Profits; H. Sennholz

This article is from a speech given to business executives in Dallas, Texas, on April 23, 1965. ALTHOUGH every businessman aims to earn a "profit," he usually knows very little about the eco nomic nature of his objective. He may even succeed in earning a profit, and yet be unable to explain this excess of proceeds that ac crues to him after all expenses are paid. The same can be said about tax collectors who se'arch for "profits" and aim to seize parts thereof for the state. And the accountants who reveal the "profits" by com paring the business revenue with the expenses. They all look at the totality of net income without any distinction of its various compo nent parts. The economist who analyzes the economic nature of "profits" ac tually perceives three entirely dif ferent sources of income. Most proprietors and partners of small businesses who think they are reaping "profits" actually earn what ecnomists call managerial remuneration. They are earning an income through their own managerial labor, supervising their employees, serving custom ers, working with salesmen, ac countants, and auditors. Obvious ly, 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 15 16 THE FREEMAN August earned through his own labor ex ertion 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 mana gerial labor market they would earn this income for services rendered to customers, for buying and selling, supervision of person nel, bookkeeping and accounting, and many other business activi ties. But the majority of American enterprises earn an income in ex cess of managerial remuneration. The economist who dissects this residi um finds yet two other het erogeneous parts. By far the larg est part, which is earned by the majority of American enterprises, is interest on the owner's or stock holder's invested capital. It ac crues to the owner on account of the time-consuming nature of the production process. Interest Whoever refrains from spend ing his income and wealth and, instead, invests them in time-con suming production can expect a return. For without it no one would relinquish his savings to provide capital for production. In terest ultimately flows from hu man 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 inter est, 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 ba.sic interest return of some 4 per cent must accrue to business lest it withdraw its capi tal from production. As labor will leave an ind ustry that pays low wages, so will capital shun an in dustry that does not yield a mar ket return. If the govern men t should tax it away or if labor unions should succeed in wresting this interest income from busi nessmen, production will neces sarily contract and ultimately fall into deep depression. No addition al capital will be placed at the dis posal of an industry whose inter est accrual is distributed to work ers inste'ad 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 consump tion may even destroy what many generations before have built and accumulated. It is difficult to ascertain the precise rate of originary interest 1965 PROFITS 17 which businessmen earn on ac count of the-time-consuming na ture of production. For reasons of comparison we cannot even use the market rate of interest applic able to loan funds because the market rate itself is a gross rate consisting of originary interest, an entrepreneurial profit compo nent 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 illustra tion of the originary interest rate, we may use the rate the U. S. gov ernment must pay for the use of funds. If we assume that the lend er of funds to the U. S. govern ment bears no debtor's risk and that inflation does not affect the loan value, we arrive at an in terest 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 busi ness, 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 U. S. Treasury bonds or savings banks deposits. As a basis for this interest cal culation you would take the esti mated present market value of your net worth, for only the pres ent value of your assets, and not the arbitrary book value reflecting past valuations or tax considera tions, is meaningful for individual motivation and action.

A merchant with a business net worth of $100,000, spending long days in his shop serving custom ers, 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 Marlcet Conditions Finally, there are enterprises that do earn pure profits. Through correct anticipation of future eco nomic conditions, businessmen may earn what economists call entrepreneu.rial profits. For in stance, through buying at a time when prices are low and selling when prices are higher, they may earn inventory profits. After in terest 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. When ever a change in demand, supply, 18 THE FREEMAN August fashion, or technology opens up an opportunity for pure profits, the' early producer reaps high re turns. But immediately he· will be imitated by competitors and new comers. They will produce the same good, render identical serv ices, apply similar methods of pro duction, and thus de.press prices until the pure profit disappears. The' first hoola-hoop manufacturer undoubtedly reaped pure profits. But as soon as dozens of competi tors had retooled their factories the market was flooded with hoola hoops. Prices dropped rapidly un til the pure profits had vanished. When the Ame·rican people sud denly 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, Ameri can Motors profits returned to the market rate of interest or even changed to losse·s.

Pure profits are very elusive. But opportunities for profits will emerge as long as there are' changes in demand, supply, fash ion, population, technology, or even the weather. As all life is change, and economic adjustments need to be made continuously, op portunities for profits will arise again and again. And yet, in spite of the com petitive forces that work incessantly in a free economy to wipe out pure profits, we, may observe numerous enterprises that suc ceed 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 di rect 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 mar kets and with stagnant technolo gy must expect to earn the lowest profits. When completely adjusted to consumer demand and without any anticipation of risk, pure prof its would indeed be completely eliminated and only the originary intere·st return would re·main. But as even a completely adjusted in dustry may face future risks, eco nomic or political, and as the risk factor cannot be eliminated en tirely from any productive invest ment, some remnant of pure profit is usually earned by the suc cessful enterprises. This is the reason why even apparently risk less industries continue to earn a little more than the 4 per cent originary intere'st. The successful public utility, for instance, which may bear little investment risk, may earn 6 or 7 per cent, which consists of 4 per cent interest and 2 to 3 per cent pure· profit. But 1965 PROFITS 19 the presence of risk also explains why some enterprises in the same industry only earn the interest re turn or even suffer loss.

On the other hand, the success ful enterprises that continuously face high degrees of risk tend to earn higher profits. For several years during the cold-war rearm ament, the manufacture of air craft and parts was exceptionally profitable. According to some sta tistics, a few aircraft manufac turers earned more than 20 per cent of net worth .. Even if we bear in mind that corporate net worth is usually understated when com pared with present values, and earnings ratios therefore are con siderably overstated, we must admit that exceptionally high prof its were earned by the most suc cessful enterprises. In short, eco nomic activity that involves a great deal of risk must yield ex ceptionally 4igh profits to the' suc cessful enterprise in order to at tract 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 per cent profit above the originary interest. Or, oil exploration and drilling which entail great finan cial 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, ,vould eliminate the in centive 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 be comes rigid and inflexible, and un able to adjust to changes in de mand, supply, and technology. Ex pansion and modernization are severely hampered. A confiscatory taxation of pure profits, malicious ly called "excess profits," destroys the vitality and dyna.mism of the market economy. (For an excellent discussion of profit and loss see Ludwig von Mises, Planning for Freedom, Libertarian Press, South Holland, Ill.) And what are the effects of taxes levied on the 4 per cent basic interest return? As described above, inte'rest is the payment for the use of capital over time. With out 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 mar ket must fall into severe depres sion. In fact, the "multiplier"

economists who usually apply their calculations to government spending would do much better 20 THE FREEMAN August 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 per cent this interest constitutes the yield of $25 billion capital in vested. And without this yield these $25 billion of business capi tal will be withdrawn from pro duction, at least as far as it is liquid and can be withdrawn with out heavy losses. For why should the owner keep his capital in vested without a return? The Great Depression gave dra matic proof of the depressive ef fects of confiscatory corporate taxation. And today, we can ob serve similar stagnating effects whenever the' Federal or state gov ernments 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 eco nomic effects of taxes that fall on the first-mentioned component, the managerial remuneration? Why should a merchant spend twelve to sixteen 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 in come the independent business man will be tempted to sell out to his big competitor and rather earn a salary as a branch mana ger than to face confiscatory pro fit taxes. In economic life it is rather dif ficult 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 re muneration. The effects, therefore, do vary. In some cases the tax merely prevents risky undertak ings, in others it causes depres sive restrictions of production, and in yet others it may cause the liquidation of small and me diurn-sized enterprises.

Addendum on Profit-Sharing For many people, profit-shar ing is thought to provide the solu tion 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 capi talistic system." Even some busi nessmen praise it for giving em ployees a sense of partnership in the enterprise, raising worker morale, avoiding strikes, reduc ing 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 1965 PROFITS 21 a sharing system. Although hamp ered and mutilated, American business continues to deliver ever more and better goods. Wages con tinue to rise on account of im proved technology and increased capital investments, not because we work ever harder and longer hours. Competition forces inves tors 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 addi tional distribution of a business man's earnings to his employees. Some proposals depend on gove,rn ment or union coercion, others aim at voluntary sharing. Most shar ing firms are rather small in size and employment. Whose Share Is to Be Shared? The economist who analyzes this supplementary sharing must ask a pointed question. Which part of the business surplus com monly called "profit" is to be di vided between businessmen and workers? Is it the "managerial remuneration" which businessmen earn through their own mana gerial services? Why should in dependent 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 Amer ican 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 ac countant 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 prin ciple: a man's labor income is de termined by the ability of his em ployer. 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 per cent of all companies, on the average, are reporting no profits.

22 THE FREEMAN August The average annual earnings for all manufacturing companies amount to eight and six-tenth 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 pro viding better tools for workers. Sharing the entrepreneurial fee, therefore, would likely do the wage-earner more harm than good." (Claude Robinson, Under standing Profits. Princeton, N. J.: D. Van Nostrand, 1961, p. 315.) Interest on Investment And finally, there is the "inter est" 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 with drawal and consumption. Such profit-sharing on a large scale causes stagnation and depression as the economic history of the past thirty-five years has repeat edly demonstrated.

Improvements in labor produc tivity and standards of living largely depend on the increased use of capital. Saving is a funda mental prerequisite of economic progress. It is hard to understand how anyone who has human bet terment 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 com panies would share their profits, labor productivity would rise greatly and everyone would bene fit. But in this case, competition would again reduce prices and profits until there would be no excess profits to share. The bene fits of rising productivity would thus accrue to consumers through lower prices and to workers through rising wages. Competi tion would not tolerate the exist ence of permanent profits to share. Therefore, profit-sharing can remain only a limited indus trial practice.

In many cases even this limited sharing is sailing under false colors. Where labor actually be comes more productive through greater effort and application, its market value rises accordingly. Competition among businessmen will cause wages to rise. A busi nessman 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 1965 PROFITS 23 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 seem ingly successful profit-sharing plans merely constitute plans for delayed payment of that part of wages that is earned through spe cial 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. ~ Fl~nning E:x:perirY'len ts in Erita,in GEORGE WINDER WHEN, in the autumn of 1964, the Labor Party came· to power in Great Britain, it naturally wanted to nationalize the factors of pro duction, transport, and exchange.