June 14, 2007
By J.D. Foster, Ph.D.
Prospects for the U.S. economy are bright. Inflation and taxes
are moderate; interest rates are low; the S&P 500 is repeatedly
setting record highs; and growth is accelerating toward 3 percent
despite the housing slump. Both the Bush administration and the
Congressional Budget Office forecast the economy to grow at 2.5
percent annually or better for the next five to 10 years.
So why are the stock market bulls and our international
competitiveness about to take a long vacation? It's all a matter of
Government forecasters analyze the share of income derived from
each major category of the tax base. They divvy up total income
according to taxable and non-taxable labor compensation, corporate
income, sole-proprietorships, interest income and some smaller
categories. Each category of income has its own effective tax rate.
The tax rate on non-taxable labor compensation is zero, obviously,
while that on corporate income is typically among the highest.
Because its effective tax rate is so high, the corporate income
share is especially important to the receipts forecast. And here a
shadow looms over the equity markets and the competitiveness of
Government forecasters expect corporate receipts to fall from
current levels and not recover for five years. (See the graph
below.) The explanation is mostly good news.
The recent recovery and expansion occurred in stages. First,
growth in GDP resumed in late fall of 2001. Then GDP growth
accelerated, but job growth remained tepid as higher productivity
generated additional output. With GDP growth accelerating and job
and wage growth stalled, corporate profits began to rise
In summer of 2003, strong job growth resumed. But labor markets
remained soft and so wage growth remained anemic; corporate profits
continued to rise. By 2006, corporate profits reached an
extraordinary 13.7 percent of gross domestic income. This compares
to a 50-year average of 9.3 percent. During the 1990s the share
never exceeded 9.7 percent. History and theory suggest the
corporate profit share will decline toward something more
consistent with the historical average.
Sustained firmness in labor markets since late fall of 2005 is
leading to stronger nominal wage growth, up 4.3 percent in 2006 and
faster than the best years of the 1990s. The recent bump in
inflation diminished real wages gains and so the corporate profits
share remained elevated. But in the years ahead, administration and
CBO forecasters believe nominal wage growth will remain strong,
inflation will subside, and so real wage growth will accelerate.
That's the good news.
The bad news is that labor's rising income share is likely to
come out of corporate profits. Corporate profits in nominal terms
are forecast to be flat even as the economy expands. The flattening
of corporate profits may not occur in the next quarter, but it will
almost surely occur before long. Flat corporate profits means flat
corporate tax receipts.
A sustained period of flat corporate earnings also implies
generally flat stock prices. It also suggests American companies
could be in for rough times on the international stage.
After-tax corporate profits are the mother's milk of companies
investing for the future. If profits flatten, Congress will need to
seriously consider cutting the corporate tax rate. At 40 percent,
according to KPMG, the total U.S. corporate tax rate is higher than
that of every other major industrialized country save Japan. A
corporate tax-rate cut may soon be essential to sustain our
High employment rates combined with solid real wage growth will
be great for American workers, spreading the benefits of prosperity
widely. However, the shift in income shares from the corporate
sector to workers may come as an unpleasant surprise to the stock
market and to our competitiveness. The effects of that surprise are
likely to linger for a few years.
JD Foster is the Norman
B. Ture Senior Fellow in the Economics of Fiscal Policy at The
First appeared in the Washington Post
Prospects for the U.S. economy are bright. Inflation and taxes are moderate; interest rates are low; the S&P 500 is repeatedly setting record highs; and growth is accelerating toward 3 percent despite the housing slump. Both the Bush administration and the Congressional Budget Office forecast the economy to grow at 2.5 percent annually or better for the next five to 10 years.
J.D. Foster, Ph.D.
Norman B. Ture Senior Fellow in the Economics of Fiscal Policy
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