People before what kind of profit?

Profit may be the most emotive and most disagreed-on word in the modern political lexicon.

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For some people, it conjures up a deep positive energy. It’s the lacquer of success that tells you your life has not been in vain, a thank you message from the universe.

For others, it’s a totem of greed. It’s the fuel barbarians pour onto the still live bodies of the civilised just before they burn them all, throw back their heads and howl as the smoke covers the moon.

Both can be right.

Whether you drive a Rolls Royce or a 1990 Subaru with a bumper sticker that says People Before Profit, you need to know this.

There’s two types of profit.

Economic profit, and accounting profit.

(for more: 1 2 3 )

Economic profit is bad. Let me explain.

Accounting profit is the profit a business makes after it has paid all its staff, all its bills. It represents a return on the capital the business owner put in at the start.

Imagine a small business person who delivers things you buy on the internet. They buy a van, putting 30,000 into the business. They could have put that money into the bank and got 5 per cent return with no risk, or $1500.

If, at the end of the year they have paid themself for all the hours they put in, and on top of that, the business makes $1500 of profit, that is accounting profit. That accounting profit is necessary for the business to run. If there’s no accounting profit, the delivery business will shut down, as delivery lady realises she should sell the van, put the money in the bank, and work for someone else.

(Really she should be looking for more than $1500 in accounting profit, to help compensate her for the risk of running a business, which is much higher than plonking your cash in a government-guaranteed deposit.)

So, accounting profit is necessary for businesses to exist.

When you see Woolworths Limited reporting a before-tax profit of $3.4 billion on sales of $58.5 billion, some of that is the accounting profit necessary for the share to be worth anything at all. (If the profit drops to zero, the dividend drops to zero. If the return on the share is zero, the value of the share is then also … zero).

But economic profit? That’s bad ju-ju. Let’s go back a step

Us economists think accountants are simpletons. We like to think about opportunity cost. So the idea that you’d measure the profitability of an enterprise without comparing it to a risk-free investment is hahaha, hyuk-hyuk, rofl, tee-hee-hee, laughable.

When an economist talks about profit, they mean it. They are referring to returns you can get over and above the next-best use of your money.  But that’s always obscured in the official data. When an company reports profit, it includes some that is necessary to cover the cost of capital, and the gravy.

And here’s the thing: under the assumption of perfectly competitive markets, there is no economic profit in the long run.

It’s only during deviations from perfect competition, or when market failures creep in that economic profit can occur. The most obvious market failure is market power. If a company is part of an oligopoly, or worse a duopoly (Hi Woolworths), or worst of all, a monopoly, then profit can be expected to ensue.

CBAThis is why we can be fairly sure the profits of Australia’s big four banks are not simple accounting profits. They operate in a protected space under the four pillars policy.

Australians think there is far more bank competition than there really is.

Of course banks should make enough to compensate the people that own the capital that allows the bank run. But should they make more?

Commonwealth Bank, Australia’s biggest, made $7.7 billion in profit last year.

The value of the Commonwealth Bank is $120 billion at time of writing. It was, at least until recently, in the top ten biggest banks in the world by value, even though it is not in the top ten by assets.

Any industry where all the competitors are making  extra profit on less assets should ring alarm bells.

Is that it? is there nothing we can do? I’m glad you asked.

A tax design idea is floating around – currently out of favour – called allowance for corporate equity. It is gentle to accounting profits, and starts to snarl and salivate when economic profits are made. As the name implies, it would allow profits to cover the cost of equity [that’s the money the owner put in, or the $30,000 van in the example above]. After that, taxes rise.

Another way of putting that same idea is to say take the mining super-profit tax and apply it across all industries.

Here’s an excerpt from the Fairfax press, quoting one of my old lecturers, John Freebairn.

“At the tax summit, Melbourne University’s John Freebairn, a former research director of the Business Council, said Australia’s super-profits tax rate might be ”more towards 40 or 50 per cent”. It would only be paid by companies earning ”monopolistic-type rent”. ”And let’s rub it into the banks,” he added. ”They seem to make much higher returns than anyone else.””

But that would not be popular. It’s one reason Wayne Swan ran from the Allownce for corporate equity idea when it had a brief resurgence a few years ago.

But recognising the difference between the types of profit is crucial for anyone who wants to make a difference to society, and tax policy makers know better than anyone else that companies making a super profit are probably managing it at the expense of the consumer.

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thomasthethinkengine

Thomas the Think Engine is the blog of a trained economist. It comes to you from Melbourne Australia.

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