Corporate profits

Jack Mintz: Inflation overstates corporate profits

Investors should not be fooled. When companies eventually replace inventory or capital, their profits will decline

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As the Canadian economy rebounds, corporate profits are reaching new highs – nearly $ 400 billion a year, almost two-thirds more than before the pandemic. To applause from investors, the TSX reached 21,000, its highest level on record.

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However, with this good news comes a red flag: inflation. The 4.4% year-over-year increase in consumer prices grabbed the headlines. But industrial prices rose 15 percent and raw material prices 40 percent. Not having seen such numbers for a long time, many of us have forgotten an important lesson about inflation: When prices rise, corporate profits can be overstated.

Inflation means that when companies come in to replace machinery, inventory, and structures, they have to pay a lot more to replace them in order to stay in business. Suppose a company buys a machine that only lasts five years. With the annual pre-pandemic inflation of two percent, the cost of replacing worn-out equipment is ten percent higher after five years. But if the inflation is 5% per year, it costs 28% more to replace the machine in five years. This means that depreciation costs will be 28 percent higher than depreciation based on historical prices. Corporate earnings don’t look so rosy once we factor it in.

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During the 1970s and early 1980s, experts developed ways to correct corporate profits for inflation. Asset values ​​recorded at historical prices have been revised to replacement cost. Depreciation and depletion costs have been reassessed upward to reflect higher prices for capital goods. Inventory costs based on their original acquisition cost have been increased to reflect current prices. Net finance income has been adjusted downward as inflation erodes the purchasing power of money loaned to others (although this helps nonfinancial firms, which are typically net borrowers and benefit from the inflation which eats away at the real value of their loans).

Correctly adjusted for inflation, today’s profits would be drastically reduced. A 1997 study estimated that between 1976 and 1993, average inflation of seven percent for that period exaggerated the rate of return on capital of Canadian firms by about one-fifth, from 14.7 to 17. , 9 percent.

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We are not there yet, but it is also not clear that current inflation is only transitory, thus rendering the experience of the 1970s and 1980s irrelevant. I agree with Larry Summers, Secretary of the Treasury to Bill Clinton and head of the National Economic Council to Barack Obama, who argued on Bloomberg TV last weekend that inflation will be anchored longer than the Federal Reserve currently believe so.

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The disruption of supply chains caused by the pandemic continues. Energy prices are skyrocketing as investments in fossil fuels lag behind. Businesses face labor shortages, with more than 800,000 vacancies in Canada. Expansionary fiscal policy and accommodative monetary policy in the United States and Canada are fueling the flames. If inflation becomes embedded in wage negotiations and supply shortages continue for some time, the price hike will last longer than expected.

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Investors should not be fooled. Unadjusted for inflation, corporate earnings appear to be excellent. But when companies eventually replace inventory or capital, their profits will decline.

Governments should also not be fooled by inflationary profits that could become targets for new taxes. The Liberals pledged during the election to raise corporate tax rates from 15 to 18 percent on bank and insurance company profits exceeding $ 1 billion. But why stop there? If the NDP insists on higher corporate tax rates for all businesses, will the Liberals resist or follow? But raising corporate taxes comes at a cost: Without sufficient cash flow, businesses won’t reinvest, become less competitive, and create new jobs.

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Another problem is that corporate and personal income taxes on the return on savings are not indexed to inflation. As inflation rises, this can lead to exceptionally high effective tax rates. For example, fearing stock market volatility, Aunt Matilda holds corporate bonds until maturity to ensure she has enough funds to cover her retirement costs. She gets a paltry three percent annual return, which the government charges at 33 percent, leaving her only a two percent return on investment. Now add four percent inflation to the mix and her investment is earning a breathtaking return minus two percent on every dollar she saves. Why is the government taxing investment returns which, in real terms, are negative?

As inflation rises, our assumptions must change. Corporate profits will not be so good once companies have to replace their capital. Governments enjoying inflationary profits should rethink tax policies that hurt investment and savings. Remember, Ottawa: our goal should be growth, not misery.

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