Corporate Profits Corporate Funny Money?

Ever since we have fallen prey to Japanese predatory trade practices, we have been told the reason is. . .the Japanese save and we don't. The lesson: capital formation results from savings. With little in the way of savings there is little in the way of capital formation, new industry with new jobs is not created and old industries do not have the capital to modernize, hence the trade gap.

The great outcry from the economic world about the Federal deficit is that when the Federal Government borrows heavily, it gets first dibs in the savings pot and it doesn't leave enough for healthy economic growth. The rest of the argument is in paragraph #1.

Corporate take over mania is still rampant in the United States. The market "short sell" of October 19 only slowed it down. Takeovers are now occurring at near their pre-October rate. Why have takeovers dominated the business world. They are a fast way to make a buck. Why are they a fast way to make a buck? Because the normal take over target is fat. Fat in the sense of assets in excess of those required to stay in business. The normal take over is paid for by selling selected assets of the company to liquidate the takeover generated debt. Junk bonds have become a growth industry because of the rapid turn around of the money.

A financial house sells junk bonds to wealthy clients. The financial institution lends the money obtained by the sale of the junk bonds to the takeover artist who uses the junk bonds to buy enough of the target to gain control and then sells the excess assets of the target to pay off the junk bonds and make a fat profit. Since the junk bonds are high risk they carry high interest and the buyer of junk bonds makes out as well.

How do targets fend off takeovers? They acquire debt. They don't shed assets by distributing them to stockholders—they acquire debt. The bottom line is that the average corporation is fat—not only with subsidiaries, but with corporate jets, summer homes, golf courses, megasalaries and juicy stock options for top management. Since the fat is usually not reflected in the price of the stock the take over targets are usually picked up as "bargains."

Consumer debt is soaring. Credit card debt is out of sight. Many people spend to the limit on all the several credit cards they have. And the mail is full of offers for new cards. The American public simply can not get enough automobiles, consumer electronics of all kinds, clothing, consumables and durables etc. Travel is booming. And in general consumers are mortgaging their future earnings to purchase goods and services today. You have to believe that high consumer debt has to be reflected in high profits someplace.

Question: Does consumer spending have anything to do with capital formation? I have a simple minded notion that consumer spending is what generates corporate profits. If profits don't result in capital formation as evidently they do not (otherwise why all the fuss about savings), where do they go? Do they go into the excess assets of corporations that the corporate raiders find so attractive? Do they go into excessive salaries and stock options for corporate management? One would have to wonder what happens to the profits? The stockholders may get some but certainly not all of them.

Hypothesis: Corporate liabilities are predictable, therefore understandable, therefore manageable. Corporate profits are not predictable therefore are not as manageable as debt.

When a corporation borrows money from a bank to purchase new plant or equipment, the debt is a known quantity. So much on the principal so much on the interest. Very knowable. When the work force is added up, labor costs become very knowable. Overhead, administrative costs, taxes, raw materials become knowable costs. The cost side of corporate finance receives great scrutiny and corporate leaders become heros of the corporate world if they can contain costs. The debit side of the ledger has no surprises. If there are any, the responsible managers are in for a surprise or two themselves.

The credit side may have surprises galore. Losing money is terrible. Breaking even is all that's required. Making some money is fine. Making a lot of money is great. What are profits? Profits are what are left over after all the debit side requirements have been met. They are tracked quarter by quarter with surprises each quarter. What to do with them? Good question. Paying an additional dividend, sure. But never paying out all the profit. Operating reserve? That's needed. Perquisites are needed to reward managers for making money, which is what they are also paid to do. Amassing reserves to expand, merge, acquire, raid. Some corporations have reserves of billions of dollars, to be used at the discretion of the top management.

The wealth of the corporation is sequestered allowing large stockholders to realize capital gains instead of simple income. Before the Tax Reform Act of 1986 capital gains were taxed at lower rates than ordinary income; now capital gains and ordinary income are taxed at nearly the same rate. This part of the law affects the speculators, the people who buy and sell securities for a living.

The principal beneficiaries of corporations amassing great wealth, (investing it or just accumulating it in interest bearing bank accounts), are those investors who don't need the money and have it parked in a corporation increasing in value without the necessity of paying taxes on the increase since it is never redeemed as cash. When the owner of such wealth dies, the heirs receive the benefit of the increased value without taxes, since in the new generation the security is assumed to have no increase in value. That is, the capital gains clock is set back to zero. Vast amounts of wealth transfer from generation to generation without taxation via this process.

For decades complaints have been leveled at corporate leaders for lack of responsible management, for lack of responsiveness to stockholders, the environment, the social community, etc., etc. How the profits of a corporation are handled has much to do with the image of corporate irresponsibility, and employees are discovering they too can play the raider game and are buying the corporations they work for.

The list of Fortune 500 companies that pay less in Federal Income Tax than the average middle class family is fairly impressive. That is supposed to change with the Tax Reform Act of 1986.

Small investors have not found much of value in corporate stocks. Mutual funds have taken advantage of this fact and have been able to profit by aggregating investments. Pension fund members similarly benefit when the pension fund is traded as a whole. But stocks are not generally acknowledged as good, income producing investments. Public utilities are often touted as good income stocks, but even this is questionable. Why is it that stocks are not good income producing investments? Well, I think the obvious answer is that stock corporations are used to sequestering income, not paying it out. Stocks are used to gamble or speculate. They are not viewed as the equivalent as a savings and loan bank.

If the profit, after a reasonable allowance for contingencies and operating reserves were paid to stockholders it would be quite a different matter. Stocks would be income producing investments. They would have all the risks bad or poor management brings, but at the least the stock holder would have a greater chance of reward if there were rewards to be had. The performance of a stock would be quite easy to judge and decisions to buy and sell would be stripped of most of the mystery. Now instead of worrying what to do with the profit: buy another corporate jet? give top management another juicy bonus? buy some unrelated business? or a golf course? invest in Amalgamated Widgets? or put it into a funny money fund? Profits after certain allowances would go to shareholders. This would take the uncertainty out of managing profits, and place them in the same knowable position as debits. You pay them. Profits become debits owed stockholders.

Companies that voluntarily paid out the bulk of their profits to shareholders should be rewarded by being excused from the Federal corporate tax. Now they would have to come to terms with the IRS on what the "certain allowances" were, but the general principle would be send the profits to the shareholders, pay no tax. Retain profits above the allowances and pay the tax.

The theory is simple: if the profits are paid out to shareholders they become ordinary income in the hands of individual stockholders who have less opportunity to finagle the IRS than the corporations. The stockholders then will pay the tax as part of their personal income tax. Instead of the Federal government receiving its taxes from the corporation the government would receive its taxes from the shareholders who profited from their stock in the corporation. This arrangement would be voluntary on the part of the corporation. Elect option (1): pay out profits, be excused from Federal income tax on the IRS approved "allowances." Elect option (2): retain profits above the allowance for any reason whatever and pay the Federal income tax on all retained profit.

Corporations that paid out their profits would be vulnerable in terms of their cash position. They would have to sell additional shares of stock or they would have a great need to borrow money. They would be mean and lean, but they would need access to assets outside their corporate immediate province. Raising money through new issues of stock may be a little iffy, so raising money normally means going to the bank.

If these corporation were to become subject to predatory banking practices they would be especially vulnerable to exploitation. To prevent failures to this profit-paying class of corporations, new banks have to be established. Federal banks with public assets, (Social Security Trust Funds, a hypothetical Land and Water Conservation Trust Fund, voluntary contributions, not to exceed $100 paid in addition to the tax due, from citizens and collected on the Federal Income Tax form). These banks, consisting of citizens funds, would be run as part of the Federal Reserve System for the specific purpose of providing capital to corporations participating in profit payout. A certificate from the IRS is all that should be needed to gain access to such a bank. And the IRS certificate would guarantee a line of credit commensurate with the income producing potential of the corporation. Interest rates would be sufficient to encourage competition and productivity—not to maximize return. Overhead in such banks would be limited to Civil Service standards of salaries and perquisites.

Private banks could participate in this scheme to whatever level of their resources they chose, but according to Federal standards. The public banks would assure capital at non-predatory interest rates. The public banks should be profitable, but not to the detriment of their clients. This system of banks should not borrow from the Federal Reserve System since they should not compete with private banks for Federal Reserve assets. The public banks should have their own assets from such sources as cited above. They should serve the national interest, supporting domestic and international trade and the national economic hegemony. What the private banks did with their profits is their business. What the public banks did with their profits would depend upon the source of their funds. If the banks funds came from the Social Security Trust, the profits should go back to the trust. If the funds came from the hypothetical Land and Water Conservation Trust Fund, the profits should be dedicated to park and recreation activities that would be to the common benefit of the citizens of the United States. If the funds came from citizen contributions to expressly fund the bank they should be used to increase the bank's assets.

The corporate raiding wolves should be encouraged to hunt for the fat sheep among the corporations. Corporate raiding seems to be the only ecological process that keeps corporations honest, so why not encourage it. The stockholders benefit, the nation benefits from enhanced tax collections and wealth is not frozen in corporate deep freezes, which doesn't even thaw from generation to generation.

The very wealthiest people of the United States, (the 0.5% that owns 35% of the nations wealth and the 10.5% [which includes the 0.5%] that owns 90%), keep their money in corporations. Much of this money passes from generation to generation untaxed.

The Reagan Administration policy of reducing taxes to encourage corporate growth did not work. Increasing defense expenditures produced abundant profits in a narrow group of defense industries which do not serve the public as a whole. Public money made the rich needlessly richer at the expense of the middle and lower classes, with no assurance whatsoever that the money would be used for capital formation.

"Industry prospers in societies in which wealth is distributed over a great number of persons and descends from the richest to the poorest by graded stages: 'the more the wealth is divided, the more consumption and consequently production increase.'" What Ferdinand Lot writes of the Roman Empire in the 3rd Century AD, (The End of the Ancient World and the Beginnings of the Middle Ages, Harper Torchbooks TB 1044 1961), is equally true today.

The Reagan economic policies with no real social or economic purpose transferred assets from the middle class to the upper class which didn't need the money and which did not put it back into circulation as increased manufacturing and industrial activity. In fact much of it seems to have gone to finance the public debt, which increased the nation's economic vulnerability. For the economy to boom and therefore strengthen the nation's economic hegemony, the middle class has to be energized. The upper classes don't consume enough to keep feudalism going let alone a modern economy. And there is no reason to believe that they will act in any way except their own self interest. The middle classes are the primary producers, through their intellect and labor, and they are the primary consumers, instituting a demand that is essentially unsatiable. They are the source of most of the taxes. To increase the potential of the middle class one does not recruit the upper classes to join the middle class, one enfranchises the lower class with their unalienable rights allowing them spontaneously to take their place in the middle class (or upper class). I change "Engine Charlie Wilson's classic quote from; "What's good for General Motors is good for the nation," to: "What's good for the middle class is good for the nation."

Corporate profit payouts would clearly benefit the middle class. A robust manufacturing and industrial sector would definitely benefit the middle class, as would the service economy appropriate to service such a manufacturing and industrial economy. The upper class will not lose, it never loses. The lower class will benefit only to the extent the society enfranchises it to exercise its unalienable rights, one of which is the right to participate in free enterprise. (The real difference among the classes is the extent to which they have access to and exercise their unalienable rights.)

Lets get over the agony of corporate taxation. Let's remove the ambiguity from corporate failure and success. Let's make investment in corporate securities a paying proposition for everyone holding the stock. There is no reason why the middle class could not look to income from corporate securities as a second income, augmenting wages and salaries during a working lifetime and augmenting retirement in the golden years. Above all let's make corporations competitive, both in the domestic and the international markets. The incentives for tax exempt profit status would make it necessary for corporations to stick to the business of business. Keeping corporations lean—book value and stock value essentially the same—would make them less vulnerable to take overs since the buy out could not be leveraged with excess assets of the corporation. At the same time mergers and acquisitions would not be inhibited but the buyer would get what was paid for, not a bonanza of hidden assets. Disruptive take overs would be inhibited but regular mergers and acquisitions would not be. We want corporations to operate in such a way as to not put at risk either the health of workers or consumers or the environment. Operating with a concept of humaneness, we want corporations to create the goods and services but as importantly the wealth necessary to operate the nation so that no one is denied their unalienable rights, and yet at the same time the nation can play its proper international role as the world's foremost democracy. Let's get down to business and stop fooling around with corporate funny money. Corporations benefiting all levels of society would be the start of capitalism with a human face.

. . . Ted Sudia . . .

Postscript: After I completed the above essay on corporate finance Paul Giordano a member of IdT brought to my attention an article in the "Harvard Business Review" entitled, "The mysterious disappearance of retained earnings," July-August 1987 # 4 by Ben C. Ball, Jr. Mr. Ball's conclusion: corporate profits are squandered. They are squandered in poor investments for the most part but for all other reasons mentioned in this and other articles on corporate finance. His solution: give the profits to the stockholders—they would probably make better use of them than the captains of industry and if stockholders lost the money they would be losing their own money in contrast to the corporate managers who are losing someone else's money. No one gains from the present system, it's undemocratic, it's unecological, and it loses money. How much worse can it get? (TWS).

© Copyright 1988
Institute for domestic Tranquility