Both main parties are promising to raise public spending after the election. This matters for company profits, because these are more dependent on government action than you might think.
To see this, we need to understand the circular flow of income and how it affects profits in aggregate, what follows is a story about total profits, not those of an individual company.
The key thing here is that one person's spending is another's income, and vice versa. This means that wages, in aggregate are not a cost to companies as long as workers spend them on UK-produced goods and services. If this happens, what firms lose at the back door in costs they recoup through the front door in revenues. In the same way, capital spending adds to profits to the extent that investment goods are made in the UK, because this means that one company’s capital spending is another’s orders. Similarly, government spending adds to profits unless it is offset by taxes. So too do exports, unless offset by imports.
We can formalise this with a national accounts identity. We know that gross domestic profit (GDP) is equal to the sum of consumer spending (C), investment (I), government spending (G) and net exports (NX). It is also equal to the sum of wages (W), profits (P), taxes on production (T) and other incomes such as those of the self-employed and rent (O). Rearranging these gives us an identity for profits:
P = (C-W) + (I-O) + (G-T) + NX.
This should be common sense. It tells us that profits are high when aggregate demand is high – the sum of consumer spending, investment, public spending and exports – and when this demand isn’t being diverted away from companies into the hands of workers, the self-employed, landlords, the taxman or foreigners.
My chart plots these four counterparts to profits since 1955 (when current data began) expressed as a share of GDP: These four add up to the share of profits in GDP. I’m using the national accounts measure of profits, which are the domestically-generated pre-tax profits of firms operating in the UK, and which excludes the overseas earnings of UK-based companies.
For most of this time, this share has been quite stable at around 21 per cent, except for a fall in the mid-1970s and peaks in the late 1980s and mid-1990s. It is now close to its long-run average.
This stability, however, disguises some big changes in the counterparts to profits.
In the 1950s and 1960s, three of our components made big contributions to the profit share: consumption minus wages, net government spending and investment minus other incomes. Since then, however, consumption minus wages has soared to become by far the main counterpart to profits.
This is partly because the savings ratio has fallen, so companies see more wages returned to them in the form of consumer spending: this was a big reason for the recovery in profits in the 1980s. It’s also because of the growth of a large group of affluent non-workers in the form of retirees. And since the 1990s, consumption minus wages has been supported by tax credits which top up workers incomes and hence consumer spending.
Another big change is the collapse in the investment-other component. In the late 1960s this was the biggest counterpart to the profit share. But this century, it has contributed nothing and in fact has subtracted from profits since 2017. This is partly because capital spending has fallen as a share of GDP – it is now under 17 per cent compared with over 20 per cent in the late 1960s and early 1970s. It is also because other incomes such as rents and income from self-employment have risen.
Thanks to this collapse, the second main contributor to profits this century – and, in fact, the only contributor alongside consumption minus wages – has been net government spending.
What all this means is that UK profits are no longer self-sustaining in the way they were during the 1945-1973 golden age of capitalism. Back then, high investment by some firms – motivated by high actual and expected profits – meant big orders and therefore high profits for others.
Instead, profits now depend more on decisions made outside the corporate sector. Will government spending and borrowing be high? Will the government continue to support the incomes of pensioners, the low-paid and those out of work? Will households continue to borrow and thereby maintain consumer spending at a high level relative to wages? In this sense, there is a dependency culture at the heart of British capitalism.
In this context, you might think the cross-party consensus for increased public spending will be welcome support for profits.
You’d be right if everything else were not to change. But it might. The increased wages and jobs created by higher public spending will leak out, in part, to imports. And it’s possible that as wages rise workers will take the opportunity to pay off some of their borrowing, thus depressing consumer spending relative to wages. It’s also possible (though debatable) that Labour’s rise in corporate taxes would depress capital spending enough to offset the stimulus to it given by higher aggregate demand. On the other hand, though, resolution of Brexit uncertainty should boost capital spending and hence profits and a recovery in euro zone demand – which is predicted by the recent pick-up in narrow money growth – should boost exports’ contribution to profits.
In cyclical terms, then, there are reasons to be cautiously optimistic about profits. This, however, disguises a long-term structural change which has made UK company profits more dependent on the state and the consumer. Which cannot be healthy.
