Friday, August 1, 2008

The Election, Taxes, and Why Corporate Profits Have to Fall

Economic theory suggests that the long run growth rate in GDP (Gross Domestic Product) is around 3%. GDP growth is a proxy for corporate profits. If you agree to this premise, then read on as to why corporate profits have to fall.

GDP can be approximated by the following:

GDP = Corporate Profits = (C – DI) + (Investment) + (G - T) + (E – I)

Consumption - Disposable Income: If term is negative, then consumer is "saving"; if consumer is "consuming more than they have in disposable income, then the term is positive, and this is a positive for corporate profits, i.e. GDP.

Investment: Related to business and private investment, think housing and projects that create shareholder value for corporations. Housing boom drove a lot of the GDP expansion...

Gov’t Spending Taxes: Gov’t generates revenues to spend on programs through taxation. If this term is positive, then the gov't runs a fiscal deficit; conversely, if negative, the term represents a fiscal surplus.

Exports – Imports: This is the trade balance...we've been running a trade deficit in the recent past, which means we import more than we export from a value perspective. The trade deficit was the only drag on GDP growth in the run-up to the bubble, and now may reverse its effect going forward, but it's still a largely negative effect.

Currently, three out of the four items are net negative, as consumers cannot spend as much, so net, we begin to save our money. Credit is not as available, or is more costly, so again, savings rate goes up and consumption goes down, both bad for corporate profits and GDP (i.e. we won't buy as much stuff...) Investment is contracting because credit is too costly and scarce for consumers and businesses. Housing drove most of this investment during bubble, so investment's effect has to be smaller going forward. The trade balance continues to be unfavorable, and as such, the only lever the government can pull to stimulate the economy is to spend. The government can raise taxes to cover its spending, or it can borrow from other countries to cover it’s spending (think Medicare, Social Security, or infrastructure) but either way, Gov’t Spending – Taxes must be (+), to expand GDP, and this means the gov't will run a larger deficit than currently or raise tax receipts to offset the spending it will incur.

Ultimately, the change in Savings, the change in investment, the change in Budget Deficit, and the change in the trade balance drives the change in GDP, which is a proxy for corporate profits.

Therefore, going forward and to summarize:

1. Savings has to go up, because our relative consumption has gone down.
2. Investment has to go down, since housing industry has slowed (residential investment) and business investment has gone down.
3. Fiscal deficit is higher than it was 4 years ago.
4. Trade balance has gotten less negative, since the dollar has helped over seas profit. However, the trade balance is still negative, which contributes to neg GDP.

The gov't could lower corporate taxes to stimulate investment by industry that eventually translates into jobs and income for its workers making terms 1 and 2 go up. However, my bet, given the rhetoric out there, is that taxes will be raised, and both candidates know it, it's the only direct lever the gov't really has in the equation above. The difference is that the gov't sees itself as jump starting the economy by spending vs. corporations, the gov't just gets the money through tax receipts versus the way corporations get the money via tax breaks. That's why the "windfall profit" tax is getting so much air time, it serves the politician's purpose two-fold with a struggling consumer that believes they do not benefit from corporate tax breaks.

Taxes are a way to transfer wealth, and it can happen along lots of different vectors. If you received a stimulus check, enjoy it. It wasn't free.

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