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Schumpeter on profit

Joseph Schumpeter made an important observation that the significance of profit is that it is the guarantee of future activities (through investment) and of future employment (through a rational choice of technologies). This has been cited by Peter Drucker in a paper published in Forbes in 1983 ( see Schumpeter and Keynes ).

If this became the exclusive purpose of profits then the Marxist analysis concerning excess production would have no basis in fact.

This rationale supports what I have called the profit paradox (see main article left) in that this aspect of Schumpeter's view is at odds with current concepts of the role of profit. The concept of profit is poorly defined and its role devisive in terms of the operational efficiency and transparency of the economy. In my opinion, limiting the role of profit to the aspects expressed by Schumpeter's observation is entirely valid and it opens a doorway to the resolution of this confused resource allocation issue that circulates around profit.

This is achieved by substituting the quest for profits by a quest for real incomes.
The profit paradox

Hector McNeill1

Perverse policy incentives:- The "profit motive" operates within a policy framework where the current means of government revenue seeking using corporate taxation of profits creates a strong incentive for owners of economic units to hide their income and misreport profits so as to minimize corporate taxation (as well as personal taxation). The regulatory legally-based accounting and audit framework also encourages business ownership to constrain wages since they are a cost set against profits. The outcome is tax avoidance and evasion on an increasing scale. As a result real incomes of wage earners are declining resulting in falling government revenues. There is a tendency for an increasing proportion of the population being unable to pay income tax. This results in increasing negative pressure on public service provisions as a result of lack of resources.

The profit paradox

The profit paradox is an analysis that shows that the profit motive gives rise to the misallocation of resources, declining government revenues and falling real incomes of wage-earners. I identified this issue by taking a specific view on the role of profits by Joseph Schumpeter as the only role of profits. See the box on the right.

It is notable that, in spite of the claims that the economy operates on the basis of freedom of choice and free markets, all of the conventional policy instruments are monopolistic state interventions (read interference) consisting of interest rate setting, money supply, taxation, government expenditure and government debt. If governments want to support the operation of free markets they need to terminate such market interventions. These impositions need to be substituted by incentives and methodologies for businesses to increase their productivity applying transparent business rules to increase real incomes at the level of the firm in a way that supports an equitable real income distribution.

Profit as an indicator of performance and target of taxation

One of the most significant distortions in national resources allocation arises from the status of profits in relation to the process of government revenue-seeking through the various methods of taxation. The system is considered to be efficient and normal, designed to gather tax revenues through the operation of a legal framework of defined accounting and audit standards. However, the accountancy standards applied have a significant impact on the outcome of optimization procedures as well as creating a significant rift between sections of the social and economic constituencies. Thus the accountancy variable to which taxation is applied is profit. The same measure, profit, is used by companies to assess their performance or relative success in their contribution to "shareholder value". There is therefore a contradiction between profit as a business performance indicator and profit as a target for taxation.

Tax evasion and avoidance

This has resulted in what is now a very large scale tax evasion and avoidance operating on a global scale. Therefore far from securing a sound basis for corporate taxation, profit is transformed into other cash flow and asset groupings on the basis of a perverse resource allocation algorithms which obscure gains from business in relation to the income of owners and proactively minimize tax burdens. This distorts measures of business performance resulting in government revenue-seeking generating a far lower revenue than the potential, damaging public service provisions.

Profit and income differentiation

Profit as a measure of performance has another significant problem related to its accountancy specification as the difference between input costs and corporate income or revenue. Wages are classified under accountancy rules as a cost. As a result there is an antagonism between the process of resources allocation and desirable levels of wages and profits.

Constraints on wages

So in addition to the motivation for companies to obscure ownership income as well as evade or avoid corporate tax, there is an additional motivation to resist rises in wages in the process of resources allocation. The general strategy followed by corporate decision-makers is to attempt to guarantee that the payment of dividends and executive bonuses outstrip inflation so as to achieve real income rises whereas wages, not being set by wage earners, are contained and, on balance, fall behind inflation thereby resulting in constantly falling real incomes for wage earners.

Thus the combination of macroeconomic policies in the form of government revenue seeking within a regulatory environment with inappropriate accountancy and audit norms generate perverse incentives and outcomes. The most unfortunate outcome is that companies cannot in fact optimise resources allocation to achieve the potential levels of productivity because of the conflicting constraints imposed by tax policy and regulations on the resources allocation procedures. Another impact of this state of affairs has been the colouring of political discourse and extremes of opinion arising from inappropriate conventional policies.

The share of profits in national income has risen and the share of wages has decreased. At the same time government revenues have fallen in real terms. This state of affairs has been exacerbated by monetary policy which, as I have explained, has been devaluing the value of the currency and real income levels in general. As a result wage earners face a significant cost of living crisis and government revenue's real purchasing power is also declining leading to a significant strain on public service provisions such as the National Health Service.

Lack of policy traction

An associated impact of the profit paradox is that the lack of coherence in management microeconomic objectives with macroeconomic policy objectives leads to a lack of policy traction.

1 Hector McNeill is director of SEEL-Systems Engineering Economics Lab

Updated: 22nd June 2015: added section: "Lack of policy traction"

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