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WorldCom as Piker: Profit Inflation by the U.S. Government

Mises Daily: Saturday, August 10, 2002 by

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News reports now indicate that WorldCom's overstatement of its profits in the last few years may exceed the $3.8 billion initially reported, perhaps by as much as an additional $3.3 billion, maybe even more. But whatever the ultimate figure may be—$7.1 billion or even $10 billion—it pales into insignificance in comparison with the overstatement of profits regularly engineered by the U.S. government.

While WorldCom overstated its own profits, and presumably incurred  liability for the payment of corresponding additional taxes,[1] the U.S. government is responsible for the overstatement of the profits of other people, namely, all the taxpayers—both individuals and business firms—who are domiciled within the United States and who earn profits. While WorldCom, quite stupidly one would have to say, increased its own tax liability, the U.S. government, quite cleverly one is tempted to say, regularly and systematically increases the tax liabilities of all who are subject to its laws and who earn profits—and thereby, of course, helps to fill its tax coffers.

If one takes the amount of overstatement that it engineers as a mere 10 percent of reported profits in the United States in the year 2001, the figure would come to more than $140 billion, just for that year.[2] The resulting increase in its tax revenues would be the appropriate tax rates times that $140 billion. In years of more rapid inflation, such as characterized the 1970s, the proportion of profits manufactured by the government could well be on the order of 50 percent, or more.

The following example explains how the government's profit-tax racket works. Imagine a company that buys a machine for $1 million, and assume that the machine will last 10 years. The company will depreciate this machine at the rate of $100,000 for each of 10 years. That will be the amount of cost that will enter into its income statement on account of the machine in each of the years.

If the company is run reasonably well, it will recover all of its costs and earn a profit besides. We can assume that in each year, it will have sales revenues of $1 million and will incur operating costs—i.e., costs on account of such things as labor, materials, fuel, light, heat, and advertising—of, say, $850,000 per year. These assumptions imply that in each year, the company earns a gross profit—i.e., profit prior to depreciation expense—of $150,000, and a net profit of $50,000.

Assuming that there is no inflation and thus nothing to make the purchase price of a replacement machine 10 years later higher than the $1 million price of the original machine, the company can afford to use up its entire $50,000 of profit each year and still be able to continue its operations. Thus, for example, if the tax rate on profits were, say, 50 percent, the company would pay $25,000 in taxes each year and have $25,000 per year remaining over. It could use those $25,000 to pay a dividend to its stockholders of $10,000, say, and the remaining $15,000 for expanding or improving its equipment or other assets.

It could afford to do these things because, in this scenario, its depreciation allowances would be sufficient to enable it to replace its machine at the end of 10 years. The saving up of the $100,000 per year of recovered depreciation expense would amount to $1 million at the end of 10 years, and that would be sufficient to buy a replacement machine at a price of $1 million.

Now enter the government with its inflation of the money supply. The new and additional money created by the government travels from hand to hand in repeated rounds of expenditure, raising business sales revenues and prices and wages in the process. It doesn't take an uncommonly great amount of inflation to succeed in doubling the sales revenues and operating costs of our hypothetical firm before 10 years have elapsed since its original purchase of its machine.

Imagine that this has occurred. In this case, our firm will now have sales revenues of $2 million per year and operating costs of $1.7 million per year. This, of course, means that our firm's gross profit too will have doubled—from $150,000 to $300,000.

But what will have happened to its net profit? It will have quadrupled—going from $50,000 to $200,000! The reason, of course, is that so long as the original machine is still in service within the 10-year period, the depreciation expense remains unchanged at $100,000. Thus, our firm's total costs will be only $1.8 million, while its sales revenues are $2 million, leaving a net profit of $200,000.

Everything now appears to be so very rosy. Pretax profits, as we've just seen, have quadrupled. Of course, taxes, too, at the unchanged 50-percent tax rate, have also quadrupled. The government and its puppets in the media would like us to believe that this last is all perfectly natural and of no consequence, that all that the government is doing is merely taking its accustomed cut. After all, the firm will now have a net profit after taxes of $100,000, and that, too, of course, is a quadrupling of the $25,000 after-tax net profit that it used to have.

There is only one problem. Along with the general rise in prices, the replacement price of our firm's machine has doubled. It now costs $2 million instead of just $1 million. The firm's accumulated depreciation allowances, which will not reach more than $1 million, will therefore not be sufficient to make possible the purchase of a replacement machine. In order to make adequate provision for replacement of its machine, our firm would have to double its annual set-aside for replacement from $100,000 to $200,000.

Its entire $100,000 per year after-tax profit is required to make this possible. Nothing is left either for a dividend payment or for any kind of expansion. Any dividend payment or attempt at expansion is at the expense of our firm's ability to replace its machine. Thus, the firm and its stockholders are actually much worse off in this situation than they were when their after-tax profit was only $25,000 per year, because that profit represented funds available after full allowance for the machine's replacement had been made. None of the current $100,000 of after-tax profit is so available.

What the government has accomplished by means of its profit inflation is a substantial increase in its tax revenues. It has accomplished this by means of a sharp increase in the effective rate at which profits in the sense of actual gains are taxed. Indeed, in the present example, without benefit of any legislative change in the 50-percent rate of tax on profits, the government has effectively increased the rate of taxation on profits to 100 percent. This conclusion follows from the fact that, after making adequate allowance for replacement, there is no real gain to the firm at all. It has no "profit" left. It has barely broken even. What the government has done in this case is apply the unchanged 50-percent tax rate to an amount of profit that is overstated by a factor of 2.

What our firm should have been able to do was take an extra charge of $100,000 per year against sales revenues, in the form of a supplementary depreciation allowance, geared to the rise in the replacement cost of its machine. Had it been able to do this, its pretax net profit would been reduced from $200,000 to $100,000. It would have paid the 50-percent tax rate on just $100,000 instead of $200,000. It then might have been able to accumulate a sufficient replacement fund, and, after payment of taxes, still have had $50,000 left over. Of course, in the face of a doubling of prices, $50,000 would buy no more than $25,000 previously bought. But at least the firm would not be worse off.[3]

The way things stand at present, inflation enables the government to tax funds that are required for replacement. The situation is the same as if, without inflation, the government taxed not only profits but also depreciation allowances.

In doing this, the government is really not so clever after all. It destroys the capital base of the economy of its own country and thus the underpinnings of its own power. This policy almost certainly played a major role in the creation of the so-called rust belt in the 1970s, when across the industrial heartland of the United States, one once-great factory after another was turned into a rotting shell, for lack of the means to maintain and replace it. The funds required had been siphoned off to pay for the government programs inaugurated under “The Great Society” and “The War on Poverty.”

Such is certainly not the policy of statesmen, but it is very much the policy of voracious looters, mindlessly lusting after the wealth of others, without the slightest regard for the consequences.

It is difficult to resist the thought that if only there were a free press in the United States, how easy it would be to bring the looters to account. But then one quickly recalls that there still is a substantially free press. The problem is that the press—the media—is intellectually corrupt, to the point that instead of calling the looters to account, it much prefers to fan the overstated profits created by the looters into hatred of the looters' victims, whom it regularly depicts as the cause of economic hardship, especially that associated with rising prices. Its relentless message to the masses is: You are suffering. The businessmen and capitalists are growing rich. Their ill will and evil is the cause of your suffering. Vote for more looters and give the looters more powers. (It is a real credit to the American people that, despite all the inflammatory propaganda of the media, there have as yet been no organized physical attacks—no pogroms—against businessmen or capitalists in the United States.)

Fortunately, the Internet now makes possible an alternative to the conventional media. Web sites such as this one now exist, which are different. They tell the truth. Perhaps they will succeed in reaching a sufficient number of American citizens to make a difference and call the looters to account after all.


George Reisman is professor of economics at Pepperdine University’s Graziadio School of Business & Management in Los Angeles, and is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996).  His book is available through Mises.org or Amazon.com. His web site is www.capitalism.net.  You may contact Dr. Reisman at MAIL. See his Mises.org Archive, and read his interview in the Austrian Economics Newsletter


[1] Can it be assumed that all of this liability will now be promptly canceled, and, indeed, taxes refunded to WorldCom to whatever extent it may actually have paid them on its nonexistent profits? Frankly, I doubt this will happen.

[2] The Federal Reserve Bulletin of June 2002 reports the sum of "corporate profits before tax" plus "proprietors’ income" as $1.442 trillion (p. A48, lines 38 and 43). Ten percent of this amount is $144 billion. 

[3] Actually, it would probably still be worse off. A $200,000-per-year depreciation charge is adequate only if the firm is able to make that large a set-aside for a full 10 years. To the extent that the rise in replacement costs occurs only after the passage of some years, replacement allowances will still not be adequate. All that can really be said for our illustration of a supplementary depreciation allowance is that there might then be some possibility of depreciation allowances being adequate and that, in any event, they would at least be less inadequate.