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OPINION

Profits in danger

Profits in danger
November 3, 2021
Profits in danger

Imagine – although the contingency is a remote one – that my bosses were to give me a big pay rise without me doing any extra work. What would happen? The answer’s obvious: somebody, somewhere would lose. It could be other IC staff who’d have to take a pay cut to pay for my rise; or readers who’d have to pay more for their subscriptions; or the IC’s owners who would see their profits fall. There’s no magic money tree here.

Which is exactly the problem with the prime minister’s claim that immigration restrictions will raise wages. If your wage rises without you producing more, all that happens is that you gain at somebody else’s expense.

But whose? Will it be other workers in the form of lower real wages as prices rise, or companies as their profits are squeezed?

There’s a nice way to think about this. It starts by rearranging national accounts identities. GDP is the sum of incomes: wages (W), profits (P), taxes (T) and other incomes such as rent or those of the self-employed (O). It is also equal to the sum of spending: consumer spending (C), investment (I), government spending (G) and net exports (NX). Rearranging these gives us an equation for profits:

P = (C – W) + (I – O) + (G – T) + NX

We can think of these as shares of GDP. It tells us that profits will be protected from rising wages if and only if consumer spending rises faster than wages; or if capital spending rises faster than other incomes; if government spending rises faster than taxes; or if net exports rise.

My chart shows the contributions of these to moves in the profit share since 1990. In this time, the total profit share has been quite stable: it fell in the late 1990s but has risen a little since 2018. The contributions, though, have varied more. In recessions, those of consumption minus wages and capital spending tend to fall, while that of the government rises. In fact, since the pandemic the government has been the biggest supporter of corporate profits.

But how will these factors contribute, or not, to profits from now on?

The government sector will be a big drag. The OBR predicts that government consumption will rise by just 5.6 per cent in the next three years while taxes on production (the relevant measure in our context) jump by 54.9 per cent. Yes, chancellor Rishi Sunak announced big rises in public spending in his Budget, but these were from a baseline which envisaged big cuts. The fact remains that fiscal policy will tighten in coming years.

Nor can we rely upon net exports contributing much. History tells us this: they rarely have made a significant contribution, in part because higher exports require more imports of parts and materials. And they are unlikely to do so soon, especially as overseas economies are cooling off. Indeed, Danny Blanchflower, a former member of the MPC, believes that the US is now entering recession.

A better hope lies with consumption minus wages. Recently, this has been a drag on the profit share because, in closing shops, restaurants and pubs the pandemic forced us to save more. Although the reopening of the economy reduced the savings rate, latest data show that it is still above its long-term average.

The OBR expects this to fall further, from 11.2 per cent in the second quarter to under 5 per cent in 2024. But this is not at all certain. It’s possible that the pandemic has permanently changed our habits by making us more frugal: the fact that retail sales volumes have fallen by over 5 per cent since April suggests that the post-lockdown recovery in spending has been much less than hoped. Cuts to Universal Credit will reduce consumer spending relative to wages, as will next year’s rise in National Insurance contributions. And higher gas and electricity prices will cause us to spend less elsewhere.

Nor is it obvious that increased investment spending will support profits much. Yes, we should see a recovery in capital spending as expansion plans that had been put on ice during the pandemic are finally enacted. And some companies, having seen that holding low inventories can be an expensive mistake, will want to rebuild them in coming months.

On the other hand, though, soaring energy costs could curb investment, by both raising costs and increasing uncertainty. And all the factors that had held back capital spending for years before the pandemic – such as depressed animal spirits, fear of future innovation and credit constraints – are still in place.

Overall, then, there are reasons to fear that there could be an economy-wide squeeze on profit margins.

Which is not to say that every company will lose. Unilever’s recent announcement of price rises shows that some will be able to protect their margins. But it is an exception; it has much more pricing power than the typical firm. Smaller companies, and those operating in more competitive markets, do face a threat.

In truth, though, the threat does not actually come very much from immigration controls. These will not raise wages overall simply because more liberal immigration policies did not cut them. The Migration Observatory has summarised the evidence as being that immigration “has small impacts on average wages”, with higher-paid workers gaining a little and lower-paid ones losing slightly.

Instead, the bigger threat to profits comes from other government policies such as an overly hasty tightening of fiscal policy. Not for the first time, immigration policy is a distraction from more significant economic developments.