Stock prices are soaring. Corporations have been reporting very strong earnings. If someone can find non-government data supporting the claim that workers are far outperforming corporations in recent years, I’d love to see the evidence.
PS. The new revisions put Mark Sadowski even further ahead of the pack, as even he underestimated the final plunge in GDP. Q2 is just a month away.
PPS. This erratic GDP data does slightly weaken the argument for NGDP targeting, but only very slightly:
1. The idea is to target a forecast of NGDP one or two years ahead, figures that are much less affected by quarter-to-quarter data quirks.
2. This does slightly strengthen the argument for targeting total nominal labor compensation, rather than NGDP, as it seems to be much closer to what’s going on in the labor market (which was OK in Q1.)
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25. June 2014 at 09:57
A fall in corporate profits would most likely be offset by either individual or government saving (kalecki profit equation): which of those sickens you, exactly?
25. June 2014 at 10:19
Or we could just say, Sumner demolishes Piketty again.
25. June 2014 at 10:51
Kalecki? Declines in deficit? Understanding the deficit is not the only factor, but has declined substantially.
25. June 2014 at 10:55
large capital consumption adjustment for Q1
25. June 2014 at 11:01
effem, I was being sarcastic. I don’t believe for a minute that corporate profits have been falling sharply.
25. June 2014 at 12:01
Doesn’t targeting nominal labor compensation make more theoretical sense anyway? I thought the principal appeal of targeting NGDP was that it was a more convenient proxy.
25. June 2014 at 12:26
Prof. Sumner,
Is there any analysis out there of Japan and what historically happened to P/E ratios and profit margins as NGDP growth expectations rose and fell?
25. June 2014 at 13:05
If NGDP were to ever be targeted by government, then Goodhart’s Law will come into play and NGDP will no longer, assuming of course it ever was, a good measure.
GDP is not officially targeted by government, but it is heavily and quite purposefully influenced by government, as it is regarded as an “important” statistic. It is an absolutely atrocious measure of economic health. GDP is set to likely fall by 50 bps? Print and spend money on drones and police tanks, and poof, GDP no longer falls and we’re all basking in prosperity.
If NGDP were similarly affected, then say good bye to arguments like “NGDP growth is on track, therefore no significant secular problems are being caused by central bank inflation.” (Of course economists have known for decades that socialism in money sets up economies for crashes. If not sooner because of accelerated inflation, then later on as the real wall is approached).
25. June 2014 at 13:14
I’m not sure why you find this so surprising. S&P 500 earnings, operating and as reported were down 4th quarter to 1st:
http://www.spindices.com/documents/additional-material/sp-500-eps-est.xlsx
Considering that stock buybacks were up 59% in the quarter, total dollar earnings were probably down more than the EPS numbers.
Assuming the employment numbers have been correct, corporations added workers in the quarter and last I checked, S&P 500 revenue was up only about 1%. Sounds like a productivity problem to me. Could be temporary or not; I don’t know. Maybe companies added workers in anticipation of a rebound in growth. If that happens, then no problem. If it doesn’t, well….
Obviously, a drop in S&P earnings doesn’t mean total corporate profits had to fall but I’d guess it is pretty well correlated.
25. June 2014 at 13:30
Macro-economics is easy. Unless money expands at least at the rate prices are being pushed up, output can’t sold and hence jobs will be lost (the Phillips Curve’s idea in reverse).
The negative outcome from the Fed’s “stop-go” monetary mis-management is the direct result of the rate-of-change (roc’s) in money flows (proxy for inflation), falling short during both the 1st qtr of 2011 – and now in the 1st qtr of 2014. We will encounter the same problem again at year’s end.
25. June 2014 at 13:45
I was surprised that the stock market surged today — is that because the market “intuited” Prof Sumners astute insight?
25. June 2014 at 15:49
dbeach, Yes, it does make more sense.
Travis, I don’t know.
Sigmund, I agree that profits may have fallen, but no where near as much as reported by the BEA. Those are horrific numbers. If true, that would be the number one story in America.
25. June 2014 at 16:33
The erratic GDP data seems like it would be more of a problem for NGDP rate targeting (which, as far as I can tell, isn’t endorsed by market monetarists) than for NGDP level targeting. As long as we aren’t letting bygones be bygones, we can afford some tracking error, can’t we?
25. June 2014 at 16:34
There is some fancy dancing around buziness inventories that makes GDP numbers jump.
BTW, retailer 7-11 can tell you how many packs of gum sell by location in real time. I wonder if more and timely data streams could be used (confidentially) by Fed. Amazon sales? UPS deliveries? Hotel stays? Residential house sales now tracked closly by Trulia, Redfin and others…seems to me some bellweather indicators or patterns could be found…
25. June 2014 at 16:35
Speaking of mysteries, what are these guys going to do;
http://harare24.com/index-id-business-zk-14125.html
‘Zimbabwe’s Reserve Bank has surprised the investment community by setting up a monetary policy committee (MPC) as the country’s authorities no longer have a monetary unit to control.
‘….The Zimbabwe dollar became worthless more than three years ago and was abandoned by the authorities. The US dollar then became the nation’s de facto currency.’
25. June 2014 at 19:32
Jesse is right.
The BEA’s quarterly corporate profits number tries to measure true economic earnings, not accounting earnings. Special post credit crisis provisions allowed small firms to reduce their accounting earnings with larger than normal depreciation expenses so as to reduce their tax bill and thereby increase their true economic earnings. These depreciation allowances are rolling off. As such these firms are now reporting larger accounting EBIT… and therefore paying more taxes. But this has the effect of reducing their true economic earnings. Thus the big drop in the BEA’s profit number, which tries to capture this effect.
So it’s just accounting rules. Why didn’t Canada show a large drop in profits? Different rules.
26. June 2014 at 06:40
Here’s another crazy thought. Maybe the publication of Piketty’s book marks the top of the inequality debate. While the administration hasn’t gotten any traction with raising the minimum wage, that hasn’t stopped states and companies from acting independently. I just saw an article recently about IKEA raising their minimum wage by 17%. This probably doesn’t explain the recent past but it might be important for the future.
26. June 2014 at 07:34
I do not believe the number.
I have no hard evidence, but I need to see another bad Q plus some restatements. One of the more interesting historical restatements was the last two quarters of GHWB presidency. In real time, I believe GDP was flat or negative. But the final GDP numbers were plus 4% in each quarter (after Clinton won with it’s the ecomony stupid).
By probable coincidence, the last time our rolling 3 year national investment was this low was during the last few GHWB years. Public company earnings may be high, but I must retain some skepticism. Bank earnings have been propped up by low funding costs. Instead of new investment we get leveraged credit at close to bubble highs, which is moving deck chairs around with banks taking vig. I do not know why public companies earnings are strong, but it’s not because of increased investment. Their interest savings are huge and fund buy backs. I have been and am still a believer that value is “fair enough” in stock markets, but that incorporates plus or minus 20%. Plus GDP as measured is really weak given the recession. Small business formation is very low, which was predicted given fiscal policies.
I really dislike our fiscal policies. But there is always more mystery than knowledge in these areas. BTW, this is the second time in a week or so I have seen implied doubt slip into your NGDP writings, however subtle. To me, this means you are thinking more critically but are not yet willing to fully share your concerns. One quarter of GDP? And maybe NGDP ain’t the ticket?
Also, no more futures talk. There will never be that contract in the foreseeable future. In other words, futures will follow belief in NGDP, not vice versa.
That is just my opinion of course.
26. June 2014 at 09:58
Step 1: Create NGDP-adjusted bonds.
Step 2: Target their spreads vs. regular bonds.
Step 3: Win.
26. June 2014 at 10:19
The change in tax laws earlier this year regarding depreciation and expensing had a major effect.
26. June 2014 at 12:12
“I was surprised that the stock market surged today”
Stocks usually always move up as long as money increases at a faster rate than inflation.
27. June 2014 at 00:20
JP Koning,
You wrote:
“The BEA’s quarterly corporate profits number tries to measure true economic earnings, not accounting earnings. Special post credit crisis provisions allowed small firms to reduce their accounting earnings with larger than normal depreciation expenses so as to reduce their tax bill and thereby increase their true economic earnings. These depreciation allowances are rolling off. As such these firms are now reporting larger accounting EBIT… and therefore paying more taxes. But this has the effect of reducing their true economic earnings. Thus the big drop in the BEA’s profit number, which tries to capture this effect.”
This strikes me as confusing and conflicting in a number of respects, but, suffice it to say if the BEA were simply using tax accounting rules this would have the effect of *reducing* EBIT in immediate post-crisis years and *increasing* corporate profits in the last quarter. To the extent the rules actually decreased corporate income taxes, this would increase, on net, post-crisis *after tax* earnings only if the net tax reduction exceeded the extra depreciation claimed (highly unlikely because a $100 reduction in EBIT would be offset by, say, only $35 increase in after tax income).
The BEA uses as source data financial accounting reports for the current year and quarters (depreciation here is unaffected by tax law changes) and for prior years uses tax filings. The former is required because data is not available from Treasury until returns are filed. Financial accounting is not directly affected by tax law changes.
The BEA methodology is explained here:
http://www.bea.gov/national/pdf/chapter13.pdf
Important here is the BEA statement at last para on page one that their numbers are not affected by tax law changes and the more detailed explanation at footnote 8. While the BEA generally does follow tax depreciation and amortization rules as the basis for its reporting, this is because of various quirks and options available under financial accounting rules, particularly regarding intellectual property. The BEA seems to be aware from historical experience that corporate profits can be skewed by temporary stimulus measures and their reporting aims to eliminate those distortions.
It would be true that with respect to *after-tax income* BEA reports would reflect the benefit of actual tax reductions in pre-2014 years. I assume Scott got his data from Table 1.10 line 17 of the following:
http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&904=2007&903=51&906=q&905=2014&910=x&911=0
That shows a big drop in EBIT in the first quarter of 2014 (what the BEA calls PBA or “profits before tax”), but if the BEA is doing its job as explained in Chapter 13 of their methodology this should not be due to changes in tax law accounting. However, despite the drop in PBA those same figures show an increase in corporate taxes. The latter could be due in part to the expiration of stimulus measures.
It is not clear based on BEA published data what would cause the big drop in PBA. Again, if this were simply due to different tax accounting rules, you would see PBA go up, not down (line 15 of the BEA report). The drop in after tax earnings can, in part, be explained by additional taxes paid and *that* can be explained by expiring tax provisions. There may, however, be other things going on here. Part of that might, for example, that the benefit of NOL carryovers from the crisis period are being lost and current taxes are increasing accordingly even though PBA, for whatever reason, is going down.
PS. An interesting tidbit from that BEA methodology chapter is that Federal Reserve Bank profits are included in corporate profits. Those profits have been up and not down!
27. June 2014 at 04:29
Vivian, JP, etc,
I feel like you are talking past each other. If you look at the BEA release (http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm ) they are quite explicate that the missing 200B prof. Sumner was asking about is in the capital consumption adjustment, and that the change was due to the changes to the section 179 depreciation eligibility. If you look at profits after tax with and without the inventory and capital adjustment ( https://research.stlouisfed.org/fred2/graph/?id=CP,CPATAX) it seems undeniable that the changes to this adjustment from 2008-2012 resulted in a higher headline figure, from 2012-2014 in a slightly lower figure, and that Q1 2014’s changes have resulted in a much lower figure.
I cannot speak to the appropriateness of their adjustment, but it does seem to be responsible for the missing billions. However, if it is a one off blip in the data, why is it reflected on the gdp side as well with a twin ‘noisy’ number in exports? I remain confused.
27. June 2014 at 05:29
Nick,
Thanks for the links. That led to an even more explicit BEA description of its methodology:
How do the economic stimulus acts impact NIPA Corporate Profits?
Over the past several years several economic stimulus acts have become law. These acts have often contained bonus depreciation provisions and higher ceilings for small business expensing. For example, the American Taxpayer Relief Act of 2012 (or “ATRA”) provides for 50 percent bonus depreciation for qualified investments placed in service during 2012. ATRA also raises the ceiling for small business expensing under Internal Revenue Code Section 179 to $500,000. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (or “TRUIRJCA”) allowed 50 percent bonus depreciation for 2011 and 100 percent for 2010.1
BEA’s estimates of profits from current production (“corporate profits with inventory valuation and capital consumption adjustments”) are not affected by these tax acts, because profits from current production do not depend on the depreciation-accounting practices used for Federal income tax purposes. BEA’s measure of current production profits reflects economic accounting practices in which depreciation is based on an estimate of the reduction in the value of fixed capital used in the production process.
BEA begins with financial and tax based data when it derives its estimates of profits from current production. It then removes the effects of stimulus acts by the capital consumption adjustment (CCAdj). The CCAdj is the difference between the depreciation consistent with the tax code and the economic depreciation that underlies BEA’s measure of profits from current production.
BEA also publishes “profits before tax” and “profits after tax” in which tax depreciation has not yet been adjusted to an economic accounting basis. Stimulus acts provisions increase the depreciation that corporations can claim and thus reduce profits before taxes by the same amount. The reduction in profits before tax leads to reductions in taxes on corporate income and profits after tax. To offset the effect of these stimulus acts on profits from current production, BEA raises its estimate of CCAdj by the same amount. As a result, changes in current production profits are not affected by the start of these acts.
Similarly, when stimulus act provisions expire or diminish (as they did in the first quarters of 2012 and 2014), the depreciation that corporations can claim for tax purposes is reduced. Because the deductible amount summed across these years and future tax years must be equal to the cost of the qualifying property, accelerated deductions in earlier years result in reduced deductions in future years. This reduction in allowed depreciation leads to increases in profits before tax, taxes on corporate income, and profits after tax, and an offsetting decrease in the CCAdj. The decrease in the CCAdj ensures that profits from current production are not impacted by the expiration of allowable depreciation from the stimulus acts. Accordingly, changes in current production profits that occur in quarters when the stimulus acts expire are not affected by the expiration of these acts.
1 In addition to ATRA and TRUIRJCA, other stimulus acts include: the Job Creation and Worker Assistance Act of 2002 (see April 2002 Survey of Current Business), the Jobs and Growth Tax Relief Reconciliation Act of 2003 (see July 2003 Survey of Current Business), the Economic Stimulus Act of 2008 (see June 2008 Survey of Current Business), and the Small Business Jobs and Credit Act of 2010. The effects of later acts are net of offsetting bonus depreciation that was claimed in earlier years. For detailed data, see the table “Net Effects of the Tax Acts of 2002, 2003, 2008, 2009, 2010, and 2012 on Selected Measures of Corporate Profits” (PDF). BEA estimates are based on data from the Office of Tax Analysis (OTA) of the Department of the Treasury and other source data. Detailed information about Treasury’s bonus depreciation calculations is available in OTA’s working paper entitled “Corporate Response to Accelerated Tax Depreciation: Bonus Depreciation for Tax Years 2002-2004” (PDF).
“http://www.bea.gov/faq/index.cfm?faq_id=1002
The figures Sumner linked to are *after* these adjustments *for all periods* So, in effect, none of the periods reported (after these adjustments) should reflect any effects of “bonus depreciation”, either when the bonus depreciation was in effect or when terminated. This methodology would clearly explain a deviation of BEA’s numbers from numbers from other sources (without the adjustments), but it should not explain the sudden drop in the first quarter of 2014 from BEA figures using a consistent adjustment methodology over all periods.
27. June 2014 at 06:05
Everyone, Thanks for all that tax information. The question is certainly above my pay grade. But I do find it implausible that GDP would fall sharply during a period where the monthly indicators like industrial production were increasing. I suspect some sort of measurement problem.
27. June 2014 at 06:21
Scott,
This is not a problem with NGDP targeting per se, but in my view it does reflect a need for better and more accurate government econometrics and accounting. You can’t target something if you don’t know where the target is and the target is wildly and unpredictably fluctuating.
It also underscores something you’ve noted here before—one should not take too much stock in quarterly changes, at least based on the current state of that accounting.
I continue to be puzzled by the BEA numbers. The very purpose of the stated BEA methodology is to avoid the temporary and abrupt changes that can be brought about by these temporary tax stimulus measures. And yet, the explanation I hear is that the abrupt change in the after-adjustment number from earlier after-adjustment numbers was due to the very thing the BEA is supposed to be filtering out.
It is possible that the BEA’s methodology is flawed. Or, it is possible that the BEA is not following its own stated methodology. Or, it is possible that there was a change in Q1 of 2014 that reflects adjustments that should have been made earlier. But, I cannot, as yet, figure out how, if the BEA’s goal is to filter out temporary tax effects, this abrupt drop in corporate profits is consistent with that goal.
PS. We need to do something about your pay grade so you can figure this stuff out.
27. June 2014 at 06:55
Is Yglesias correct or incorrect about this?
http://www.vox.com/2014/6/27/5846430/obama-was-against-the-export-import-bank-before-he-was-for-it
“The real cost of the Ex-Im Bank is born not by the Treasury, but by everyone else. Cheaper loans for Boeing and Caterpillar mean ever-so-slightly less stimulative monetary policy for the rest of us.
……….
“if the Ex-Im Bank went away maybe the Fed would do more Quantitative Easing or other unconventional stimulus.”
27. June 2014 at 08:53
Corporate profits are the leading edge of the economy. If this sticks for another quarter we are heading for a recession , at 0 % interest rates.
If you look at the Great Recession, stocks were soaring well into the beginnings of the crisis. Stocks don’t predict much.
27. June 2014 at 08:55
-But I do find it implausible that GDP would fall sharply during a period where the monthly indicators like industrial production were increasing. –
You answered that question in the post, because of profits. And profits usually lead things like industrial production for obvious reasons.
27. June 2014 at 09:08
I know the laws people are talking about and they do not effect profits except to shift around the time table of when you pay the taxes.
If there is plunge in profit rates because of these depreciation laws it’s because profits were never that high to begin with. Which would also explain weak investment numbers.
28. June 2014 at 07:14
Vivian, I need a high enough pay grade so that I can work less and learn more about the things I’m already supposed to know. 🙂
I agree that we need better NGDP data.
Travis, That sounds like monetary offset!
29. June 2014 at 10:35
A couple of issues come to mind:
1) number assumes same number of workers.
– Population in US increased (http://en.wikipedia.org/wiki/Us_population)
– Unemployment rate of workers decreased (increasing number of those sharing the pie)
– More ‘youth’ entered market, with fewer retiring (again more people per ‘slice of pie’).
2) Businesses continue to shift ‘profits’ and taxes offshore 3) Corporate mergers move profits offshore (Softbank acquiring Sprint, Deutsche Telecom acquiring Metro PCS).
Challenge with looking at only 2 numbers assuming all others are constant in an open (since our world is flat) system. Plus the other issues with the validity of the numbers looked at in the 1st place as explored above.
30. June 2014 at 10:00
My updated thoughts on the plunge in profits.
30. June 2014 at 16:43
JP, I left a comment but I think it was deleted. Why did machine prices soar in 2014:Q1? And why didn’t the BEA data show an unusual rise in depreciation in 2014:Q1?
Cute final sentence, but of course it can’t be true, as I never went through any sort of thought process on depreciation. You must think before you can suffer illusions. 🙂
10. April 2015 at 06:07
[…] Scott Sumner has pointed out twice now, the huge decline in GDI is almost entirely due to a fall in corporate profits. Whereas employee […]