Profits: How Much Is Too Little?

By David B. Tinnin

Profit is today a fighting word. Profits are the life blood of the economic system, the magic elixir upon which progress and all good things ultimately depend. But one man's lifeblood is another man's cancer.

--Economist Paul A. Samuelson

And so it is. Profits are called by many names these days, many of them bad. Obscene, exorbitant, excessive are the leading pejoratives. By contrast, nonprofit has gained an altruistic, almost hallowed connotation. Psychologically, that prejudice may be understandable, but economically it makes no sense. Profits can, of course, be immoral--if they are exploitative, for example, or result from price-fixing schemes or monopolies. But most profits are not so earned. Instead, they are an essential and beneficial ingredient in the workings of a free-market economy.

Nobel Laureate Samuelson addressed his pugnacious remarks to a forum of European and U.S. business leaders and economists at Harvard earlier this year. At the invitation of Management Expert John Diebold, the leaders had gathered to discuss new challenges to the role of profits in Western economies. Almost without exception, the speakers testified to the pressures and pinches now afflicting the profit system. In some instances, most notably Sweden, Socialist governments are levying confiscatory taxes on corporate profits and insisting upon huge contributions to pension funds, which in turn are being used to buy up the companies; "fund Socialism" was the term Swedish Economist Erik Lundberg employed to describe the process. In Britain, the Labor Party's left wing continues to demand the nationalization of shipbuilding, aircraft production and banking--in disregard of the fact that most of Britain's already nationalized industries are chronic money losers whose inefficiencies are a major cause of the country's dismal economic plight. In West Germany, the unions still support the profit motive but are demanding a more decisive voice in how earnings are allocated between workers and shareholders.

In the U.S., attacks on profits are more rhetorical than real. No excess-profits tax has been levied on U.S. corporations since the Korean War. In fact, the regular federal tax on corporate profits has been lowered over the past three years from 52% to 48%. Hardly anyone questions the basic right of business to make some profit. The question has been, how much?

With the resurgence of corporate profits, that question is likely to be posed more often and more insistently. Opinion polls suggest that a majority of the public believes that corporations earn much more than they actually do, and favor higher taxes on profits. Hence, it would behoove Americans, too, to rid their minds of what Samuelson characterizes as the suspicion that profits are "an exploitative surplus which fat men with an unfair penchant for arithmetic skim from the gross national product."

Dark suspicion of profit is an ancient turn of mind. Within Western culture there are deeply ingrained philosophical and religious misgivings about the morality of profits--most simply put, that to earn from the labors of another is an intrinsically evil form of extortion. Michel de Montaigne, the 16th century French thinker, entitled one of his essays "The Profit of One Man Is the Damage of Another." His thesis: "Man should condemn all manner of gain."

However, as the era of capitalism dawned two centuries ago, the profit motive found an able defender. In The Wealth of Nations, Adam Smith argued that profits are the legitimate return for risk and effort and that the "Invisible Hand" of market forces would convert private greed into public benefits. A century later, Karl Marx was not so sure. Arguing the opposite view, he asserted that labor, not capital, was the essential ingredient that added value to goods or raw materials in the manufacturing process. Thus, in his view, profit was the "surplus value" that the capitalist unjustifiably tacked on to the real worth of the product. In the early part of the century, Bernard Shaw and his fellow Fabians contended that profits should be taxed into oblivion in order to create a new, socialist order. They believed that the profitless economy would function more effectively--and they were wrong. Since the onset of the Industrial Age 100 years ago, profits have proved to be indispensable to a prosperous economy.

In a capitalist economy, profit is, above all, the motivator.

Without a hope of reasonable profit, no one would start a business, introduce a new product or service, or even continue producing an old one. And without the reality of profit, no business in the long run can keep itself alive--except by government subsidy, which has to be paid partly out of taxes levied on the profits of other businesses. Says Democratic Senator William Proxmire of Wisconsin, often a critic of U.S. business: "Profits are what drive this great economy."

There are, of course, other ways of organizing production.

Communist nations manage to achieve growth by following detailed output and investment plans drawn up and enforced by a state central planning agency. But the state-owned economies in

Communist countries are almost always disjointed by bureaucratic stupidity. The most frequently cited example is agriculture. It is true that the Soviet Union suffers from natural handicaps, including bad weather and arid soil. Even so, the basic problem is its communal farming system, which fails to provide the farmers with sufficient motivation. The dismal results are well known; Moscow must buy huge tonnages of grain from the profit-seeking farmers of the U.S.

Profit is also important as a measure of efficiency in industrial enterprises--a way of keeping economic score. Whether a business is well or badly run, whether investments are productive or misguided, whether the products are competitive and appealing--judging performance without reference to profits is like watching a baseball game where nobody bothers to count runs. Again, the Soviet experience has demonstrated the efficacy of profits. For years a Soviet factory manager fulfilled his quota under the central plan by turning out a certain amount of goods regardless of expense or popular demand. But now, in order to improve quality and control costs, most Soviet-bloc countries have set up managerial systems that rely heavily on profits --though they are called, of course, by other names.

Whatever their role in the Soviet-bloc economies, profits are essential to the smooth functioning of American society. Government services, from the federal to local level, rely crucially on corporate income and property taxes. U.S. corporations paid $40.6 billion in federal income taxes last year and an estimated $6.6 billion to state and local governments. For Washington, a decline in corporate profits would immediately cause a larger budget deficit. For state and local administrations, money-losing companies can mean reductions of public services, ranging from dirty streets due to a lack of funds for sanitation men to layoffs of teachers.

The profits that are left after taxes are either paid out as dividends to stockholders ($32.1 billion in 1975) or reinvested in the business ($33.2 billion). Most of those profits that are turned into dividend checks are then taxed a second time, as income, when they reach the shareholders' mailboxes--an excess that Democratic Presidential Candidate Jimmy Carter says he disapproves of.

There is an old myth, which should have been laid to rest decades ago, that dividends flow mainly into the pockets of wealthy individuals. Actually, there has been a historic if little heralded shift in the pattern of share ownership. In terms of dollar value, nearly half of all corporate shares these days are owned by institutions such as pension funds, insurance companies, college endowments, even churches. Without even realizing it, millions of Americans rely on corporate strength for their own future security. The assurance of a retirement income, the soundness of an insurance policy, the availability of a college scholarship--all may well depend heavily on the continued profitability of U.S. corporations.

As for retained earnings, they are a prime source of the investments in new plant and machinery that increase production, improve product quality and create jobs. Aggressive and innovative companies often retain high percentages of their profits for expansion. One example: Levi Strauss & Co., whose jeans clothe the world. The company, a large share of whose stock is owned by the Haas family, generally retains nearly 90% of its profits for reinvestment, like the recent opening of a new factory in the little town of Roswell, N. Mex. The plant created 350 new jobs, each at a cost to the company of $17,000.

Other companies may choose to borrow the money for expansion. But even then the investment depends on profit, since lenders will not advance expansion funds to a company that has little prospect of earning money. In the long run, an absence of profit means that a company cannot buy the plant and equipment it needs to remain competitive. The ultimate losers are the workers. Or, in the words of an unexpected defender of the profit system, British Labor Party Prime Minister James Callaghan: "If there are no profits, there will be no jobs."

Why, then, the widespread suspicion of profits? In the U.S., the biggest reason is probably a wild misunderstanding of just how much profit corporations actually make. In one poll conducted by the Opinion Research Corp. of Princeton, N.J., a majority of those questioned thought that companies averaged 330 profit on each dollar of sales. A sampling of college students by Standard & Poor's yielded an even higher estimate: 450. The actual figure is below 50 --and the overall trend has been downward. According to a FORTUNE survey, the 1975 median profit margin of the nation's 500 largest industrial corporations shrank to 3.9% of sales. That was the thinnest margin in 17 years.

In 1976, it is true, profits are climbing back. But over the long run, an ever increasing percentage of national income has been shifting away from profits toward wages and salaries. In 1950, 64.1% of corporations' domestic income was used to pay wages, salaries and fringe benefits, while profits comprised 15.6%; by 1975 the share of wages and salaries had risen to 76%, while profits had fallen to only 8.3%.

Today profits, far from being too high, are still too low to ensure the nation's continued economic health. Among the top 20 industrialized countries, the U.S. in recent years has fared badly in terms of new industrial investment per capita; only Luxembourg and Britain rank lower. As a result, the U.S. may already, in fact, have become enmeshed in an intolerable economic dilemma in which the nation's private employers no longer create enough new jobs to absorb young workers coming into the labor force.

Otto Eckstein, a member of TIME Board of Economists, warns that the production capabilities of a number of important basic industries, including chemicals and paper, are so limited that they could create bottlenecks that would impede the U.S. from cutting its unemployment rate much below 6% in the immediate future. Such a high jobless level means increasing welfare rolls and social unrest.

The forecasts of capital requirements for the next decade, however, are stated in figures that are almost incomprehensibly huge; the estimates range up to $4 trillion for the new plants that will be needed to bring the U.S. nearer to becoming a fully employed society. But investment capital on that scale will certainly not be available unless there is a strong and sustained rise in profits that carries well beyond 1976.

Despite general agreement about the need for tremendous amounts of new capital, there is no consensus about how the money should be raised. Liberal economists generally favor more generous individual tax cuts and an ever growing money supply to stimulate consumer buying, which in turn creates heightened economic activity. Conservative economists, on the other hand, argue that there has been too much emphasis on consumption and not enough on accumulation. They would prefer federal policies that would enable companies to keep more of their earnings either through higher depreciation allowances for the purchase of new equipment or a further lowering of the corporate tax rate. Ideally, there should be a mix of both approaches so that the consumer, as well as the investment sectors of the economy, would remain healthy.

Given the confusion over profits, it is questionable whether the U.S. can actually arrive at such a solution. While there is a need for greater understanding about the beneficial role of profits, there is also a need for clearer reporting of corporate income. As Management Expert Peter Drucker has pointed out, the three main measures used by corporations today--gross and net income plus earnings per share--are far too superficial. A much more analytical system is required that would relate the firm's performance to more telling indicators, such as the return on invested capital, competitive strength, the company's historical earnings trend, and relation of research expenditures to the development of new products.

Equally bad, under the present system, earnings are compared only with the preceding quarter--or year. This leads to wild gyrations in the loss and gain columns. The profit may be up 75% from a year ago, but then, a year ago may have been miserable.

These swings are, humanly enough, magnified by corporate officers, who pooh-pooh losses while boasting about profit increases in hyperbolic press releases. The press then magnifies the problem by often reporting profits in language more appropriate to space shots or sporting events: profits leap, soar, skyrocket--or plunge, plummet, nosedive.

It is time for a more sober analysis of profits and their importance as the engine of economic growth. It is a historic irony that in the U.S., the stronghold of world capitalism, so few citizens understand that profits provide the basis for the prosperity on which rests the well-being of both individuals and the nation. David B. Tinnin

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