U.S. investment: Have capitalists gone on strike? (Part 4 of 5)
Corporate profits in the United States
The below graph reflects the ratio of corporate profits to non-residential fixed investment. This graph reflects a ratio very similar to the prior graphs in this series, noting that corporate profits relative to non-residential fixed investments have nearly doubled relative to the 1980s.
What is non-residential fixed investment and why is it important?
Non-residential fixed investment is the amount of goods not consumed but used for future production. This includes items such as railroad and factory construction. Investment in future production is important in order to maintain economic growth. Plus, new investments are likely to provide incremental improvements in productivity. This is because new investments, such as new factories, are likely to incorporate newer productivity-enhancing technologies. Without new investments involving more efficient technology, productivity levels would likely remain flat and economic growth rates would slow.
Consumption versus investment
As we described in U.S. consumer spending: Sustaining the unsustainable?, consumption as a percentage of the economy has grown from approximately 60% of the U.S. economy in the ’80s to approximately 70% of the economy today. Non-residential fixed investment had averaged near 14% of gross domestic product (or GDP) in the 1980s. But it’s closer to 12% currently, reflecting the overall decline in investment in the United States in general. Gross capital formation, formerly known as “gross domestic investment,” has declined from 20% of GDP in the 1980s to 15% today—having hovered between 19% and 20% from as recently as 2004 through 2008. So the overall decline in investment as a percentage of GDP seems to have grown over the years, replaced by post-1980 consumerism and, most recently, government spending.
This trend prompts the question, without significant growth in overall investment (including investment in factories, as reflected in non-residential fixed investment in the above graph), how can the United States maintain consumption levels without government spending? The answer appears to be that the United States won’t be able to sustain current consumption levels without significant investment growth. Overall gross capital formation returning to the historical 20% of GDP from the current 15% would be a good start. Perhaps the 70% of GDP contribution provided by consumption would have to take a 50% retrenchment toward the 60% of GDP that prevailed in 1980. But in doing so, consumption need not necessarily shrink in absolute terms. Investment simply needs to grow disproportionately relative to consumption in the future. How can that happen? Simply end the “capital strike” and vigorously reinvest corporate profits into long-term investments in the United States.
Critics may point out that redirecting corporate profits to long-term investments instead of the current trend toward share buybacks and dividend payments could lead to lower stock prices. That would only be the case if future investments were less profitable than prior investments. Perhaps that is the case. Perhaps not. Do CEOs really know what the global economy will look like in five, ten, or twenty years? If they do, the above graph suggests one of two things. First, they could be predicting an ongoing slowing of growth. This would continue the current post-1970 trends, where they simply break out a ruler and extend the historical growth lines. Second, they could simply have too much of their near-term compensation tied to unvested stock options. Clearly, what the capitalist needs is faith that the future can be and will be much better. This will require significant salesmanship on behalf of any presidential administration. Perhaps the Obama Administration raising the capital gains tax from 15% to 20% scared some capitalists out of the pool.
Capitalists: “We’re not just winning, we’re killing them”
Obama’s frustration over growing the U.S. economy found a lightning rod in the comment made by the second richest man in America, Berkshire Hathaway CEO Warren Buffett. (Forbes 400 reports his net worth at $46 billion, behind the top-ranked Bill Gates at $66 billion). As Warren Buffet remarked in an interview with Charlie Rose on PBS TV, “There has been class warfare going on… It’s just that my class is winning (capitalists). And my class isn’t just winning, I mean we’re killing them (labor).”
From the end of World War II to approximately 1983, both the top 10% of Americans and the bottom 90% of Americans had seen their real incomes double. That was the WWII dividend. Since 1983, the top 10% of Americans have seen their real incomes double again, while the bottom 90% have seen modest declines in real income. According to Thomas Hungerford of the Congressional Research Service, these developments in inequality have been overwhelmingly the result of the Supply Side Economics Dividend—the cut in capital gains and dividend tax rates.
Rising capital gains taxes: A disincentive to invest?
Obama raised capital gains tax rates back to 20%—after Bill Clinton had cut these rates from 28% to 20% in the 1997 Budget Deal, and Bush Jr. cut from 20% to 15%. While conservatives may point to higher capital gains taxation as yet another disincentive to invest, investors should note that the most aggressive rise in corporate gains taxes came about as a result of Ronald Reagan’s Tax Reform Act of 1986, in which capital gains taxes were effectively brought on par with ordinary income, or 28% under the Alternative Minimum Tax (33% for high income earners subject to phase-outs).
Despite these high tax rates on capital gains, the overall simplification and streamlining of taxation under this act appears to have led to a very significant recovery in the 1980s—despite being an essentially “revenue-neutral” change in tax receipts. As a result, we could see higher capital gains taxes as a potential disincentive for future investment. However, the current levels of taxation aren’t excessive by historical standards, and they’re well below Reagan era levels. Many argue that much of the Tax Reform Act of 1986 has been gutted by years of subsequent lobbying, and what the United States needs in terms of tax reform is to reinstate the Reagan era measures, and to restore the fundamental integrity of this act.
In summary, an increase in non-residential fixed investment in the United States could be an excellent start to potentially rectifying the growing inequality gap in the country by potentially equipping the U.S. worker with higher productivity technologies. This would translate into growing real wages and purchasing power relative to the past. While the recent rise in capital gains taxes from 15% to 20% may have cooled capital’s interest in long-term investment, given the possibility of even further hikes in the future, in the current environment, we might consider this Obama Administration capital gains tax hike a fairly small cost in relation to the benefits currently being provided by large government deficits and ultra-low nominal and real interest rates. These are currently driving the dramatic reduction of the U.S. budget deficit (from 10% in 2009 to nearly 4% currently). The government has convinced the public that it can stave off a crisis. Can the government now convince the capitalist that it’s time to make even more long-term investments in the U.S. economy?
Should private investment data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So, investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment.
For further analysis of how China could be affected by slowing consumption in the United States, please see China’s exports: Is the golden age of cheap labor coming to an end? For further analysis of how Japan’s export-led recovery could be affected by U.S. consumption trends, please see Why Japanese exports could break out of a 5-year slump in 2013. For further analysis of consumption trends in the United States, please see U.S. consumer spending: Sustaining the unsustainable?
Browse this series on Market Realist:
- Part 1 - Greenspan’s lament: The lack of fixed investment in the U.S.
- Part 2 - Kudlow’s lament: Is capital on strike in the U.S.?
- Part 3 - Why is Obama angry with capitalists over private investment?
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