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Profit and Investment: Does More of One Mean Less of the Other?

Written by Dean Baker   
Tuesday, 02 July 2013 14:44

One of the simple facts of the economy that troubles many economists is the absence of any relationship between profits and investment. Economists like to tell people that if we make investment more profitable, we will have more investment. It turns out the world doesn't work that way.

Here's one of my favorite graphs of the economy going back to the early years right after World War II. It's about as simple as it gets. It shows the investment share of GDP. Then it shows the profit share of net value added in the corporate sector. The measure of profit here is the broad measure of business operating surplus. Using net takes away the downward bias in recent years that would result from a rising depreciation share of output. The last line is the after-tax profit share.

profit and investment shares 2013-07-02

The first item worth noting here is that investment doesn't fluctuate all that much. It peaks at 13.4 percent of GDP in 1981. The closest it ever comes to this share again is in the looniness of the stock bubble when the ability to raise money on Wall Street for every crazy idea pushed the investment share up to 12.7 percent of GDP. Even this number is overstated by 0.3-0.4 percentage points because of the growth of car leasing in the 1990s. (A leased car is owned by the leasing company and therefore counts as investment. By contrast, when a consumer buys a car it is treated as consumption.)

The takeaway is that anyone who expects a huge uptick in investment to provide a major boost to demand is either smoking something serious or simply has never looked at the data. It hasn't happen in the last 65 years and it's not about to happen now.

But the other part of the story that provides great fun and amusement is the seeming inverse relationship between profits and investment. Note that the investment share is at its highest in the late 1970s and early 1980s when the profit share (both before and after-tax) is at its lowest. The profit share, especially the after-tax share, rises in the 1980s as the investment share falls. Then we have a further rise in the last five years and the investment share falls again.

Why isn't a higher return to capital associated with more investment? Well if there is a substantial amount of monopoly power in the economy then it would not be surprising that we don't see more profits leading to more investment. In that case the high profits are a direct result of restricting supply. The last thing a company wants to do in this context is produce more output, which would then push down its profit margins.

Apple is the quintessential example of such a company. It's a hugely profitable company that can't think of anything to do with its profits. Recently it has been giving more of them back to shareholders in dividends.

Unfortunately the Apple story is not unique. We have many industries where the leading firms are drowning in profits for which they have no use.

If investment is driven by demand this can actually lead to the perverse situation we see in the graph. The more money that goes to firms in profits the less goes to workers in wages. If workers spend their wages, in contrast to companies hoarding profits, then we see less demand growth as the profit share rises.

I won't say that this is necessarily the story behind the picture in the graph, but it certainly fits better than a story that has investment increasing in response to a rise in profits.



Sorry, I had not seen the notes requesting specifics on the data. For the before tax share of net domestic product I divided line 8 by line 3 in Table 1.14 of the NIPA. After-tax profits are line 8 minus line 12, divided by line 3. The investment share of GDP (actually non-residential fixed investment) is line 9 divided by line 1 in Table 1.1.5. Hope that helps.

Comments (6)Add Comment
Corporate governance
written by Justin Holt, July 03, 2013 8:38
Dear Dr. Baker,

A great research subject would be to see how pronounced the relationship is between corporate pay structures and investment. John Galbraith in “The New Industrial State” argued that a shift away from paying management in profits towards paying them a salary had some of the following outcomes:

1. The shift from owner managers to non-owner managers was a worry in corporate governance literature arising in the 1930's. If non-owner managers were paid in profits they would treat their firm as a cash cow. If they were paid a salary only, or mostly, then their continued income stream would depend on the longevity of the firm. Thus, a tendency toward investment.

2. If management can't receive profits then they will tend to invest in corporate amenities: large buildings, nice offices, company jets, etc. They don't own these items but they can enjoy their use.

3. In order to gain larger salaries there is a tendency to grow the company. This makes the company less vulnerable to competition and allows employees to gain promotions across the board.

Galbraith the Younger (James) wrote about this shift to a degree in “The Predator State.”

Justin Holt
written by ltr, July 09, 2013 4:09
Dear Mr. Baker,

I have repeatedly tried to duplicate this graph on FRED2 but cannot. Please explain the graph more clearly. I do not understand what you have done and I know this is not right:

written by ltr, July 09, 2013 5:11
Please help, the graph makes no sense. I cannot duplicate it nor can friends.
written by ltr, July 10, 2013 7:24
Dear Mr. Baker,

Please, please explain the graph carefully so that others can understand it. This is an important post for us to understand, but the graph does not make sense and I cannot duplicate it.
written by ltr, July 11, 2013 9:39
Please, Mr. Baker do explain the graph to us. My colleagues and I do not understand the graph abd we have really tried to.
written by ltr, July 11, 2013 11:43
Dear Mr. Baker,

I am quite sure the graph is wrong now. I am not trying to be critical but only asking that you look at the graph and correct it or explain why I cannot duplicate it.

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