In the previous piece, I addressed a popular argument for the necessity of profit margin mean-reversion grounded in the Kalecki-Levy profit equation:
Profit/GNP = Investment/GNP + Dividends/GNP – Household Saving/GNP – Government Saving/GNP – ROW Saving/GNP
I made three points. First, proponents of the argument are ignoring the Dividends/GNP term, which can adjust upward (and has adjusted upward) to satisfy the equation at higher long-run profit margins. Second, retained corporate profit is household saving, therefore the equation’s model of a competitive transfer between the two is specious. Third, the high-end share of spending and consumption has increased alongside the profit margin increase, rendering the associated wealth transfer from the lower and middle classes to the wealthy more sustainable than it would otherwise be.
Ultimately, the Kalecki-Levy profit equation is an equation about the limits that wealth inequality imposes on corporate profitability. If there were no wealth inequality–specifically, no inequality in the distribution of household equity ownership–there would be no “balance of payments” constraints on corporate profitability. Any constraints that do arise in association with the equation are attributable to the hard reality that the distribution of household equity ownership is radically skewed towards a small, affluent segment of the population. A transfer of income from labor to profit is a transfer of income from the masses to them, a transfer that cannot go on forever.
In this piece, I’m going to explore an issue that is often forgotten in discussions about wealth inequality: wealth redistribution. It is true that there is currently an enormous amount of wealth inequality in the U.S. economy. But there is also an enormous amount of wealth redistribution, much more than in any prior period in U.S. history. The Kalecki-Levy profit equation fails to properly account for the impact of this wealth redistribution.
In the early 1950s, a meaningful share of the wealth redistribution that took place in the U.S. economy took place at the corporate level, via the corporate tax. Since then, the corporate tax burden has fallen dramatically and the household tax burden has risen dramatically, particularly for high-end households. This shift has created the appearance of an unsustainable “transfer” of wealth from households to corporations in the form of higher after-tax profits, but the “transfer” is actually a transfer from wealthy households to corporations–an entirely fungible and sustainable transfer, given that wealthy households own the corporate sector.
To account for the impact of the shift, I’m going to derive and test an improved formulation of the Kalecki-Levy profit equation, a formulation that puts the full burden of wealth redistribution on the corporate sector at all times. This improved formulation will allow for a more accurate apples-to-apples comparison between the present and the past. Interestingly, on the improved formulation, profit margins end up being roughly at their historical averages.
The Original Kalecki-Levy Profit Equation
Before I introduce the improved form of the equation, I’m going to briefly derive and explain the original. The reason for the brief derivation and explanation is so that the next section, which discusses, household saving, deficit reduction, and the 2012-2013 fiscal cliff, makes more sense to the reader.
First, some definitions. Saving means “increasing your net wealth.” Investment means “creating new net wealth.” Wealth can mean whatever you want it to mean–the only constraint here is that you have to apply the definition consistently.
On these definitions, the only way an economy can save in aggregate–collectively increase its net wealth by some amount–is if it invests that same amount on a net basis, that is, collectively creates new net wealth equal to that amount. If it doesn’t invest and create new net wealth, then its people, when they try to save, will be fighting over a finite supply of existing net wealth. The result will be zero sum–any one person’s saving (increase in wealth) will necessarily have to come at the expense of another person’s dissaving (decrease in wealth). Aggregate saving will be nil.
We arrive, then, at the following maxim, which doesn’t necessarily hold true on an individual basis, but always holds true on an aggregate macroeconomic basis:
(1) Saving = Investment
Now, let’s divide the economy into four sectors: households, corporations, government, rest of the world (ROW). On this division, the aggregate saving of the overall economy equals the individual saving of each of these sectors:
(2) Saving = Household Saving + Corporate Saving + Government Saving + ROW Saving
Combining (1) and (2) we get:
(3) Household Saving + Corporate Saving + Government Saving + ROW Saving = Investment
Note that the term “investment” here doesn’t just refer to corporate investment; it refers to the total combined investment of all of the sectors–not only the building of new factories by corporations, but also the building of new homes by households. In the present context, it’s actually an investment rate–how much is invested per year. Saving is also a rate–how much the net wealth increases per year.
Now, Corporate Saving equals Profit minus Dividends. So (3) becomes:
(4) Household Saving + (Profit – Dividends) + Government Saving + ROW Saving = Investment
Rearranging we get an equation for profit:
(5) Profit = Investment + Dividends – Household Saving – Government Saving – ROW Saving
This is the Kalecki-Levy profit equation, an equation discovered, in a different form, by the economist Jerome Levy in 1908, and refined by the economist Michal Kalecki in the 1930s. If we divide each term by GNP, we get an equation for profit as a percentage of GNP, which crudely approximates the corporate profit margin (profit as a percentage sales).
(6) Profit/GNP = Investment/GNP + Dividends/GNP – Household Saving/GNP – Government Saving/GNP – ROW Saving/GNP
The NIPA sources for each term are given in the table below. They are directly available online from the BEA here:
To test the equation, we can compare its predictions to actual NIPA reported profits from 1947 to year-end 2013:
What the equation is saying, in simple terms, is this. Profit/GNP cannot rise net of dividends unless one of the following, or some adequate combination thereof, occurs: (1) corporations invest the increased profit back into the economy, (2) the other sectors increase their investment without also increasing their saving (meaning they lever up their balance sheets–that is, invest with borrowed funds rather than with their own income, so that their new assets are matched to new liabilities, creating no net increase in wealth, and therefore no additional saving), or (3) the other sectors reduce their savings rates.
There’s a limit to how much corporations can invest. There are only so many profitable projects to invest in. There’s also a limit on the extent to which the other sectors can lever up their balance sheets or reduce their savings rates. For the Household and ROW sectors, the leverage constraint is preference-based and market-based (Households and ROW don’t like to borrow, and lenders will only fund a certain amount of it), whereas the saving rate constraint is need-based (people need to maintain a stock of wealth for retirement or emergencies). For the government, both limits are political (driven by the decisions of policymakers).
The implication, then, is that there is a limit on how high the profit margin can sustainably get. If it is elevated, it will necessarily be elevated because corporate investment is elevated, because non-corporate leveraging is elevated, or because the savings rate is depressed. As these abnormal conditions revert to the mean, so too will the profit-margin. Or so the argument goes.
Household Saving and Deficit Reduction: The 2012-2013 Fiscal Cliff
In recent years, the Government Deficit has risen substantially relative to its long-term average. Its rise has been driven by the plunge in Investment that took place in the Great Recession, a plunge that the U.S. economy has yet to fully recapture. In general, Investment and the Government Deficit tend to be closely inversely correlated.
In 2012-2013, the U.S. economy embarked on a deficit reduction program. Investment was in the process of recovering, so there was room for the deficit to fall. The concern, however, was that if the deficit reduction was too large, or if it was instituted faster than the investment recovery could keep up with, that the result would be excessive consumer strain, a reduction in corporate revenues and profits, and an associated recession.
Those who voiced this concern, myself included, failed to appreciate the inherent flexibility of the household saving term. With the exception of corporate tax increases and direct contract spending cuts, fiscal overtightening doesn’t directly hit corporate revenues or cause recessions. Instead, it puts a choice on households–reduce your savings rates or reduce your expenditures (which, if chosen, will force a reduction in corporate revenues and profits and cause a recession.)
For obvious reasons, households naturally prefer to reduce their savings rates over reducing their standards of living. And so, in response to the 2012-2013 deficit reduction program, they predictably chose the former. Rather than decrease their consumption, they saved less than they otherwise would. The Household Saving term fully absorbed the portion of the deficit reduction that rising investment couldn’t make up for, allowing corporate revenues to continue to grow and the economy to avoid a recession.
In truth, there is currently room for the household saving rate to fall further, should it need to. If policymakers were to impose another misguided fiscal austerity program, the hit would most likely be absorbed in lower household saving. For households to choose to maintain or increase their savings rates at the expense of their standards of living, they need to get scared–specifically, scared that their jobs are no longer secure. Then, they will cut back on spending and increase their savings–which is what we saw them do in 2008, as their homes values were fell, as unemployment rose, and as the negative mood in the economy grew. A 2% payroll tax increase, or a small spending reduction, such as what we saw with the furloughing of government employees, isn’t going to be capable of creating that level of fear in the present environment.
We tend to think that reductions in household saving are “unsustainable.” But we have to remember that we’re talking about a savings rate. It’s not as if households are depleting or burning down their wealth when they reduce their savings rates. What they are actually doing is reducing the pace at which their net wealth is growing each year. There is no rule that says that their net wealth has to grow at any specific pace; the important point is that it’s growing rather than contracting.
Now, it’s true that younger generations need to save for retirement. But older generations are free to anti-save, spend down their wealth. The high saving of younger generations tends to offset the anti-saving of older generations, allowing younger generations to prepare for retirement without pushing up the aggregate household saving term. Indeed, as the demography of an economy shifts towards old age, aggregate household saving tends to fall. The number of older anti-savers comes to offset the number of young savers. If Japan’s experience provides any sign of what’s to come for the US, we should expect to see household saving continue to fall over the next several decades, and possibly even go outright negative at some point. Note that this won’t necessarily generate further increases in the profit margin, because investment will also fall as the population ages.
For reference, here are the values for each of the terms in the equation from 2Q 2006 to 4Q 2013, alongside the average from 1947 to 2013:
As you can see in the table, investment plunged in the Great Recession. The government deficit expanded to absorb the impact of the investment plunge and the increase in household saving associated with the deteriorating economic mood. As the recovery and expansion have taken hold, investment has gradually risen back towards normal levels, and household saving has gradually fallen. Given that most of the 2012-2013 austerity is behind us, a continued rise in investment–which still has a very long way to go before it reaches normal levels (current: 3.93%, average: 8.35%)–will be the key ingredient in achieving a normalized deficit going forward (not that it matters–deficits don’t really matter, but it’s an optical thing for policymakers).
It turns out that in the fiscal cliff, the government deficit was forcibly reduced by a larger amount (3%) than the rise in investment (less than 1%) could keep up with. But there was no problem, household saving fell by the amount that it needed to (roughly 2%) in order to absorb the difference. The economy avoided recession, corporate revenues continued to grow (albeit at a pathetic nominal rate), and the profit margin held like a rock–on NIPA profits, it’s currently within a couple bps of a record high, and on company reported S&P profits, it’s at a new all time high.
The Impact of Wealth Inequality
In the present context, the Kalecki-Levy profit equation is something of a red herring. Those who cite it as a reason for the necessity of profit margin mean-reversion tend to forget about a crucial term that fixes everything: the Dividends/GNP term. In theory, an economy can sustain profit as high as 100% of GNP, as long as the uninvested balance of that profit is paid out as dividends, where it will explicitly add to the household and ROW saving terms (via the increased dividend income). In practice, the uninvestable balance of profit is always eventually paid out as dividends (or utilized in the equivalent: acquistions and share buybacks). Over the last 30 years, Dividends/GNP have risen alongside Profits/GNP, as expected (FRED).
More importantly, the equation treats corporations as if they were actual separate members of the economy, with their own selfish interests. They are not. They are inanimate property–the property of households and foreigners. When corporations retain profit, the net wealth of the households and foreigners that own them increases, therefore the households and foreigners are effectively “saving.” Given the way the BEA defines terms in NIPA, that saving isn’t reflected in the equation. But it’s 100% real. It can be monetized at any moment through sales in the market, provided that market prices sufficiently reflect corporate value (and right now, they most definitely do). The following chart compares what household saving would be if it reflected household claims on retained profit (red) with household saving as actually tabulated using NIPA definitions (blue) (FRED):
The problem, of course, is that the household sector is not composed of one big happy family that “saves” together. Rather, it is composed of millions of families. Most of these families do not own equities. And so “household saving” that takes place in the form of higher dividends, higher corporate net worth and a higher stock market does not accrue to them. To the extent that such saving comes at the expense of other forms of income–in particular, wages and interest receipts–the end result may not be sustainable.
It is in this sense that the Kalecki-Levy profit equation is really an equation about household wealth inequality. If there were no inequality in the household distribution of equity ownership, the equation would be of little relevance to the present profit margin debate.
The following charts show the distribution of household asset ownership among the top 1%, the top 10% and the bottom 90%:
As you can see, the top 10% of households own 81% of the stock market. When corporations save, it is that small contigency–not the larger pool of households–that receives the “household saving.”
Now, the top 10% of households also owns 70% of all cash deposits and 94% of all financial securities (the balance of which consists of credit assets). For this reason, the portion of the recent profit margin increase that has been driven by the Fed’s low interest rate policy is entirely sustainable. That policy does not take money from lower and middle class households to give to wealthy households. Instead, it transfers money from one part of wealthy household portfolios (cash and credit) to another part of those same portfolios (equities).
Note that a similar shift is sustainable in the areas of pension and life insurance. The payouts associated with pension and life insurance obligations tend to be defined. Thus interest rates tend to affect the corporate sector for which those payouts are a liability, not the household sector to which those payouts are due. A low interest environment makes it more difficult for the corporate sector to meet its pension and life insurance obligations, but such an environment also make the corporate sector more profitable. As before, the result is a wash.
Risk-averse investors will obviously lose out in such a transfer, and will therefore view it negatively. But we mustn’t confuse their plights with the plights of average households. Average households are not in the business of owning financial securities–of any type. They are in the business of taking on debt to fund the purchase of a real asset: a home that they can live in. As you can see in the table, they owe a hugely disproportionate amount of the debt in the economy relative to their asset base, and therefore foot a hugely disproportionate amount of the bill for the interest–mostly mortgage interest, but also credit card interest and student loan interest. Low interest rate policies are of significant benefit to them, not only because they stimulate the economy relative to the alternative, but also because they reduce the interest payments that the households have to make to wealthier savers. That’s why the Federal Reserve has kept interest rates at zero, and will continue to do so for the foreseeable future.
Now, the situation is very different when we talk about the shift in income from wages to profit, which is the shift that has driven the majority of the present profit margin increase. That shift takes money from the low and middle classes of the economy, who earn their income almost entirely from wages, and gives it to the wealthy.
The following chart shows wages as a percentage of GNP from 1947 to 2013:
The plunge is striking. Note that this chart doesn’t reflect the wealth shift inside the wage space. The wages of the wealthy have increased much more over the last 60 years than the wages of the lower and middle classes, making the situation more extreme.
The large increase in wealth inequality that has ensued over the last 60 years should cause us to worry about what is actually going on inside the Household Saving term in the Kalecki-Levy profit equation. If Households in aggregate are saving only 3% of GNP every year, and if that saving includes the high-saving of the wealthy, to include saving related to the elevated dividend income that only they receive, what is happening to the savings rates of the lower and middle classes? Might we be in a situation where their savings rates have to actually be negative in order for them to be able to spend, consume, and participate at the level that a growing economy needs? It’s a fair question to ask.
As I pointed out in the previous piece, the worry is alleviated by the fact that the wealthy consume a much larger share of the overall pie than the lower and middle classes, and that the share of their consumption has increased meaningfully alongside the increase in their income share. Their increased consumption has made it possible for the lower and middle classes to consume less without harming the economy.
But is the increased consumption of the wealthy enough to allow the lower and middle class to maintain an adequate savings rate without derailing the economy? Again, it’s a fair question to ask.
The Impact of Wealth Redistribution
It turns out that there is an important ingredient in the mix that we’re ignoring here: the redistribution of wealth. Wealth inequality has increased dramatically, but so has the amount and the extent of wealth redistribution.
The previous chart of wages, frequently cited, is deceptive in two respects. First, it doesn’t include benefits such as employer contributions to healthcare and retirement, which are a type of wage. Second, it doesn’t account for the enormous rise in transfer payments–income that accrues almost entirely to the non-equity-owning, wage-earning lower and middle classes via the redistribution of pre-tax income.
The following chart shows wages as a percent of GNP (green), wages plus benefits as a percent of GNP (blue), and wages plus benefits plus transfer payments as a percent of GNP (red), from 1947 to 2013 (FRED):
As you can see, total non-capital income properly measured to include supplements paid to the poor and middle class (the red line), is at a record high relative to GNP. Now, some of these transfer payments are paid for via the government deficit. But the vast majority is paid for by taxpayers. And just as the wealthy earn most of the capital income, they pay most of the taxes. They therefore fund most of these transfers.
To highlight the example of federal income taxes, the following charts show the share of total federal taxation and income paid by the top 1%, 2%-5%, 5%-10%, 10%-25%, 25%-50%, and bottom 50% from 1980 to 2013:
As you can see, the top 10% pay roughly 70% of all federal income taxes, up from roughly 49% in 1980.
On the income side, the top 10% earn roughly 45% of all income, up from roughly 32% in 1980. So their tax share has grown much more than their income share.
An Improved Formulation of the Kalecki-Levy Profit Equation
The problem with the Kalecki-Levy profit equation is that it can’t account for the impact of increased wealth redistribution inside the household sector. To illustrate, suppose we start with the terms in the equation in the following configuration, which was the configuration at the end of 2013:
Suppose we then reduce wages by 10% of GNP. Wages are a cost to the corporate sector, therefore profits will rise from roughly 10% of GNP to roughly 20% of GNP. Suppose that all of the profit increase goes to increased dividends. Dividends, then , will rise from roughly 5% of GNP to roughly 15% of GNP.
Assume, for simplicity, that households own 100% of the corporate sector, and that the rest of the world owns 0%. If household consumption stays constant, the 10% wage reduction will have no effect on household saving. This is because dividends will rise by the same amount that wages fall (the dividend increase is being accomplished by taking from wages). Because both types of income feed into household income, household income will stay constant through the change. But saving is just income minus consumption. Therefore if consumption stays constant, saving will stay constant too. We will end up with the equation in the following configuration:
Obviously, the shift would be unsustainable–with the unsustainability revealed in the ridiculously high profit margin. It would represent a wealth transfer of 10% of GNP from the bottom 80% to the top 20%. Crucially, household consumption would not be able to stay constant through the transfer. The top 20% of would end up with extra income equal to 10% of GNP that they wouldn’t know what to do with–they certainly wouldn’t be able to consume an extra 10% of GNP, nor would they be able to invest it in the economy; there aren’t enough useful projects to go around. Their only choice would be to hoard it–take it out of the economy. The lower and middle class would therefore lose it for good, without a way to get it back. They would have to cut their expenditures by 10% of GNP–either that, or run a massive borrowing deficit. The balance of payments between the sectors would therefore unravel, revealing the profit margin increase as unsustainable.
Now, to illustrate the equation’s shortcoming, suppose we put in place the exact same wage reduction and profit increase, except this time we tax and redistribute 100% of the associated increase in dividends. The top 20% will earn an extra 10% of GNP in dividends, but they will pay an extra 10% of GNP in taxes back to the government, so their after-tax income will end up unaffected. The bottom 20% will lose 10% of GNP in wages, but will receive that 10% of GNP back in the form of transfer payments. Their after-transfer income will be unaffected, and therefore the system will remain unperturbed. However, the equation will register the same profit margin extreme as before, with profits at a ridiculous 20% of GNP:
As before, the temptation is to look at this configuration and conclude that it’s unsustainable. Given the skewed distribution of equity ownership, profits and dividends cannot sustainably rise by 10% of GNP at the expense of an associated 10% reduction in wages. The result would be a massive transfer of wealth from the bottom 80% that earns income through wages to the top 20% that effectively receives all of the economy’s profit and dividend income. But the transfer is sustainable in this case, because redistribution will fully transfer it back. The equation, as applied, is flawed because it doesn’t account for the effect of the redistribution, the transferring back. It therefore creates the false impression of an impending balance of payments crisis, where there is none.
Now, consider a final twist. Instead of taxing the increased profit at the household level, via a dividend tax, and then redistributing it via transfer payments, suppose that we tax it at the corporate level, via a corporate tax, and then redistribute it. There’s no difference between this option and the previous option–both options identically redistribute the money from the top 20% back to the bottom 80%, undoing the previous transfer. But the ensuing configuration of the Kalecki-Levy profit equation will turn out to be very different under this option. The equation will rightly register no change at all. Profit margins will remain exactly what they were before the round trip transfer:
Evidently, if redistribution occurs at the corporate level, profit margins don’t change. But if it occurs at the wealthy household level, which is ultimately the exact same thing, profit margins do change–they increase, creating the false perception of a wealth transfer from the poor and middle class to the rich that isn’t actually happening.
In the 1950s and 1960s, a larger portion of “wealth redistribution” was accomplished through the corporate tax, and a smaller portion was accomplished through income taxes on wealthy households. Since then, the general amount of “wealth redistribution” has significantly increased, and the target of that redistribution has shifted away from corporations and towards the wealthiest households–specifically, the top 10% to 20% of earners, who now pay the lion’s share of total taxes.
For this reason, evaluating today’s profit margin against the profit margin of the past is illusory from a balance of payments perspective. The current profit margin ends up looking much higher than the profit margin of the past, even though the final balance of payments condition, after redistribution is taken into account, is no more extreme now than then.
To accurately reflect the impact that rising amounts of wealth redistribution have had on the sustainability of higher profit margins, and also the effect of the shift in the tax burden from corporations to wealthy households (that own the corporate sector), we need to reconfigure the equation so that 100% of the economy’s tax burden falls on the corporate sector at all times across history. Then, comparisons with the past will be appropriately apples-to-apples.
To modify the equation, then, we take the taxes that households (and the ROW) pay, to exclude sales taxes, property taxes, and social insurance contributions, and add those back to household and ROW savings (simulating a scenario where they aren’t taxed at the household or ROW levels). We then subtract them instead from corporate profits (simulating a scenario where they are taxed at the corporate level instead). The equation becomes:
(7) Fully-Taxed Profits/GNP = Investment/GNP + Dividends/GNP – Pre-tax Household Saving/GNP – Government Saving/GNP – Pre-tax ROW Saving/GNP
The following chart shows the calculated and actual reported profit margin under this improved formulation of the equation, followed by table with NIPA references:
As you can see, in this formulation, the profit margin, which was 63% above its historical mean in the prior formulation, ends up being roughly on par with its historical average, and below the average of the pre-1970 period.
Now, to be clear, a comparison of the present values of the “fully-taxed” profit margin with the historical average does not give an accurate picture of the sustainability of current profit margins from the perspective of competition. The “fully-taxed” profit margin is not a real profit margin that any business actually sees–it’s just a construct. It’s deeply negative because corporate profits are a very thin slice of the economy, smaller than the total quantity of taxes raised. Corporations cannot afford to pay all of the economy’s taxes; their pre-tax profits are too small.
But a comparison of the present values of the “fully-taxed” profit margin with the historical average does give an extremely useful picture of the sustainability of current profit margins from the perspective of the balance of payments of the different sectors of the economy, specifically between the wealthy and the lower and middle classes. The “fully-taxed” profit margin gets pulled down during periods where wealth redistribution is high and pushed up during periods where it is low, a necessary adjustment if we want to properly compare the balance of payments implications of various profit margin levels across history. The comparison should not be an absolute comparison; it needs to be a comparison net of wealth redistribution.
It is true that the actual corporate profit margin is higher now than in the past, reflecting a transfer of wealth from the lower and middle class to the wealthy. But the transfer is sustainable because the wealth is ultimately being transferred back, via higher levels of redistribution and higher levels of taxation of wealthy households relative to the past. That sustainability is reflected in the fully-taxed profit margin, which is roughly on par with its historical average (rather than 63% above, as it is in the earlier formulation).
The following chart shows what happens to household savings under the improved formulation of the equation:
Relative to the respective averages, the upper line, the pre-tax household saving, is significantly less depressed than the lower line, the after-tax saving. The vast majority of the difference between the two lines is borne by the wealthy, through their tax contributions. So when we ask the question, how can the lower and middle classes be saving anything when the saving of the total household sector, to include the saving of the high-saving wealthy, is only 3% of GNP, the answer, again, is wealth redistribution. If you netted out the cost of wealth redistribution (taxes), without netting out the benefits (the incomes that accrue to the lower and middle class via government spending), the household sector would actually be saving 15% of the entire economy. The difference between the 15% and the 3% is what the wealthy directly give back. It’s a much larger number than it used to be.
Now, the “fully-taxed” corporate profit margin above excludes sales, property, and social insurance taxes. The rich pay a disproportionate share of those taxes (a disproportion which has also been rising), but the disproportion is not as extreme as it is in the area of the income tax proper (where the top 20% pay almost everything), therefore we leave them out. For perspective, the following chart and reference table show the “fully-taxed” corporate profit margin with sales, property, and social insurance taxes with them added in:
As you can see, the profit margin on this accounting is even less elevated. It’s well below the levels of the idealized 1940s, 1950s, and 1960s.
To conclude, rising profit margins do not pose a threat to the economy’s financial stability because they’ve been coupled to rising levels of wealth redistribution. We would do best to stop worrying about profit margins, which are ultimately a distraction, and focus instead on the variable that drives outcomes in capitalist economies: the return on equity.