Corporate profits in the US are up. But is this good for society at large. May be yes, may be no. Economists have two hands!
First, higher profits create greater economic inequality. Rising aggregate profits correspond to a decline in labor’s share of output, contributing to stagnant wages. Also, greater profits for some corporations but not others may create greater wage inequality.and
Second, the rise in profits might represent a decline in competition and, with that, a decline in economic dynamism. While a dynamic, competitive economy rewards innovative firms with high profits and punishes poor performers with low profits, sustained aggregate profits suggest, instead, that firms are able to get away with higher prices because competition is limited. Firms engage in political “rent seeking”—lobbying for regulations that provide them sheltered markets—rather than competing on innovation. If so, then high profits portend diminished productivity growth.Or
But there is a more optimistic narrative about the rise of profits. Perhaps profits are rising because firms are increasingly making profitable investments in new technology, in IT, or in their organizational capabilities. In this account, high profits represent increased economic dynamism.So which is it? The answer matters.
In a new research paper, I tease apart the factors associated with the growth in corporate valuations relative to assets (Tobin’s Q) and the growth in operating margins. I account for the roles of R&D, spending on advertising and marketing, and on administrative costs, including IT. I also consider investments in lobbying, political campaign spending, and regulation; and I look for links between rising profits and industry concentration and stock volatility.He continues,
I find that investments in conventional capital assets like machinery and spending on R&D together account for a substantial part of the rise in valuations and profits, especially during the 1990s. However, since 2000, political activity and regulation account for a surprisingly large share of the increase.
Much of this result is driven by the role of regulation, so it is important to understand the link between regulation and profits. Lobbying and political campaign spending can result in favorable regulatory changes, and several studies find the returns to these investments can be quite large. For example, one study finds that for each dollar spent lobbying for a tax break, firms received returns in excess of $220.Which is why many economists want government kept out of business as much as possible. Light-handed regulation being best. It minimises the rents on offer.
A more interesting and less obvious question is how can regulation in general should be associated with higher profits? Isn't one big reason for regulation to keep profits down? Bessen explains,
Yet even regulations that impose costs might raise profits indirectly, since costs to incumbents are also entry barriers for prospective entrants. For example, one study found that pollution regulations served to reduce entry of new firms into some manufacturing industries.In short, regulators don't have the knowledge to fully predict the reactions of the firms they regulate and this can result in unintended consequences. Bessen goes on to say,
Even when regulators try to reduce prices, firms can benefit. For example, in 1992 Congress passed the Cable Television Consumer Protection and Competition Act in response to high cable TV rates. Regulators expected cable prices to fall by 10%. Instead, however, cable companies changed their programming bundles, prices did not fall, and corporate valuations increased.
The pattern around the 1992 Cable Act is representative: I find that firms experiencing major regulatory change see their valuations rise 12% compared to closely matched control groups. Smaller regulatory changes are also associated with a subsequent rise in firm market values and profits.So Bessen's research supports the view that political rent seeking is responsible for a significant portion of the rise in profits. Again this tells us we want to keep government and business as far away from each other as possible. The more governments interject themselves into the world of business the greater the opportunity for firms to influence government actions to the firm's advantage.
Bessen concludes by saying,
Two characteristics make these changes particularly worrisome. First, the link between regulation and profits is highly concentrated in a small number of politically influential industries. Among non-financial corporations, most of the effect is accounted for by just five industries: pharmaceuticals/chemicals, petroleum refining, transportation equipment/defense, utilities, and communications. These industries comprise, in effect, a “rent seeking sector.” Concentration of political influence among a narrow group of firms means that those firms may skew policy for the entire economy. For example, the pharmaceutical industry has actively stymied efforts to address problems of patent trolls that affect many other industries.The only way you can hope to, at least, limit business influence is to create a system whereby the payoffs to influence are small because governments interfere little. The irony of having lots of regulation is that you make rent seeking profitable, and firms go where the profits are. Lots of regulation can result in lots of lobbying since there are lots of rents to be had.
Second, while political rent seeking is nothing new, the outsize effect of political rent seeking on profits and firm values is a recent development, largely occurring since 2000. Over the last 15 years, political campaign spending by firm PACs has increased more than thirtyfold and the Regdata index of regulation has increased by nearly 50% for public firms. However much political rent seeking has affected economic dynamism and inequality so far, the effect is likely to be greater in the near future.
Of course firms are not the only groups that can gain by influencing governments and regulators. Trade unions or consumer groups or environmental groups or churches, or health groups or universities or ..... all can gain by trying to influence governments in ways that help that particular group. If there are rents on offer then they are available to all.