We have tended to think of taxes in terms of rates. Mitt Romney’s solution to the current economic malaise includes across the board personal tax cuts and a lowering of corporate rates. Supposedly, the private market will respond to these tax incentives and an investment-led recovery will result. Yet American business is more profitable today than it has been for most of its corporate history. The most recognized proxy for corporate profitability is the return on equity of the S&P 500. In the four quarters ending in March, the S&P 500 earned $96.42 on a beginning book value of $579.14, thus producing a highly attractive return on equity capital of 16.5 percent. The average return on equity in the last 75 years is closer to 13.5 percent. This 3 percent superior rate of return relative to its long term average represents an economic rent. To the average American, this economic rent is a tax, and society would benefit greatly from bringing it down through competition rather than making it larger through fiscal policy.
To guide policy we need to ask ourselves, why does this superior rate of return exist? Is it structural? Have we allowed so many business combinations that the predominant industry structure is one of oligopoly and therefore competition for market share will be permanently lacking? The solution here might be a little old fashioned trust busting. Have we realized the globalization panacea such that American business is now focused on highly profitable product development and brand management activities, leaving the capital intensive and low margin manufacturing activity to others? If this is the case, should policy actively encourage the reintegration of business to recapture jobs that have shifted abroad? Finally, is American business deserving of the superior rate of return as it manages for efficiency and reaps the benefits of low labor costs from the elevated levels of the unemployed and underemployed?
There are elements of truth in each of the aforementioned propositions, but it is more likely that the superior rate of return is due to policy mistakes that influence the mobility of capital. For if capital is truly mobile, it would force regression to the mean and eliminate the superior rate of return. That 16.5 percent rate of return exists in the context of a 1.5 percent 10-year U.S. treasury bond; presumably there are numerous small competitors with access to cheap capital that would operate well under this highly profitable umbrella in the short run and collapse it in the long run. By doing so they would hire the unemployed. Has banking reform been focused so heavily on the large “too big to fail” banks that the smaller community banks remained starved for funds?
The Federal Reserve has guided its policy to “lean against the wind of deflation.” They have successfully created inflation of 2.5 percent per year since the crisis in 2008 while managing bank deposit rates to nearly zero. This is a pro-business, anti-saver policy. Large business has reaped the benefit of a superior rate of return and their cost of debt has declined yet no competition has developed to compromise their profitability. It is time for the Federal Reserve to do something different. Perhaps focus its efforts on bank lending standards and the volume of loans rather than interest rates alone.
Policy makers have been successful in establishing prosperity for the large business sector but the specific prosperity of the large business sector has not resulted in general prosperity for all. If we do not believe that capitalism acts to eliminate abnormal profits (economic rents) then we must fall back to a position that the market based economy of our forefathers is gone and has been has been replaced by a more rigid, crony capitalism. This alternative is unacceptable.
There is something terribly unhealthy about an economic environment in which large business earns economic rent (a personal tax to the average citizen) in the context of an 8 percent unemployment rate and a 15 percent under-employment rate. With short-term interest rates at zero and long-term interest rates below inflation, one would expect the profitability of the S&P 500 to be subnormal, perhaps 3 percent below the long-term normal but certainly not 3 percent above. The problem is more likely linked to competitive barriers rather than to corporate tax rates.
It is clear that business is performing well while the household sector continues to struggle. This is an unsustainable condition. The economic pendulum has swung heavily in favor of capital and to the detriment of labor. It is better to eliminate the tax of economic rent through competition rather than through tax rates. Let’s hope the political will develops to embrace the former rather than the later.
Glensky is a former Wall Street financial manager who now lives in North Myrtle Beach.