Wednesday, December 10, 2014

Follow Up to Rant about Risk & Recovery

Here is the last graph from yesterday's post.  I think this goes to the heart of the problem with discourse about national economic policy.  People frequently fail to make a very important distinction.  Capital does not search for maximum profit.  Capital searches for maximum risk-adjusted profit.

Be careful.  The scales differ on the two vertical axes.
We have the argument about viewing the economy as a fixed pie vs. viewing it dynamically, so that instead of fighting over shares at a given time, we should work to increase the rate of growth.  And that's a good argument to have.  And, lowering risk will arguably lead to higher growth.  But, there is a more subtle and powerful point to be made here.

Capital is foundationally deferred consumption.  Returns to capital don't reflect simply the added value to production at a point in time.  They reflect cash flows over time.  They reflect the premium to deferred consumption.  The level of profits in an economy reflect a numerator and a denominator.  And, the operator in the denominator is risk.

If risk premiums decline, risk-adjusted profits will be higher, all else equal.  And, the way this shows up in national shares is that the share of domestic production claimed by capital declines as competitive pressures push the equilibrium returns down to their risk adjusted equilibrium level.  When the premium for taking risk declines, income to capital at risk declines, and the income retained by less risky factors (labor and debt holders) increases.

This is what we see in the graph in the three long recoveries (1960s, 1980s, and 1990s) where the business cycle was able to continue expanding for several years after equilibriums were re-established from recovering profits coming out of the preceding recessions.  As the long recoveries aged, risk premiums declined, and more income went to labor and debt - especially to labor.  (Interest income was relatively flat in the late 1980's, but it was pushing against the downward trend that resulted from sharply decreasing inflation rates.)

On the other hand, here is the result we see to changing corporate tax rates over time.  Effective domestic corporate tax rates have declined from about 50% to about 30% over the past 60 years or so.  Note how corporate profits before taxes have fallen over this time, leaving corporate profits after tax relatively level.

I don't want to over-sell this.  As I've discussed, this is only a portion of returns to capital, so the level of this share is somewhat dependent on the arbitrary distinctions of corporate vs. non-corporate profit and returns to debt vs. returns to equity.  (Corporate debt has a tax advantage over equity.  So, we should expect some increase in profits as corporate taxes decline simply because firms have less incentive to use debt in their capital structures.  More operating profit would be allocated to net profit for equity holders.  So, we should expect some increase in corporate profits, even if corporations don't bear the tax.)  But, all else equal, if corporate taxes actually fell to corporations, profits would be on the order of 50% higher today than they are because of falling corporate tax rates.

It's such a shame that our public debates revolve around matters such as taxation which have such little long-term effect over time in areas where financial arbitrage is operative, and which involve clear costs.  On the other hand, when capital's risk is reduced, profit shares decline.  There is no mitigating factor here.  Is there somebody who is against that?....No?...Then what are we arguing about?  It's about risk.

Morgan Warstler frequently points out at Scott Sumner's blog that one benefit of NGDP targeting is that by stabilizing nominal production, the effect of fiscal policies on real production will be highlighted.  I think NGDP would also illuminate the effects of national policies on risk.  Most of the movement of income shares now is the result of moving into and out of equilibrium as we move through demand fluctuations of the business cycle.  If demand fluctuations can be minimized, then changes over time to capital return behaviors will be more clearly the product of changes in risk perception, risk aversion, and the related level of real interest rates.

I have posited that low home prices are also keeping compensation shares down.  About half of the decline from 1970s levels of compensation share has gone to corporate capital and about half to excess gains to home ownership.  The shift to corporate capital happened during the volatile 1970s and early 1980s.  Total corporate shares (profit + interest) have been level since 1985.  The drop in compensation from the bottom in 1985 has substantially all gone to homeowners.  (In the first graph, Net Operating Surplus includes all returns to capital, including rental income attributed to homeowners.)  If monetary accommodation leads to rising real estate values, this should also boost compensation shares.  And, if NGDP level targeting meant that the Fed stopped worrying about real estate prices, that would be another great side benefit of the policy.

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