[Originally published in the Freeman, November 1964, this article is included in Free Market Economics: A Basic Reader, edited by Bettina Bien Greaves.]
Although every businessman aims to earn a "profit," he usually knows very little about the economic nature of his objective. He may even succeed in earning a profit, and yet be unable to explain this excess of proceeds that accrues to him after all expenses are paid.
The same can be said about tax collectors who search for "profits" and aim to seize parts thereof for the state. And the accountants who reveal the "profits" by comparing the business revenue with the expenses. They all look at the totality of net income without any distinction of its various component parts.
The economist who analyzes the economic nature of "profits" actually perceives three entirely different sources of income.
Most proprietors and partners of small businesses who think they are reaping "profits" actually earn what economists call managerial remuneration. They are earning an income through their own managerial labor, supervising their employees, serving customers, working with salesmen, accountants, and auditors. Obviously, their services are very valuable in the labor market. They would earn a good salary if they were to work for the A&P or a 5&10¢ store. Therefore, that part of a businessman's income that is earned through his own labor exertion is a kind of wage or salary, and as such, totally unrelated to economic profits.
Most small businessmen with incomes up to $20,000 and $25,000 fall in this category. In the managerial labor market they would earn this income for services rendered to customers, for buying and selling, supervision of personnel, bookkeeping and accounting, and many other business activities.
But the majority of American enterprises earn an income in excess of managerial remuneration. The economist who dissects this residuum finds yet two other heterogeneous parts. By far the largest part, which is earned by the majority of American enterprises, is interest on the owners or stockholders invested capital. It accrues to the owner on account of the time-consuming nature of the production process.
Whoever refrains from spending his income and wealth and, instead, invests them in time-consuming production can expect a return. For without it no one would relinquish his savings to provide capital for production. Interest ultimately flows from human nature. Men of all ages and races value their present cash more highly than a claim payable in the future. Therefore, in order to induce an investor to relinquish his cash for production, which will yield its fruits in the future, a premium, called originary interest, must be paid. In other words, the businessman who invests in his own enterprise should hope to earn on his investment the same kind of income as the lender who extends a loan to a borrower.
This basic interest return of some 4 percent must accrue to business lest it withdraw its capital from production. As labor will leave an industry that pays low wages, so will capital shun an industry that does not yield a market return. If the government should tax it away or if labor unions should succeed in wresting this interest income from businessmen, production will necessarily contract and ultimately fall into deep depression. No additional capital will be placed at the disposal of an industry whose interest accrual is distributed to workers instead of owners. In fact, the liquid capital of that industry will even be withdrawn and turned to other employment where interest can still accrue. Capital consumption may even destroy what many generations before have built and accumulated.
It is difficult to ascertain the precise rate of originary interest which businessmen earn on account of the time-consuming nature of production. For reasons of comparison we cannot even use the market rate of interest applicable to loan funds because the market rate itself is a gross rate consisting of originary interest, an entrepreneurial profit component that flows from the risks of the individual loan, and finally, a risk premium that flows from the dangers of monetary depreciation wherever inflation is practiced. But for reasons of simple illustration of the originary interest rate, we may use the rate the US government must pay for the use of funds. If we assume that the lender of funds to the US government bears no debtors risk and that inflation does not affect the loan value, we arrive at an interest rate that may constitute the originary rate, which is the rate businessmen should hope to earn as a basic interest return on their invested capital.
Suppose your net worth of business, stated in present value, amounts to $100,000. Originary interest on that amount would come to $4,000 a year, which you would earn even in such riskless investments as US Treasury bonds or savings-banks deposits. As a basis for this interest calculation you would take the estimated present market value of your net worth, for only the present value of your assets, and not the arbitrary book value reflecting past valuations or tax considerations, is meaningful for individual motivation and action.
A merchant with a business net worth of $100,000, spending long days in his shop serving customers, supervising his help, and otherwise managing the business may thus earn $4,000 interest and $20,000 managerial remuneration without actually reaping any profits.
Pure Profits — Temporary Response to Changing Market Conditions
Finally, there are enterprises that do earn pure profits. Through correct anticipation of future economic conditions, businessmen may earn what economists call entrepreneurial profits. For instance, through buying at a time when prices are low and selling when prices are higher, they may earn inventory profits. After interest allowance is made for the time of investment, stock market profits are pure profits. Of course, such profits are connected with risk on account of the uncertainty of the future. Instead of reaping profits, many businessmen suffer losses.
Contrary to popular belief, pure profits are only short-lived. Whenever a change in demand, supply, fashion, or technology opens up an opportunity for pure profits, the early producer reaps high returns. But immediately he will be imitated by competitors and newcomers. They will produce the same good, render identical services, apply similar methods of production, and thus depress prices until the pure profit disappears. The first hula-hoop manufacturer undoubtedly reaped pure profits. But as soon as dozens of competitors had retooled their factories the market was flooded with hula hoops. Prices dropped rapidly until the pure profits had vanished. When the American people suddenly discovered their need for compact cars, American Motors, who was the early manufacturer, temporarily earned pure profits. After General Motors, Chrysler, and Ford invaded the field, American Motors profits returned to the market rate of interest or even changed to losses.
Pure profits are very elusive. But opportunities for profits will emerge as long as there are changes in demand, supply, fashion, population, technology, or even the weather. As all life is change, and economic adjustments need to be made continuously, opportunities for profits will arise again and again.
And yet, in spite of the competitive forces that work incessantly in a free economy to wipe out pure profits, we may observe numerous enterprises that succeed in earning them over lengthy periods of time. The reason must be sought not only in the superior management of some enterprises in which gifted entrepreneurs direct the speculative aspects of business, but also in the different degrees of risk connected with the various industries.
Industries that work with a minimum of risk in stable markets and with stagnant technology must expect to earn the lowest profits. When completely adjusted to consumer demand and without any anticipation of risk, pure profits would indeed be completely eliminated and only the originary interest return would remain. But as even a completely adjusted industry may face future risks, economic or political, and as the risk factor cannot be eliminated entirely from any productive investment, some remnant of pure profit is usually earned by the successful enterprises. This is the reason why even apparently riskless industries continue to earn a little more than the 4 percent originary interest. The successful public utility, for instance, which may bear little investment risk, may earn 6 or 7 percent, which consists of 4 percent interest and 2 to 3 percent pure profit. But the presence of risk also explains why some enterprises in the same industry only earn the interest return or even suffer loss.
On the other hand, the successful enterprises that continuously face high degrees of risk tend to earn higher profits. For several years during the cold-war rearmament, the manufacture of aircraft and parts was exceptionally profitable. According to some statistics, a few aircraft manufacturers earned more than 20 percent of net worth. Even if we bear in mind that corporate net worth is usually understated when compared with present values, and earnings ratios therefore are considerably overstated, we must admit that exceptionally high profits were earned by the most successful enterprises. In short, economic activity that involves a great deal of risk must yield exceptionally high profits to the successful enterprise in order to attract the necessary capital. It is obvious that the aircraft industry that continuously faces a great many imponderables, and often has suffered heavy losses, could not attract the needed capital if no more could be expected than a one percent profit above the originary interest. Or, oil exploration and drilling which entail great financial risks would not be carried on without high rewards for success.
Interference with Profits
Taxation of these high rewards, or their arbitrary distribution to workers, would eliminate the incentive for risk-taking. Why should a man risk his capital in production if he can only suffer losses? In that case he would shun every productive investment, and search for riskless employment of his funds. The economy thus becomes rigid and inflexible, and unable to adjust to changes in demand, supply, and technology. Expansion and modernization are severely hampered. A confiscatory taxation of pure profits, maliciously called "excess profits," destroys the vitality and dynamism of the market economy. (For an excellent discussion of profit and loss see Ludwig von Mises, Planning for Freedom.)
And what are the effects of taxes levied on the 4 percent basic interest return? As described above, interest is the payment for the use of capital over time. Without it capital cannot be invested and production must come to a standstill. When the government levies its confiscatory taxes on this basic income component, the market must fall into severe depression. In fact, the "multiplier" economists who usually apply their calculations to government spending would do much better calculating the depressive effects of this taxation. Let us assume, for instance, that the government imposes a tax of $1 billion on the interest return of business. At 4 percent this interest constitutes the yield of $25 billion capital invested. And without this yield these $25 billion of business capital will be withdrawn from production, at least as far as it is liquid and can be withdrawn without heavy losses. For why should the owner keep his capital invested without a return?
The Great Depression gave dramatic proof of the depressive effects of confiscatory corporate taxation. And today, we can observe similar stagnating effects whenever the federal or state governments raise their basic levies on business, such as the social-security taxes and unemployment taxes which fall on every business regardless of its profitability.
And, finally, what are the economic effects of taxes that fall on the first-mentioned component, the managerial remuneration? Why should a merchant spend 12 to 16 hours daily in his store if he cannot earn an income that is comparable with the salaries earned by other managers? If profit taxes encroach upon this income the independent businessman will be tempted to sell out to his big competitor and rather earn a salary as a branch manager than to face confiscatory profit taxes.
In economic life it is rather difficult to ascertain the impact of profit taxation. The same tax in some cases may fall on pure profits, in others on basic interest, and yet others on managerial remuneration. The effects, therefore, do vary. In some cases the tax merely prevents risky undertakings, in others it causes depressive restrictions of production, and in yet others it may cause the liquidation of small and medium-sized enterprises.
Addendum on Profit-Sharing
For many people, profit-sharing is thought to provide the solution to our labor problems. It is said to hold the key to industrial peace and represent the ideal of industrial democracy. According to a Senate committee report, profit-sharing is "essential to the ultimate maintenance of the capitalistic system." Even some businessmen praise it for giving employees a sense of partnership in the enterprise, raising worker morale, avoiding strikes, reducing turnover, increasing efficiency, and so on. In fact, profit-sharing is said to afford workers a stake in our capitalistic system.
These people do not seem to realize that the market economy is a sharing system. Although hampered and mutilated, American business continues to deliver ever more and better goods. Wages continue to rise on account of improved technology and increased capital investments, not because we work ever harder and longer hours. Competition forces investors and businessmen to share the fruits of their investments with their customers through lower prices and with their workers through higher wages.
But in popular terminology "profit-sharing" proposes to give the workers more than higher wages through competition in the labor market. It means an additional distribution of a businessman's earnings to his employees. Some proposals depend on government or union coercion, others aim at voluntary sharing. Most sharing firms are rather small in size and employment.
The economist who analyzes this supplementary sharing must ask a pointed question. Which part of the business surplus commonly called "profit" is to be divided between businessmen and workers? Is it the "managerial remuneration" which businessmen earn through their own managerial services? Why should independent businessmen yield their labor income while managers and supervisors in the service of large corporations continue to earn a market wage?
Is it the "pure profit" which businessmen are urged to share? Only a small percentage of American enterprises actually earn pure profits. Now, are the fortunate workers who found employment in profitable enterprises to earn more than their fellow workers in average firms? Should an accountant who serves a brilliant stockbroker earn $100,000 per year while his equally competent fellow accountants labor at $5,000 or $6,000? What is to determine his remuneration? But, whatever the sharing plan should provide, it introduces a dubious wage principle: a man's labor income is determined by the ability of his employer. I doubt that this is the matrix for human cooperation, the key to industrial peace. On the contrary, it would create new sources of conflict. Most workers who receive wages only would probably demand "equal pay" from their profitless employers, which would aggravate rather than alleviate the labor situation.
Many people fail to realize that industry doesn't have much profit to share. According to Claude Robinson's excellent analysis, 45 percent of all companies, on the average, are reporting no profits. The average annual earnings for all manufacturing companies amount to 8.6 cents per dollar of investment. "If we allow five cents as a form of interest," Robinson concludes, "the remaining three and six-tenths cents is left for entrepreneurial risk-taking. Should the three and six-tenths cents entrepreneurial fee be shared, it could at best mean an insignificant wage increase, and would surely decrease the willingness of owners to take the investment risks involved in providing better tools for workers. Sharing the entrepreneurial fee, therefore, would likely do the wage-earner more harm than good." (Claude Robinson, Understanding Profits. Princeton, N. J.: D. Van Nostrand, 1961, p. 315.)
Interest on Investment
And finally, there is the "interest" which capitalists usually earn on their invested funds. But, a forced reduction of this basic yield not only prevents capital formation but also causes its withdrawal and consumption. Such profit-sharing on a large scale causes stagnation and depression as the economic history of the past 35 years has repeatedly demonstrated.
Improvements in labor productivity and standards of living largely depend on the increased use of capital. Saving is a fundamental prerequisite of economic progress. It is hard to understand how anyone who has human betterment at heart can urge us to reduce the award of saving by sharing it with those who did not earn it but propose to consume it.
The friends of profit-sharing sometimes argue that if all companies would share their profits, labor productivity would rise greatly and everyone would benefit. But in this case, competition would again reduce prices and profits until there would be no excess profits to share. The benefits of rising productivity would thus accrue to consumers through lower prices and to workers through rising wages. Competition would not tolerate the existence of permanent profits to share. Therefore, profit-sharing can remain only a limited industrial practice.
In many cases even this limited sharing is sailing under false colors. Where labor actually becomes more productive through greater effort and application, its market value rises accordingly. Competition among businessmen will cause wages to rise. A businessman who then proposes to share his profits with his workers may merely be using this means to pay higher market wages. But instead of making payments every Friday, he may hold off paying for six months or a year, and call this profit-sharing. It is my opinion that most of the seemingly successful profit-sharing plans merely constitute plans for delayed payment of that part of wages that is earned through special effort and application.
In all such cases the workers would be well advised to insist on payment of higher wages rather than expose their earnings to the risks of business. Workers may even lose their delayed wages in case the business should lose money through poor management decisions.