Here is some background on the investment question from the previous post, and related topics.
I’ve been fooling around recently with assembling a comprehensive account of sources and uses of funds for the US corporate sector from the Integrated Macroeconomic Accounts (IMA). (It’s much easier to do this with the IMAs than by combining the NIPAs with the financial accounts from the Fed.) The goal is a comprehensive account of flows of money into and out of the corporate sector, grouped in a sensible way.
My goal here is not to make any specific argument, but to provide context for a bunch of different arguments about the finances of US businesses. I think this an important thing to do – both mainstream and heterodox people tend to make claims about specific sets of flows in specific periods, but it’s important to start from the overall picture. Otherwise you don’t know what questions it makes sense to ask. It’s also important to give a complete set of flows, for the same reasons and also to check that one’s claims are logically coherent. Needless to say, you also have to measure everything consistently.
Some people do do this, of course — the social accounting matrices of Lance Taylor and company are the best versions I know of. But it’s relatively rare.
The IMAs are a fairly new set of national accounts, motivated by two goals. First, to combine the “real” flows tracked by the BEA with the financial flows and balance-sheet positions tracked by the Fed into a single, consistent set of accounts; and second, to produce a set of US accounts that conform to the System of National Accounts (SNA) followed by most of the rest of the world. (The SNAs are sort of the metric system of national accounts.) The first goal is more completely realized than the second – there are some important differences between the IMAs and SNAs. For our purposes, the most important one is the definition of the corporate sector. In the SNAs corporate businesses include, broadly, any enterprise staffed mainly by wage workers that produces goods and services for sale; this includes closely-held firms, government-owned enterprises, and many nonprofits. In the IMAs, the corporate sector is based on tax status, and so excludes partnerships and small family businesses, nonprofits, and government enterprises.
The nonfinancial corporate sector on the IMA definition accounts for roughly 50 percent of US value-added. [1] I think there are good reasons to focus on this 50 percent. This is where most important productive activity takes place, and where essentially all the profit that economic life is organized around is generated. It’s also the sector where the conceptual categories of economics best correspond to observables. We don’t directly see output in public sector or nonprofits, don’t directly see wages and profits in noncorporate sector, we don’t see either in the household sector. Finance of course has its own issues.
In any case! Figure 1 shows the corporate sector’s share of value added since 1960.
I am not sure what substantive significance, if any, most of the movements in this figure have. Some large part, perhaps most, of them reflect definitional or measurement factors rather than any change in concrete economic activity. That said, the secular rise in finance as well as government does, I think, reflect changes in what people do all day. The only one of these lines that definitely means what it seems, is the long-run rise in government – given the way the accounts are constructed, there must be a corresponding rise in the share of public sector employment. The household sector line basically reflects changes in the weight of spending associated with owner-occupied housing – the nonprofit piece of this is fairly stable over time. The fall and rise in the noncorporate business sector may also reflect the changing weight of real estate – where noncorporate forms are common – and independent-contractor arrangements. But it may also reflect shifts in legal forms and/or BEA imputations, that don’t involve any substantive change in productive activity.
Nonetheless this figure is important — less for what it tells us about economic substance than for what it tells us about economic data. Any series that exclusively or disproportionately draws from the corporate sector (nonresidential investment is an obvious and important case) will be scaled by that top line. And any discussion of factor shares needs to take into account the change in the shares of sectors where wages and/or profits are not directly observed.
Figure 2 is the real point of this post. It’s my broadest summary of sources and uses of funds in the corporate sector. All are measured as a share of total corporate value added. The same data is shown in the table at the end.
I’ve organized this in a somewhat nonstandard way, but which I think is appropriate for the questions we are most interested in. The vertical scale is fraction of corporate value-added, or output. The heavy black line shows the share of output available to corporate managers. Above the line are three deductions from value-added: first, wages and other compensation of labor; second, in gray, taxes, including both taxes on production and corporate income taxes; and third, the narrow white band, net payments to the financial system. This last is interest and other property payments, less interest, dividends and other property payments received. These are the three categories of payments that are effectively imposed on corporations from outside. [2] The area below this line is the internal funds at the disposal of management – what’s often referred to as corporate cashflow.
In red are two main uses of funds by corporate managers. The bottom red area is investment. Above this is payouts — first dividends, and then the top red area, net share repurchases. This latter includes both repurchases in the strict sense and shares retired through cash mergers and acquisitions – aggregate data combines them. The difference between the black line and the red line is net financial saving by the corporate sector. Where the heavy black line is above the top red line, the corporate sector is a net lender in financial markets – its acquisitions of financial assets are greater than the new debt it is incurring. Where the red line is above the black line, as it usually is, the corporate sector is a net borrower – its new debt is greater than its acquisition of financial assets.
Finally, the dotted black line shows reported depreciation. (Consumption of fixed capital in the jargon of the accounts.) This is not actually a source or use of funds. And there are serious conceptual and measurement issues with defining it – so much so that, in my view, it’s probably not a usable category for describing real world economies. Nonetheless, it is necessary to define some other terms that play a big part in these discussions. Most importantly, profits can be regarded as the difference between cashflow and depreciation. [3] And net investment is the difference between investment and depreciation.
The same items are presented in the table at the end of the post, for three periods and for the most recent full year available.
As I discuss below, some terms are grouped here differently from the way they are presented in the IMAs. Obviously, how exactly we aggregate is open to debate, and the pros and cons of different choices will depend on the questions we are trying to answer. But I think some picture like this has to be the starting point for any kind of historical discussion of the US economy.
So what do we see?
First, the labor share (i.e. labor costs as a percent of value added) is quite stable around 63-64 percent of value added between 1960 and 2000. It only begins falling in 2002 or so, dropping about 4 points in the early 2000s and another 3 points in the wake of the Great Recession, with a modest recovery in the past couple years. This timing is quite different from the impression most people have — what you’d get from straightforwardly looking at the wage share of GDP — of a steady long-term decline from the 1970s.
There are two reasons for this difference. First, during the 1970s and 1980s, the non-wage share of labor costs (mainly health benefits) rose quite a bit, from around 5 percent to around 10 percent of total compensation. This explains why labor cost growth did not slow during this period, even though wage growth did slow. Since healthcare prices were rising quite a bit faster than overall prices during this period, the rising share of health benefits in compensation also meant that the cost of labor to employers was also rising faster than the value of compensation to workers. [4] This factor becomes less important after the early 1990s, when the non-wage share of labor compensation flatted out.
Second, the labor share in the corporate sector is quite a bit higher than the labor share in finance and noncorporate businesses — the two sectors whose share of GDP has increased in recent decades. This means that even if there were no change in factor shares within each sector, the labor share for the economy as a whole would fall. Again, I don’t know how much of the difference in factor shares between sectors is a measurement issue, how much it reflects shifting legal forms of organization of the same kinds of activities, and how much it reflects real differences in how claims on the social product are exercised. But either way, it’s important to understand that a large part of the observed fall in the labor share over the past generation is explained, at least in an accounting sense, by this shift between sectors.
Moving on to taxes, there is also a substantial fall in this claim on corporate value-added, from 16 percent in 1960 to around 11 percent today. But here, the decrease comes earlier, in the 1960s and 1970s – the tax share has hardly changed since 1980. (I suspect that if this figure were extended to earlier dates, there would be a large fall in the tax share in the 1950s as well.) This means that after-tax profits show a more steady long-term rise than do pre-tax profits.
I should note that “taxes” here combines two items from the IMAs — taxes on production, and taxes on profits. In the national accounts, there are good reasons to separate these — taxes on production enter into the cost of output and so have to be treated as a factor payment, while taxes on profits are not part of costs and so are treated as a transfer. This distinction is critical if we are going to calculate GDP in a consistent way, but for substantive questions it’s not so important. To government, managers and other economic actors, taxes are all mandatory payments from the corporation to the state, however they are assessed.
After taxes comes net financial payments. As defined here, this is interest, rent and net current transfers, less interest, rent and dividends received. In other words, it is net payments on the corporate sector’s existing financial assets and liabilities. It’s represented on the figure by the white space between the thin black line and the thick black line. The first thing to notice about these net payments by corporations is that they are almost always positive and never significantly negative. In other words, over the past 56 years the corporate sector as a whole has never received more income from its financial assets than it has paid on its financial liabilities. You can see that the largest share of corporate value-added going to financial payments came in the high-interest 1980s; in most other periods the balance has been close to zero.
I’ll come back to this in a later post – a next step in this project should be precisely to unpack that white section. But the fact that the net financial income of the corporate sector is small, never positive, and shows no significant trend over time, is already enough to reject one popular story about financialization, at least in its most straightforward form. It is simply not the case that nonfinancial corporations in the aggregate have turned themselves into hedge funds – have replaced profits from operations with income from financial assets. The Greta Krippner article that seems to be the most influential version of this claim is a perfect example of the dangers of focusing on one piece of the cashflow picture in isolation. [5] She looks at financial income received by corporations but ignores financial payments made by corporations (mostly interest in both cases). So as shown in Figure 3, she mistakes a general rise in interest rates for a change in the activities of nonfinancial businesses.
Returning to Figure 2: After subtracting labor costs, taxes and interest and other financial claims, we are left with the heavy red line — the share of value added available as cashflow to corporate managers. This rises from 20 percent in the 1960s to as high as 25 percent in the 1990s, to around 30 percent today. This increase in the corporate profit share (gross of depreciation, net of taxes) is one of the central facts of modern US macroeconomic history.
In the broadest terms, corporations can use cashflow in three ways. They can invest it in order to maintain or grow the business; they can distribute it to shareholders; or they can retain it for later use in some financial form. This last use can be, and often is, negative, if investment and payouts are together greater than cashflow.
Investment here includes gross capital formation, defined in the national accounts as spending on durable equipment, structures, software, research and development, and the creation of intellectual property. (The last two items have been included in the national-accounts measure of investment only since 2013.) It also includes the change in private inventories and spending on nonproduced durable assets, which I assume is almost all land. This item is listed separately in the IMAs, and it’s not obvious how to handle it: Corporate purchases of land have different macroeconomic implications than spending on new means of production, but from the point of view of the people making the investment decision there’s no major difference between money spent on a building and money spent for the land it sits on. This item is generally very small — well below 1 percent of total investment — but, like inventories, it’s highly cyclical and so plays a disproportionate role in short-run fluctuations. About a tenth of the fall in investment between 2008 and 2010, for example, was in nonproduced assets.
Somewhat surprisingly, there is no downward trend in the investment share. It was 17 percent of value added in the 1960s and 1970s, versus over 18 percent in this decade, and 19 percent in the third quarter of 2017 (the most recent available).
If investment today is, if anything, historically high as a share of corporate output, why have so many people (including me!) been arguing that weak investment is a problem? There are several reasons, though perhaps none are entirely convincing.
First, as I pointed out in the previous post, in recent years there has been an unusual divergence between investment in the corporate sector and investment in the economy as a whole. Residential investment by households remains very low by historical standards; nonresidential investment by noncorporate businesses is also low. At the same time, financial and especially noncoporate businesses always invest at lower rates than nonfinancial corporations, so the rising share of these sectors leads to lower overall investment. Second, the recovery in corporate investment is relatively recent – things looked different a few years ago. Nonfinancial corporations’ investment share fell extremely sharply in 2009, to its lowest level in 45 years, and took several years to bounce back. So when we were discussing this stuff three or four years ago, the picture looked more like a secular decline. Third — and probably most relevant for my work — while investment is relatively high as a share of corporate value added, it is quite low as a share of profits or cashflow. There is a genuine puzzle of weak investment, as long as we don’t ask “why are corporations investing less?”, but instead ask “why haven’t high profits led corporations to invest more?” Fourth, there has been a large increase in reported depreciation — from around 10 percent of value added in the 1960s to around 15 percent today. While I think for a number of reasons that this number is not really meaningful, if you take it seriously, it means that while gross investment has risen slightly, net investment has fallen a lot, to about half its level in the 1960s and 70s. Finally, if you take a strong Keynesian or Kaleckian view that it’s business investment that drives shifts in demand, then the ratios shown here are not informative about the strength or weakness of investment. The ratio of investment to output, in this view, only tells us about the size of the multiplier. To assess the strength or weakness of investment, we should instead look at the absolute increase in investment over the business cycle, which — while it’s picked up a bit in the past year — is still quite low by historical standards. I’ve made this argument myself, but I wouldn’t want to push it too far — investment is not the only source of autonomous demand.
Moving on in Figure 2: Above investment is payouts – first dividends, then net share repurchases. Here we see what you’d expect: These flows have gone up a lot. Dividends have doubled from 4.5 percent of value added in the 1960s and 1970s to 9 percent today, while net repurchases have gone from less than nothing to 6 percent (and as high as 10 percent in the 2000s.) Measured as a share of corporate cashflow rather than value added, dividends have remained stable at around 50 percent. Retained earnings as conventionally defined — profits minus dividends — have also been roughly stable as a share of value added.
Including net share repurchases with dividends is the biggest way my presentation here departs from the format of the IMAs. There, net share issuance is classed as an addition to liabilities, just like issuance of new debt. Net repurchases are the same as negative issuance — the equivalent, in the IMA framework, of paying back loans. The difference, of course, is that share repurchases have no effect on the balance sheet. This is the fundamental reason I think it makes sense to group repurchases with dividends. The flow of dividend payments is not affected by the number of shares outstanding. [6] It’s also important that market participants clearly perceive share repurchases as equivalent to dividend payments. If you read the financial press, dividends and buybacks are always treated as two forms of shareholder payouts.
Personally, I don’t have any doubts that this is the right way to look at it — today. But this is a good example of how the relations between economic and accounting categories are always somewhat slippery and can change over time. Whether net share issuance should be classed with dividends (and interest payments, etc.) as a current transfer, as I do, or whether it should be considered a financing transaction, where the standard IMA presentation puts it, depends on the way these transactions are actually used – it can’t be answered a priori. Again, I think it’s reasonably clear that, given their use today, net stock repurchases should be grouped with dividends. But in the 1950s or 1960s, treating them as financing made more sense. Also, this adjustment needs to be made consistently. If we are going to count repurchases as dividends, we have to subtract them from the headline measures of retained earnings and corporate saving. We will probably want to make an equivalent adjustment to the accounts of other sectors as well, though this poses its own set of challenges.
Another thing to consider is that we see negative issuance not only when corporations repurchase their own shares, but when shares are purchased for cash as part of mergers and acquisitions. This is not necessarily a problem. If we are just adding up payments for the sector as a whole, the two sets of flows are equivalent. On a more concrete behavioral or policy level there are important differences, but we’ll pass over those for now.
If we look at dividends alone, 2016 saw them at their highest share of corporate value-added, of profits and of cashflow since the IMAs begin in 1960; and almost certainly since the 1920s. If we measure payouts as dividends plus net share repurchases, then 2016 levels were still a bit short of the peak in the mid-2000s. Share repurchases have been a bit lower (around 5 percent of value added) in 2017 than 2016; unfortunately, the quarterly IMAs don’t have dividend data, but the financial accounts suggest that dividends have declined somewhat as well. It seems that the 2-point decline in the profit share since its 2014 peak is now beginning to be reflected in payouts to shareholders. By comparison with any period before the mid-2000s, payouts are still very high. Still, their decline over the past year seems significant – though maybe the tax bill will give them a second wind.
The final item in Figure 2 is the space between the heavy red line and heavy black line. This shows the financing gap – the net financial borrowing (if positive, with the red line above the black line) or lending (if negative) by the corporate sector. In my opinion this is a much more relevant number than corporate saving as conventionally defined. As the figure shows, nonfinancial corporations are normally net borrowers in financial markets; the brief periods of net lending are all associated with deep recessions. As the figure also makes clear, however, this specific interpretation is quite sensitive to counting share repurchases as payouts. If net equity issuance is treated as a form of financing, then the aggregate corporate sector has been mostly close to a zero balance in financial markets and has more recently been a substantial net lender. On the other hand, if we think of this gap as showing the net credit-market borrowing by the nonfinancial corporate sector — as it more or less is — then the conclusion holds regardless of how you treat stock buybacks. Either way, by this measure the recent expansion is not exceptional: As of 2016 credit-market borrowing by the corporate sector was still smaller, as a share of value-added, than it was at the high points of the 1980s, 1990s or 2000s.
The same results are shown below for three periods and for the most recent year. I won’t recap the table, it’s the same stories as above. Just to be clear, the values are the averages for the periods shown for the flows listed in the second column. So for instance labor costs accounted for an average of 63 percent of corporate value-added during 1960-1979. The first column just shows the accounting relationships between the flows.
| Flow | 1960-1979 | 1980-1999 | 2000-2015 | 2016 | |
|---|---|---|---|---|---|
| 100 – | (A) Labor costs | 63 | 64 | 60 | 59 |
| – | (B) Taxes | 15 | 12 | 12 | 12 |
| – | (C) Net financial payments | 1 | 2 | 1 | 1 |
| = | (D) Internal funds (cashflow) | 21 | 22 | 27 | 29 |
| (E) Dividends | 5 | 5 | 7 | 9 | |
| + | (F) Net share repurchases | -1 | 2 | 4 | 6 |
| = | (G) Payouts | 4 | 7 | 11 | 15 |
| (H) Investment | 17 | 18 | 18 | 18 | |
| – | (J) Depreciation | 10 | 13 | 15 | 15 |
| = | (K) Net investment | 7 | 5 | 4 | 3 |
| (G) + (H) – (D) = | (I) Financing gap | 0 | 3 | 2 | 5 |
| (D) – (J) = | (L) Profits | 11 | 9 | 13 | 14 |
What do we take from all this? Again, my goal here was not to make any particular substantive claim, but to lay out some essential context for more specific arguments about corporate finances that I’ll make in the future. But it is interesting, isn’t it?
[1] Value-added is the difference between sales and the cost of material inputs. It’s the best way to measure the output of various sectors. For the economy as a whole, total value-added is identically equal to GDP.
[2] Of course corporations have some control over their wage, tax and debt-service payments. But these are not mainly decision variables for corporate management in the same way that investment and shareholder payouts are. Or at least I think it’s reasonable to so regard them.
[3] Whether they are exactly this value or only approximately depends on the profits concept being used. In any case, it’s important to keep in mind that the values of depreciation used by corporations for reporting profits to financial markets and to the tax authorities, may be quite different from the depreciation reported in the national accounts.
[4] The different behavior of prices of workers’ consumption basket and of output in general was the subject of the first substantive post on this blog, seven years ago. It’s an important topic!
[5] While I don’t agree with the claims in this article, I’m a big admirer of Krippner’s other work.
[6] The big exceptions, of course, are cases that involve all of a given corporation’s shares — IPOs and transactions that take a company private. These do respectively create and extinguish dividend flows. For this reason, when using micro data, it may make sense to use gross rather than net repurchases; but this isn’t possible with the IMA data. IPOs however are a quite small part of the overall net issuance/repurchase of shares, and I am pretty sure that firms going private are as well. Private equity might create some more serious issues here — this is something I’d like to understand better. On the other hand, the advantage of using net rather than gross repurchases is that it eliminates repurchases that are simply compensating for stock issued as part of compensation packages.
Interesting post.
Is there a difficulty regarding domestic vs. aggregate measures? For instance, is value added a domestic measure while dividends come from global corporate profits? Is that one reason why payouts are so high relative to value added?
Looking at NIPA tables and Fed flow of funds data, I find it difficult at times to conceptually keep track of domestic vs aggregate measures.
Was this a stupid question?
Sorry, thought I’d replied earlier.
The answer is that the IMAs are using a consistent defiition of the corproate sector for all variables. (That’s one reason to use them.)
If foreign transactions are generating cashflow for the US corproate sector, that has to show up here somewhere, either as higher reported cashflow and profits (if the foreign affiliates are consolidated) or higher financial income (if they aren’t). There are no wormholes in the accounts — there’s no way for foreign profits to pay for US payouts without first showing up somewhere as a source of funds.
Excellent post. This is a great way to do analysis.
I need to spend more time looking at this, but one thing struck me on the financialisation issue. To the extent that there has been financialisation of US corporations, it has probably involved extensive accumulation of low taxed foreign earnings, held overseas and not paying dividends. This income will show up in the IMAs as reinvested earnings on direct foreign investment (basically, imputed dividends). I think your figures do not include these imputed dividends, because otherwise they should show net financial income from the mid-90s onwards.. Of course, we don’t know how much of those foreign earnings are attributable to regular business profits as opposed to investment income.
“Including net share repurchases with dividends is the biggest way my presentation here departs from the format of the IMAs. There, net share issuance is classed as an addition to liabilities, just like issuance of new debt. Net repurchases are the same as negative issuance — the equivalent, in the IMA framework, of paying back loans. The difference, of course, is that share repurchases have no effect on the balance sheet. This is the fundamental reason I think it makes sense to group repurchases with dividends. The flow of dividend payments is not affected by the number of shares outstanding. It’s also important that market participants clearly perceive share repurchases as equivalent to dividend payments. If you read the financial press, dividends and buybacks are always treated as two forms of shareholder payouts.”
I have no problem grouping share repurchases with dividends, but I’m having trouble understanding what you mean by:
“The difference, of course, is that share repurchases have no effect on the balance sheet.”
Both dividends and share repurchases reduce cash as an asset and the aggregate value of equity (book value plus retained earnings) by the same amount. Dividends reduce cash and the retained earnings component from what it would be otherwise, and share repurchases reduce cash and the aggregate book value of equity from what it would be otherwise. The balance sheet changes in the aggregate equity sense in both cases in the same way.
Can you elaborate on the point you are making?
You are right, that was badly phrased. Repurchases do of course affect the asset side of the balance sheet just as dividend payments do. I agree with you that for accounting purposes we can treat dividends and share repurchases as equivalent, from the firm side. (It gets trickier on the shareowner side.) “The diference” here refers to the difference between share repurchases and loan repayments. Both show up in the IMAs as negative financing. But the loan repayment reduces a liability while the share repurchase does not.
Interesting question by JKH on:
“Including net share repurchases with dividends is the biggest way my presentation here departs from the format of the IMAs. ”
For what purpose?
In national accounts, dividends affect the current account and the financial accounts and share repurchases affect only the financial account.
Yes, the national accounts do put net stock issuance in the financial account. I think that it makes more sense to group them with dividends because they are regarded as equivalent by corporate decisionmakers and financial markets.
“[1] Value-added is the difference between sales and the cost of material inputs. It’s the best way to measure the output of various sectors. For the economy as a whole, total value-added is identically equal to GDP.”
?
I tought total value added was equal to NDP?
Or is “depreciation” not included in the material inputs? I think it should be.
No it is not.
There is actually a good reason for this — we really want to assemble GDP out of observable market prices.
Thanks for the answer.
I understand that GDP is a more meaningful measure than NDP because it is more observable, my problem is that in my understanding GDP is not the sum of total added value, because total added value is the definition of NDP.
In other words I think that we do not know the sum of all added value, and we use GDP instead because it’s more knowable.
At this point I wonder if I’m wrong about the definition of added value, or if it is another of those definitions that mean something in theory but something different in terms of accounting.
I have never seen the term value added to refer to sales net of costs including depreciation. Doesn’t mean nobody uses it that way, I just haven’t seen it.
Well, probably I’m the weird one here, but I really don’t understand why depreciation would not be considered a cost like the others.
There is the practical reason that it is hard to put a number on depreciation, but at the level of theory I think it should.
The reason I count it as a cost is that I spent a lot of time thinking about the whole story of Marx’s “calculation problem”, the “tendency of the rate of profit to fall” etc., and in that context depreciation would totally be counted as a cost.
This is rather irrelevant to the thread, but I’ll put it here anyway (yay internet):
In Marx there is this implicit macro model where we have, in a situation of “simple reproduction” :
– country A starts the year with a certain amount of capital, let’s say 500$;
– 100 workers produce 150$ of stuff using said capital (GDP=150$), but they consume 50$ of capital, thus with an NDP of 100$;
– of the 150$ of stuff reproduced, 50$ are used to reintegrate the capital (assuming simple reproduction, that implies that the amount of capital remains unchanged);
– the other 100$ are then divided between, say, 70% to the workers and 30% to capital as “surplus;
– the “rate of profit” thus would be 30$/ (500$+70$)= 5,2%, and depends both on the wage share, in this case 70%, and on the capital to income ratio, in this case 5/1 yearly (the capital to income ratio is a time dependent value because it’s the relationship of a stock and a flow). Bortkiewicz calculated this wrong because for some reason he didn’t think in terms of a stock of capital VS a flow of income ratio, but rather just about the difference between NDP and GDP, and thus came out with a wrong value for the rate of profit; this error caused a century or more of misunderstanding, but is due to the fact that Ricardo himself didn’t get the stock/flow comparison right.
Now in my example, the “added value” is 100$, and since there are 100 workers working for one year, this means that the value of 1 year of labour is 1$ (whereas the price of labour, aka wage, is 0.7$).
If we assume simple reproduction, this means that of the 150$ of stuff produced the 50$ of stuff that go to replace used capital are capital goods, whereas the remaining 100$ are consumption goods, 70$ of which are consumed by workers and 30% of which are consumed by capitalists.
In this example, it’s obvious that “depreciation” is part of the 50$ of reproduced capital goods, not of the 100$ of consumption goods shared between workers and capitalists (what Marx calls “revenue”).
Excellent post. This is a great way to do analysis.
I need to spend more time looking at this, but one thing struck me on the financialisation issue. To the extent that there has been financialisation of US corporations, it has probably involved extensive accumulation of low taxed foreign earnings held overseas. The income on this cash is not repatriated as dividend and shows up in the IMAs as reinvested earnings on direct foreign investment – basically, imputed dividends (I have to thank Ramanan for pointing this out to me on an earlier occasion). I think your figures do not include these imputed dividends, because otherwise they should show positive net financial income from the mid-90s onwards. Of course, we don’t know how much of those foreign earnings are attributable to regular business profits as opposed to investment income.
“Finally, the dotted black line shows reported depreciation. (Consumption of fixed capital in the jargon of the accounts.) This is not actually a source or use of funds.”
I don’t understand this.
Consider a simple income statement – revenue, cost of goods sold, wages, interest expensive, depreciation, taxes, and profit.
The quantity (depreciation + profit) is effectively a residual of revenue less the other expenses.
Depreciation is a carve-out of that residual.
Profit is then the further residual.
Depreciation and profit thus defined are obviously both subsets of (depreciation + profit). And they are both well-defined subsets of the original revenue that is the ultimate source of funds prior to the carving out of other expenses.
So depreciation is no less a source of funds than is profit in that sense. Both are derived in their own way from the ultimate funds source, which is revenue.
>The quantity (depreciation + profit) is effectively a residual of revenue less the other expenses.
>Depreciation is a carve-out of that residual.
My understanding is that depreciation (CFC) isn’t calculated as a residual, but using various depreciation tables against the existing stock of fixed capital (the cumulative sum of previous periods’ net Capital Formation [the IMAs don’t call it “investment].)
>So depreciation is no less a source of funds than is profit in that sense.
I always confuses me when I find expenditures (here, in the case of depreciation, an imputed expenditure based on depreciation tables) referred to as “sources” of funds. ??
I get what you’re saying, but…this “in that sense” description seems like a very stylized way of describing things. Nobody says “we can use these funds from depreciation” to fund this project.”
My understanding is that depreciation (CFC) isn’t calculated as a residual, but using various depreciation tables against the existing stock of fixed capital
I think you’ve misunderstood what JKH is saying. *Cashflow* is a residual. Depreciation is then calculated as you say, with profits being left as the residual of the residual. All of us are on the same page on this.
I always confuses me when I find expenditures (here, in the case of depreciation, an imputed expenditure based on depreciation tables) referred to as “sources” of funds.
The actual source of funds is cashflow. But since cashflow can be divided into profits and depreciation, if profits are counted as a source of funds then depreciation must be also. There’s nothing paradoxical here — depreciation in this context represents not any actual decrease in the value of existing assets — which as we know can’t be measured quantitatively — but the part of available funds that is (notionally) set aside to replace worn-out assets. The latter is both measurable and a source of funds — in the sense that total sources of funds equal funds set aside to replace existing assets, and funds not set aside.
Nobody says “we can use these funds from depreciation” to fund this project.”
You’re the businessperson, I’m not. So I take your word for it that people do not say this. But nonetheless it is the whole point of counting depreciation in the first palce — to set aside money that can be used to pay for new capital equipment when the old stuff wears out. This is more transparent, I think, in the older version of depreciation, sinking funds (used more I think by UK firms than in the US? — I could be wrong about that) where you literally had a part of cashflow put aside in a separate account that would be drawn on to put up new buildings (or buy other capital assets) when the old ones reached the end of their working life. When there’s an actual fund to draw on it’s clear that it’s a source of funds. But I don’t think the logic is any different today with depreciation just an accounting category.
>*Cashflow* is a residual. Depreciation is then calculated as you say, with profits being left as the residual of the residual.
(Preface: I don’t think it helps to add another term here (cashflow), or at least need to define its accounting identities to avoid us talking past each other.)
That sort of describes how things are presented at the top of the FFA accounting, with depreciation (and taxes and dividends) deducted from profits:
Profits before tax (book)
– Taxes on corporate income
– Net dividends
+ Capital consumption allowance
= U.S. internal funds, book
But not in the IMAs. CFC is deducted from Value Added right up top.
Gross value added
Less: Consumption of fixed capital
The rest ensues, ending with the ultimate residuals:
Net national income/Balance of primary incomes, net
THEN taxes and transfers, and you get:
Disposable income
(Which for firms equals Net saving)
>cashflow can be divided into profits and depreciation
Sure, you can talk about gross cashflow, or net of depreciation.
But you can just as easily say: cashflow can be divided into profits, depreciation, taxes, and dividends(/share buybacks). Are taxes and dividends sources of funds for firms?
Added #s here for reference:
>depreciation in this context represents not (1) any actual decrease in the value of existing assets — which as we know can’t be measured quantitatively — but the (2) part of available funds that is (notionally) set aside to replace worn-out assets.
I think of it as precisely #1. An effort to tally the value of real stuff (“capital”) over years, using the perpetual inventory accounting method. NatAccount explanations say this explicitly.
>#2 is measurable
I don’t understand at all. It’s estimated using depreciation tables. (“(Notionally)” speaks volumes?)
>it is the whole point of counting depreciation in the first palce — to set aside money that can be used to pay for new capital equipment when the old stuff wears out.
I think it’s rather to provide an ongoing accounting estimate of the stock of “real” assets (and change in that stock), so the balance sheet can accurately represent total assets year in and year out. And hence book value.
I just can’t imagine that depreciation figures are even considered when Intel is deciding whether to build a new fabrication plant. Depreciation is a “sunk loss” (and only roughly estimated, at that).
>sinking funds
I invest in commercial real estate ventures. They usually sequester some invested/borrowed funds into a separate account for “capital improvements” which they then draw down, so these funds/accounts indeed “sink.” I’ve never seen these expenditures broken out as “replacing depreciated goods” (eg worn-out carpets) vs “new additions/improvements.” You can certainly think of it that way, but it seems inappropriately stylized cause the two are almost impossible to distinguish, and there’s little takeaway value from understanding the accounting that way.
Worn-out carpets — the things depreciation tables are trying to estimate — certainly don’t figure as a source of funds.
I know how the IMAs are organized. This whole post is presenting IMA data – I couldn’t have written it without knowing the order things are presented in.
I thought cashflow was a widely used concept which didn’t need explanation – it’s simply profits plus depreciation. It can be net or gross of tax, just like profits. I prefer to use cashflow because I think that depreciation/CFC is not a meaningful concept. I do not think the metaphor of capital as a physical quantity which diminshes over time is suitable for quantitative analysis. You don’t have to agree but I really don’t think I’m doing something weird or eccentric here. The mainstream literature uses the term “cashflow” this way all the time, and so does the business press.
But you can just as easily say: cashflow can be divided into profits, depreciation, taxes, and dividends(/share buybacks). Are taxes and dividends sources of funds for firms?
Sure, why not? In general, we can organize the accounts in all kinds of ways, as long as we count everything exactly once. With respect to taxes, all of these are legitimate:
– all taxes as a deduction from cashflow, which is then net of tax (the way I do it here)
– all taxes as a use of funds, out of cashflow gross of tax
– some taxes counted each of these two ways (the IMA approach)
– or, we can use cashflow net of tax and call taxes both a source and use of funds. There is nothing either inconsistent or unreasonable about this. it corresponds to the idea that the firm sets aside some funds to pay taxes (the source) from which taxes are subsequently paid (the use).
There is usually no reason to take this last approach with taxes, since (a) taxes normally have to be paid and (b) are paid continuously. But with depreciation there is good reason to, since the funds set aside for depreciation (i.e. replacing existing assets) aren’t necessarily spent as the depreciation is incurred, and might instead be used for some other purpose. That’s the whole reason people look at measures like EBITDA, right? — a measure of the funds that would potentially available to meet various financial claims.
Similarly, if you first deducted dividends from your source of funds (say, you used retained earnings rather than cashflow) then you could have dividends as both a source and use of funds. This would make even less sense than with taxes, since here there is no obligation apart from the payment itself. But any time you have a situation where there is some separation between making provision for some expenditure and actually laying out the money for it, it’s not unreasonable to count the former as a source of funds and the latter as a use.
I just can’t imagine that depreciation figures are even considered when Intel is deciding whether to build a new fabrication plant. Depreciation is a “sunk loss” (and only roughly estimated, at that).
Of course, I agree. But the book value of real assets does not in any way factor into their decisionmaking either, does it? Historically the reason we have depreciation as an accounting category at all is to distinguish funds available for expansion or income for owners, from funds needed to maintain existing capital stock. The idea is that e.g. you are not really making money as a landlord if you are deferring maintenance that will require you to put in more money down the road than you are taking out today. The only way depreciation/CFC makes any sense as a quantitative concept, is as a measure of spending eneded to maintain the existing capital stock. If in practice there is no way to distinguish “repalcement” investment from “new” investment — and I agree with you that in many contexts there is not — that simply means depreciation is not a useful concept at all. Which is what I’ve been saying!
There just is not a physical stock of capital. Not approximately, not estimated, not roughly, not practically and not theory. There just isn’t anything to measure there.
Worn-out carpets — the things depreciation tables are trying to estimate
I don’t agree. What the tables are trying to estimate is the money that must be spent to replace the carpets. They are in units of dollars, after all.
[I ran out of reply levels here so excuse this being out of order.]
I totally understand what you’re saying. Takes me back years, to when I asked JKH what it means for something to “fund” something else. He responded kind of angrily and dismissively, but I’ve been struggling with the question ever since.
In this discussion: if we say depreciation is a “source of funds,” does it also make sense to say that depreciation “funds” investment? They seem like commensurate statements to me, but maybe “source of funds” is an accounting term of art that I’m confuting with “funding”? I just have trouble understanding how an asset decline can fund something.
>There just is not a physical stock of capital. Not approximately, not estimated, not roughly, not practically and not theory. There just isn’t anything to measure there.
Maybe: There just is not a *numerable* physical stock of capital? (Absent leets or utils as units of measure…) I’ve certainly said similar: http://www.asymptosis.com/we-have-no-idea-what-our-capital-is-worth.html
But depreciation, and the perpetual-inventory method, sure seems like an attempt to estimate/numerate that…
Would be interested to hear more about this:
> Historically the reason we have depreciation as an accounting category at all is to distinguish funds available for expansion or income for owners, from funds needed to maintain existing capital stock.
[I hope this comment will appear in the proper place]
“I do not think the metaphor of capital as a physical quantity which diminshes over time is suitable for quantitative analysis.”
I do not think it is a metaphor.
I thin that you (JW) are taking for granted a “money view”, that is you are thinking in terms of value and transfers of money or otherwise exchange value, so you think in terms of funds, but the more intuitive way of thinking is in terms of stuff, that has a price.
So depreciation is an attempt to calculate the quantity of stuff that is consumed, not a quantity of value.
Now the problem is, is the quantity of stuff consumed useful in whatever sense?
I think it is: we generally think of income in net terms, if for example I rent a house for a price that is equal or lower to the money I have to spend to repair it I’m just wasting my money, I’m not really making a “profit” (or rent) from it.
On the other hand depreciation is just an estimate, so I understand that it is problematic if you want a quantitative analysis.
“There just is not a physical stock of capital. Not approximately, not estimated, not roughly, not practically and not theory. There just isn’t anything to measure there.”
Only if you take a strict “money view”, otherwise I’m quite sure factories do exist, in practice and also in some theories. If for example one factory employs 100 workers, to employ 200 workers you need two factories: it’s only approximative but it’s true. If factories close, for example, they will need less repairs, so this will cause less demand for other capitalists.
“So depreciation is an attempt to calculate the quantity of stuff that is consumed, not a quantity of value.”
Do you have any evidence for this claim? Nothing, and I really mean nothing, in the history of depreciation accounting suggests this is remotely true to me. This seems like something you just think should be true so you’re claiming it is.
Depreciation is a completely constructed accounting convention, associated with government reporting laws, to regularize fixed investment as a cost. Otherwise, businesses take a major loss when they buy large, new capital equipment and then earn what looks like additional profits avalaible to other claimants. This leads to a lack of proper replacement investment. Instead with depreciation rules the fixed investment expenditure is recognized as a cost over a series of accounting periods where the fixed investment good is “in use” at a completely arbitrary rate. It has nothing to do with the physical condition of the actual equipment.
You can tell this because depreciation schedules have nothing to do with the actual secondary market saleability of any given fixed investment good. Let alone that for the vast majority of equipment, there isn’t a secondary market at all. To the extent there is, it’s at such a discount over acquisition cost that a business that’s a going concern, that valuation is useless. How do we know? Because the going concern nature of businesses was what led and justified this accounting rule to begin with!
Depreciation is a completely constructed accounting convention, associated with government reporting laws, to regularize fixed investment as a cost. Otherwise, businesses take a major loss when they buy large, new capital equipment and then earn what looks like additional profits avalaible to other claimants. This leads to a lack of proper replacement investment. Instead with depreciation rules the fixed investment expenditure is recognized as a cost over a series of accounting periods where the fixed investment good is “in use” at a completely arbitrary rate. It has nothing to do with the physical condition of the actual equipment.
Yes exactly. Thanks Nathan. This is just what I’ve been trying to say.
Finally backing up to the 40,000 foot level – an excellent post.
It’s taken me a while to get more comfortable with the graphics of your figure 2, but the story is there.
Several final comments.
With regard to your point on the shortcomings of depreciation as an unambiguously accurate or legitimate measure, I think that cash flow (profit + deprecation) is reliably and relatively more meaningful than either of its components in that context. It was in that sense also that I noted that profit and depreciation are both subsets of cash flow and rank pari passu in that sense as component “sources of funds”.
I’m personally stuck on the old format methodology of combining NIPA and the Fed Flow of Funds report in deriving a broad interpretation of things. Just lazy I guess. I sometimes visualize a maximally comprehensive flow of funds format that combines non-income flows of funds granularity (i.e. gross financing flows as in the old Z report) with full income statement granularity of cash flows.
You’ve constructed a flow of funds format that melds that latter income statement granularity with only summary or net information for non-income (financing) flow of funds. That’s the inverse of melding gross non-income flow of funds detail (i.e. gross financing flows as featured in the original Fed report) with summary equity flow information (i.e. netting income statement flows for their contribution to the flow of funds as in the old core Fed report).
Last point once again of the issue of dividends versus share repurchases:
Regardless of how these things are treated relative to income accounting classification in the broadest sense, there is no question that they both affect the aggregate book equity account and that this must be recognized consistently and accurately in any ultimately useful flow of funds report. The income or non-income accounting nexus should be subservient to that fact. Conversely, there is no reason for that nexus to interfere with or be an impediment to a coherent flow of funds treatment.
I’m not sure what I just said on the last point is consistent with what you’re saying or what Ramanan is saying or both or neither.
: )
Thanks for the thoughtful comments.
I think that cash flow (profit + deprecation) is reliably and relatively more meaningful than either of its components in that context.
I’m relieved to hear you say this.
I need to write about this more at some length, but my own view is that depreciation is just not a meaningful concept in a macro context. With other flows we are aggregating observable market transactions, plus some imputations based on market prices for transactions we can’t directly observe. But depreciation is imputation from beginning to end. The procedure followed by statistical agencies like the BEA is essentially circular — you apply a fixed set of depreciation rates to the existing stocks of capital of various types, with those stocks in turn calculated from investment flows and your depreciation estimate for the previous period. There’s no direct connection with the depreciation reported in private accounts, which anyway isn’t based on market prices either.
I’m personally stuck on the old format methodology of combining NIPA and the Fed Flow of Funds report in deriving a broad interpretation of things.
Yes, that’s how I and probably almost everyone is used to doing things. I only discovered the IMAs recently and realized how much more suitable they are for telling macroeconomic stories.
You’ve constructed a flow of funds format that melds that latter income statement granularity with only summary or net information for non-income (financing) flow of funds. That’s the inverse of melding gross non-income flow of funds detail (i.e. gross financing flows as featured in the original Fed report) with summary equity flow information (i.e. netting income statement flows for their contribution to the flow of funds as in the old core Fed report).
Yes, that’s a good way of putting it. It’s the reverse of the presentation in the financial accounts. Of course in principle one ought to be able to use varying mixes of granularity depending on the question at hand.
Regardless of how these things are treated relative to income accounting classification in the broadest sense, there is no question that they both affect the aggregate book equity account and that this must be recognized consistently and accurately in any ultimately useful flow of funds report.
Yes, I don’t think there is any argument about that. The question is not about how to treat them in isolation, just where to group them when aggregating.
Now there is a substantive question about whether or when it makes sense to treat valuation changes in equities as a change in the corporate sector’s liabilities and net worth, as the IMAs do. But this post doesn’t consider valuation changes so that doesn’t come up here.
Yes – I hear your point regarding the density of imputation. There are special things about the quantification technique used to specify depreciation that make it a very squishy concept.
My point, which I’m now pretty sure you appreciate, is that profit itself is the squishy brother of depreciation, in the sense that it’s the complement of depreciation within a reasonably well defined calculation of cash flow overall.
Those squishy brothers are more solid together when united as cash flow.
Hence, the consistent source of funds constitution at that level of analysis.
Thanks for the exchange. It gives me a bit of motivation to get up off my rear and have another look at the IMA’s.
Hi All. Nice to see the gang back together. 😉 Where’s SRW?
Multiple thoughts:
• I think there would be a lot of value-add from a datviz designer on Figure 2. Like JKH, it took some careful parsing for me, and if that’s true for JKH and me, then… (Now that I understand it, it’s great.)
• Agree with Josh (and I think JKH) that the perpetual-inventory method of tallying firms’ capital over decades — capital formation less depreciation/CFC, yielding net capital formation which is cumulated year to year, is dicey. You’re basically guessing on depreciation, with inevitable errors, which also cumulate.
The alternative measure, of course, is firms’ current market cap. What’s interesting is that the firm sectors’ book value and market caps moved closely together, 1960-1990. Since then they’ve diverged wildly, with market cap growing much faster than book value. (This takes us back to those discussions of the B.1, which is based on market cap.)
• For our discussions it’s worth noting that in the IMAs the path from starting ending net worth is through the capital account.
+ Current-account saving
+/- cap account lending/borrowing
+/- revaluation
+/- other changes in volume
The Financial Account is basically an addendum and alternate presentation of that. Its lending/borrowing differs from the Capital Account by the statistical discrepancy. (So yes: you could just as easily take the path through the Financial Account.)
• I agree that Josh’s presentation combining dividends and share repurchases as economically equivalent flows is importantly revealing, at least post-1990 (or post-1982, when Rule 10b-18 was instituted?). Heck, you could even classify dividends as a capital transfer rather than a current-account transfer. Or even…(ducking!) do the same with CFC?
• A topic I queried JKH on forever ago, and that Josh pinged me about on twitter just recently: In the IMAs the firm sectors’ equity is treated as just another liability on its balance sheet. All firms’ holdings of other firms’ equities (invisibly) net out, so all that’s left is net equity “owned by” and “owed to” other sectors.
And crucially, that net equity liability is marked to market (market cap). So when equity markets go up, firms’ “net worth” goes down! (While households’/ROW’s equities/assets/NW goes up). Seems kinda wacky, but what’re you gonna do? Firms don’t own their own net worth; their righthand side balancing item is not net worth, but shareholders’ equity. The possessive apostrophe is significant: The ownership relationship is asymmetrical, one-way.
The IMAs, trying to deliver consistent presentation for all sectors, do have something labeled “Net Worth” as firms’ bottom line. But it’s book value minus market cap. Pretty weird. The accounting presentations for different sectors do vary in a lot of ways, and this is one where I think the firms sectors should be presented differently.
But knowing that, it’s easy to back those equity valuation changes out of firms’ ∆NW.
• Bottom line, the fact that almost no economists understand any of the accounting issues we’re discussing here—what all these accounting measures *mean*—leaves me…somewhat dispirited. The heterodox/post-keynesian/accounting-based crowd is way better than the rest, but still…
@Nathan Tankus
“This seems like something you just think should be true so you’re claiming it is.”
This might be true.