Profits are up. Operating margins for firms publicly listed in the US show a substantial and sustained rise. Corporate valuations are up as well. That is good news for managers and investors. But is it good news for society?
Economists such as Joseph Stiglitz and Luigi Zingales find the rise potentially troubling for two reasons. First, higher profits create greater economic inequality. Rising aggregate profits correspond to a decline in labor’s share of output, contributing to stagnant wages. Also, greater profits for some corporations but not others may create greater wage inequality.
Second, the rise in profits might represent a decline in competition and, with that, a decline in economic dynamism. While a dynamic, competitive economy rewards innovative firms with high profits and punishes poor performers with low profits, sustained aggregate profits suggest, instead, that firms are able to get away with higher prices because competition is limited. Firms engage in political “rent seeking”—lobbying for regulations that provide them sheltered markets—rather than competing on innovation. If so, then high profits portend diminished productivity growth.
But there is a more optimistic narrative about the rise of profits. Perhaps profits are rising because firms are increasingly making profitable investments in new technology, in IT, or in their organizational capabilities. In this account, high profits represent increased economic dynamism.
So which is it — political rent seeking or cutting-edge investments? In a new research paper, I tease apart the factors associated with the growth in corporate valuations relative to assets (Tobin’s Q) and the growth in operating margins. I account for the roles of R&D, spending on advertising and marketing, and on administrative costs, including IT. I also consider investments in lobbying, political campaign spending, and regulation; and I look for links between rising profits and industry concentration and stock volatility.
I find that investments in conventional capital assets like machinery and spending on R&D together account for a substantial part of the rise in valuations and profits, especially during the 1990s. However, since 2000, political activity and regulation account for a surprisingly large share of the increase.
Much of this result is driven by the role of regulation, so it is important to understand the link between regulation and profits. Lobbying and political campaign spending can result in favorable regulatory changes, and several studies find the returns to these investments can be quite large. For example, one study finds that for each dollar spent lobbying for a tax break, firms received returns in excess of $220.
It is less obvious, however, that regulation in general should be associated with higher profits. Indeed, critics of the regulatory state regularly decry the costs imposed by regulations. Yet even regulations that impose costs might raise profits indirectly, since costs to incumbents are also entry barriers for prospective entrants. For example, one study found that pollution regulations served to reduce entry of new firms into some manufacturing industries.
Even when regulators try to reduce prices, firms can benefit. For example, in 1992 Congress passed the Cable Television Consumer Protection and Competition Act in response to high cable TV rates. Regulators expected cable prices to fall by 10%. Instead, however, cable companies changed their programming bundles, prices did not fall, and corporate valuations increased. The chart below shows that the aggregate market value of cable companies relative to assets (Tobin’s Q) rose following the Act, compared to valuations of other firms....MORE