How Does A Corporation Make Money

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This article presents the research findings of a leading U.S. corporation, AT&T, on a series of important economic questions and issues, with an interpretation of the material by one of the company's top executives. The subject is corporate earnings patterns in different industries, investment trends, the relation of profits and investment to GNP, and other questions. (Sources and explanatory notes for the charts are provided in the "Technical Appendixto Thinking Ahead.")

Exhibit I

Part A. GNP and plant and equipment expenditure data are quarterly data seasonally adjusted at annual rates, obtained from Survey of Current Business, U.S. Department of Commerce.

Part B. The plant and equipment investment includes nonresidential, nonfarm producers' durable equipment and structures. Total private corporation profits after taxes and plant and equipment investment were obtained from the Economic Report of the President. Pre-1929 data are from the U.S. Department of Commerce.

Part C. External sources include stocks, bonds, mortgages, and bank and other loans. Internal sources include undistributed profits, capital consumption allowances, trade payables, taxes on profits, and other liabilities. Total sources equal external plus internal. The information was obtained from Survey of Current Business, U.S. Department of Commerce.

Exhibit II

Information was obtained from Capital Goods Review prepared by the Machinery and Allied Products Institute, Washington, D. C. The data refer to all corporations. Amounts are estimated at 1964 prices.

Exhibit III

Debt ratios are based on information published in Moody's Industrial and Public Utility manuals and companies' annual reports. Bond yields are from Moody's bond surveys and exclude telephone issues. The Bell System bond yield index is maintained by the AT&T Company and is composed of 10 issues considered representative of all System long-term issues with respect to maturity, coupon, size of issue, and so forth. It is constructed on the same basis as Moody's industrial and utility bond yield indexes.

Exhibit IV

The data for the 528 manufacturing companies shown in Parts A, B, and C are drawn from the "Compustat" industrial companies series magnetic tape provided by Standard & Poor's. The tape was processed by an IBM 7074 computer to derive the data used here.

The companies represent a broad-base series having consistent and meaningful data. Certain industries (e.g., mining and oils) which have depletion allowances are excluded because comparability would be difficult. Some other companies are excluded where data are incomplete.

The data plotted on the charts are the average of the annual returns on average common equity for the period shown. Thus, Borden Company, which had an average return of II.8% for 1946–1965, is represented in the 10%–12% bar in Part A. Similarly, it is one of the dots shown in the 10%–12% box for the food industry in Part C.

Return on equity capital rather than return on total capital (or total assets) is used to allow a direct and meaningful comparison of returns between the manufacturing industries and the electric industry. Differences in capital structure, as shown in Exhibit III, largely compensate for differences in basic industry risk so that the equity securities are regarded as comparable.

Accounting differences between companies (e.g., depreciation) are minimized by: (1) excluding the balance sheet item of deferred taxes and investment credit from equity capital; (2) using averages over a relatively long period; and (3) using a common data source ("Compustat").

Exhibit V

Part A. Figures show rates earned on average common equity for the 528 manufacturing companies identified in Exhibit IV.

Part B. This chart was included in the Economic Report of the President, January 1966. GNP figures are seasonally adjusted annual rates. Unemployment figures are percentages of civilian labor force, seasonally adjusted. The potential GNP trend line increases at a rate of 3·5% from the middle of 1955 to the last quarter of 1962, and at a rate of 3·75% thereafter.

Part C. Plant and equipment expenditures are those previously identified in Exhibit I, Part A. GNP data were obtained from the Survey of Current Business. Pre-1929 GNP figures are from the U.S. Department of Commerce. Corporate profitability is shown as the rate of return on common equity for Standard & Poor's 425 industrial companies (1946–1965) and 50 industrial companies (1929–1940). Data prior to 1929 are based on the earnings of the 50 largest manufacturers for which information is available. This series is maintained by AT&T and is based on information provided in annual reports.

Exhibit VI

The 128 electric companies represent a broad-base series having consistent and meaningful data. The data were gathered from Federal Power Commission reports, Studley Shupert & Co., Inc., Moody's Investors Service, and annual reports, and were processed by computer in a method similar to that used by the 528 manufacturers. The companies in the series represent large operating electrics with capital of $10 million or more. The series excludes holding companies. 1965 data were not available for the electrics at the time data were processed.

Exhibit VII

Marriage data are from the National Center for Health Statistics, U.S. Public Health Service. Alaska and Hawaii have been included beginning in 1959 and 1960, respectively.

Population data are from the U.S. Bureau of Census. Series D projections were used for 1982–1985—Alaska and Hawaii being included throughout. Appropriate interpolations were made to obtain yearly data.

What level of earnings is required if U.S. business is to grow and prosper to meet national objectives? What is the best test of corporate earnings adequacy? There is much uncertainty and confusion regarding these questions. In this article I shall develop the point of view that the best guide to an answer is not earnings-per-share trends or the cost of capital; it is the concept of opportunity costs. For perspective on this position, some new data are presented to show patterns of corporate earnings, capital expenditures, and other important aspects of the U.S. economic picture today.

As a public utility executive who faces the practical problem of raising large amounts of new capital from investors, I am naturally very much concerned with the implications of earnings and investment trends for national economic policy. At the outset of this discussion, therefore, let us examine the close relationships among plant and equipment expenditures, profits, and growth in gross national product (GNP). By way of conclusion, I shall raise some questions relative to the significance of the corporate earnings and investment picture for public policy.

How Profits Nurture GNP

The United States has emerged as the most productive and economically most powerful nation on earth. The upward thrust in the U.S. economy's expansion has resulted in a level of national living that is at once the envy and aspiration of every other nation. Indeed, "blue collar" workers in the United States currently enjoy a standard of living equal to or surpassing that realized by most of the so-called privileged classes in many advanced Western nations.

But this does not mean that the need for economic growth in the United States is diminishing. Just the opposite is true. The increasing importance of growth is underscored by the projected increase in the labor force to 94 million by 1975. Since all of the 1975 labor force has already been born, its future can be predicted with actuarial precision. In accordance with the findings of the March 1966 Manpower Report of the President, the U.S. economy must expand enough to provide jobs for 14 million additional workers during the next decade if our nation is to keep 96% of the civilian U.S. labor force actively employed, as it did in 1965. This means that jobs must grow at a 50% greater rate than in the past decade if we are merely to "hold our own."

We Americans are committed, however, to more than just "holding our own" on jobs. The 79th Congress, in the Employment Act of 1946, set forth our nation's economic goals as the promotion of maximum employment, production, and purchasing power. More recently, Congress added two more objectives: a stable price level and preservation of the integrity of the U.S. dollar with the help of balance of payments controls. Of these various goals, the doctrine of full employment has been the overshadowing one. It has been accepted by both political parties. It has been the focus of attention for the past 20 years in each of the Economic Reports of the President. And it has been the subject of a good deal of Congressional concern as well as of the legislation promulgated by recent administrations.

Will our nation's productive capabilities be able to keep pace with its economic and social commitments in the years ahead? More specifically, will the output of the private sector be adequate to meet the truly enormous demands of a sharply rising labor force, a rapidly growing body of elderly citizens, and an ever-rising population of school and college age? To throw some light on these fundamental questions, we must consider more fully the framework within which the corporate sector of the U.S. economy has operated in recent years and consider the goals of future years. Such an examination will, I believe, make two things clear:

1. Economic growth depends on corporate investment in new plant and equipment.

2. Investment in new plant and equipment depends on profits.

Let us look at some of the facts demonstrating each of these relationships.

GNP & Investment

During the past 20 years, U.S. corporations have expended some $800 billion on new plant and equipment. Part A of Exhibit I depicts the close relationship between plant and equipment spending and the upward trend of GNP. To facilitate the growth in GNP from the going rate of $200 billion a year at the beginning of 1946 to some $700 billion by the end of 1965, corporate plant and equipment spending was stepped up from a rate of $15 billion to some $55 billion at the end of 1965. As shown on the exhibit, plant and equipment expenditures are considerably more volatile than GNP. Sharp dips in plant and equipment expenditures have invariably characterized years of recession. Conversely, strong upturns in plant and equipment spending have keynoted years of boom and prosperity.

Exhibit I. Relationships among GNP, plant & equipment expenditures, and profits (Dollar figures in billions)

There has been a significant increase in the ratio of capital investment to jobs. For example, in 1946 the average investment per worker in manufacturing industry was about $7,000. In recent years the average capital invested per worker has exceeded $25,000. These data underscore the need for continuing high corporate outlays for plant and equipment. This is particularly the case if we are to expand job opportunities to meet the expectations of new members of our growing labor force.

Pushing GNP up to $1,000 billion in 1965 dollars (the level often forecasted for the early 1970's) will require an annual growth rate of about 5½%. This is an extremely large order. Most economists would realistically settle for something less. But "something less" would still be something more than the 3½% to 4% rate recorded since the end of World War II. In short, few will contend that past growth rates will be adequate for the years ahead. To support the higher growth rate just suggested will likely require continued increases in plant and equipment expenditures to perhaps two or more times today's level. The major question is: How can this level of investment be attained?

Investment & Profits

Under the profit-and-loss incentives inherent in our free enterprise system, plant and equipment expenditures can proceed only when reasonably adequate profit opportunities are contemplated. Part B of Exhibit I shows the close relationship between corporate plant and equipment expenditures and corporate profits over some 40 years of U.S. economic history. While the relationship is not a mathematically perfect one, it is clear from the relatively straight path of the dots that there is a close interlink between corporate profits and corporate spending.

The overriding importance of profits in spurring investment was recognized by President Kennedy when he stated: "In a free enterprise system there can be no prosperity without profit. We want a growing economy and there can be no growth without investment that is inspired and financed by profit." A parallel thought was pointed up by President Johnson in his 1965 Economic Report when it was noted that federal policy included "a full understanding of the key role of private investment in total market demand and in the long-term growth in incomes, and of the need for adequate profit incentives to stimulate this investment."

While profits are not the only source of funds for capital investment, they play the key role. The importance of internal sources, primarily reinvested earnings and depreciation charges, is indicated in Part C of Exhibit I. The lower section of the chart shows the persistent tendency of internal funds to satisfy about three fourths of corporate needs.

Reinvested earnings, of course, are generated directly from profits—being the balance remaining after the payment of cash dividends to shareowners. Additionally, the ability to raise money by selling debt or equity securities is also directly dependent on the outlook for profits. To compete in the capital markets and raise capital successfully, a company must present investors with compelling reasons for placing their savings with the corporation and accepting a risk. The most compelling reason is a solid earnings record and the prospect of improved earnings in the future.

In view of the heavy capital spending by corporations since 1946, the question quite naturally arises: Has capital spending by corporations been overdone? Exhibit II indicates that the answer is a clear no; in fact, there has recently been a rapid escalation in the amount of equipment of American industry that exceeds 10 years of age. This has occurred despite the sharp upturn in corporate outlays in the past decade. These data suggest that heavy corporate outlays for new facilities during World War II and in the early postwar years up to and including the Korean War have served to present American industry today with an "old age" problem. Also, modern research and development has served to shorten the "life span" of productive facilities. The on-rush of modern technology has made some projects economically obsolete almost before they are off the drawing boards.

Exhibit II. Sharp increase in amount of equipment over 10 years of age (Dollar figures in billions

Big Question

All this certainly makes it important to know what level of earnings is required if U.S. business is to grow and prosper to meet national objectives. The big question is: What is the best test of corporate earnings adequacy?

The answer to that question is not universally agreed on. To clarify some of the issues, I will proceed to analyze three criteria commonly cited as guideposts for corporate expansion.

Failure of EPS

The first criterion focuses on short-term increases in earnings per share (EPS) as the sole guideline. Proponents of this criterion contend that any expansion which increases EPS during the immediate future is desirable. On the surface, this approach does sound quite attractive, but it can be misleading in a number of ways.

Consider the sale of new shares. In a strong bull market in stocks, market prices are usually well above book values. Hence there may be a tendency to sell new shares to investors and to apply the proceeds to projects of low or questionable earnings potential. Should this occur, the company's stock will likely undergo radical reappraisal when investors come to realize that the projects undertaken are earning below the rates they contemplated when they purchased the shares. In short, today's increase in EPS may be tomorrow's decrease if investor expectations and investment potentials are not taken properly into account.

Another way the EPS criterion may lead management to seek short-run gains in per-share earnings is by resorting to increased debt in the capital structure. As discussed later, appropriate corporate debt ratios have become rather firmly established among different industries. If management imposes undue financial risk on the common shareowners by "leveraging" its capital unwisely, i.e., adding too high a proportion of debt obligations, it will be only a question of time before the company's shares are reevaluated in the market.

From the broader view of corporate ethics, shifting to greater leverage raises a fundamental question: Since investors purchase shares on the basis of a given capital structure policy, is it proper for management to alter that policy and take advantage of stockholders who may be "locked in"—that is, unable to sell at a reasonable profit—when the change in leverage policy finally becomes apparent? This is a particularly pregnant question with respect to the small shareowner who does not have the advantage of the large professional staffs employed by the institutional investors. The latter analyze such matters closely and can dispose of their equity holdings as soon as an adverse debt trend is detected.

Still another way the EPS criterion can be misleading stems from the adoption of accelerated depreciation with "flow-through" of the deferred federal income tax to income. If the corporation adopts accelerated depreciation and enters the higher charges on its books, no problem is presented with respect to reports to shareowners. Likewise, provision can be made to "normalize" the taxes with a reserve account. However, if a company should "flow-through" the deferred federal taxes to current income and reap the tax advantage without provision for the deferred liability, shareowners—particularly owners of small holdings—may be unaware of the fact that the gain is only temporary.

Finally, a company's EPS performance may be affected by postponing expenditures that should be made today for the sake of long-term growth. Although the advantage will be short-lived, this will not be apparent from use of the criterion.

Of course, the EPS standard can be useful under certain conditions. Once the minimum acceptable rate has been achieved, EPS can show increases due to a rising rate of return on investment. Likewise, with an acceptable rate of earnings, the plowback of reinvested earnings will result in increased per-share earnings due to the greater investment base, i.e., increased book equity per share. In these circumstances the use of EPS is not subject to the shortcomings just outlined.

Errors of Market Tests

According to a second criterion of appropriate corporate earnings, expansion is justified if earnings exceed the cost of capital. This is consonant with the well-recognized precept of capital budgeting that projects should be ranged according to expected profitability, with the cutoff point somewhere above the cost of capital. Referring to the significance of the cutoff point or rejection rate, one authority has stated: "Its purpose is to keep the company from making investments that cannot earn enough to pay their cost of capital."¹

Many companies may set their target earnings rates somewhat above the cost of capital for a variety of reasons. Among these reasons is the possibility that if some projects fail to earn at the anticipated rate, overall earnings may be depressed below the cost of capital. As a result, prudent management would suggest a cutoff point well above the cost of capital.

In the case of regulated business, recent research by Judge Harold Leventhal demonstrates that cost of capital is subsidiary in importance to comparable earnings data.²

Substantial and complex problems can, and do, exist in all industries with respect to how the cost of capital is to be determined. The most common approach is to determine the cost of debt and the cost of equity and then meld the two in an appropriate capital structure. But (as we shall see) the appropriate capital structure varies among different industries. In consequence, the overall cost of capital will differ although the respective costs of debt and the respective costs of equity could be approximately the same for companies of comparable credit standing.

The cost of debt for a company with high-grade credit is relatively easy to determine. This is pointed up in Exhibit III. As shown on the left-hand side of the exhibit, there are substantial differences in debt ratio of each of the three industry groups. High-grade industrials have a debt ratio of about 15% ; the Bell System carries about 35% debt; and the high-grade electric utilities are in the 50% range. Nevertheless, as the right-hand side of the exhibit shows, the bonds of these three groups sold on an almost identical yield basis during the decade 1955–1964. This indicates that investors have regarded the investment risks attending the debt of these three groups to be approximately the same, despite the differences in debt ratio.

Exhibit III. Average debt ratios and bond yields, 1955–1964

It is important to bear in mind, however, that the differences in capital structure impose different degrees of financial risk on the equity holder; as the left-hand side of Exhibit III shows, varying proportions of debt must be served before the equity holders' interests can be served. Thus, from the viewpoint of the equity holder, these differences in capital structure largely offset differences in basic industry risk.

Difficulties of Measurement

Although the principles just mentioned should be reasonably obvious, there has sometimes been controversy as to how the cost of equity should be determined. This controversy arises because some persons accept, without serious challenge, the theory that equity costs can be determined in the securities markets. Such market tests frequently employ the ratio of dividends to market prices or the ratio of earnings to market prices. From the 1930's through most of the 1950's, such ratios were widely accepted as measures of equity costs; and conceptually, stocks were regarded as identical to bonds, since the ratios were, at base, somewhat analogous to bond yields. Relatively little attention was paid to the fact that the ratios were valid measures of equity cost only in a stagnant situation where current earnings, dividends, and market prices might remain forever unchanged.

In the past half dozen years or more, during which growth has become pretty much universally associated with stock ownership, the use of dividends-price and earnings-price ratios has gone into eclipse for purposes of determining equity costs; even those who accepted the ratios in former years no longer support them. The reason for this is readily understood: D/P and E/P ratios have been below bond yields in recent years, and no one would seriously assert that equity costs are less than bond costs. Underlying the almost universal rejection of the ratios is one stubborn fact: investors pay today's market prices on the basis of what they reasonably consider management will earn in the future. Therefore, it is absurd for management to relate today's market price to current earnings and to conclude that this is all investors expect.

The obvious shortcomings of current D/P and E/P ratios for determining capital costs may be largely overcome by following the investor's capitalization rate approach. The advantage of this method is that it gives primary consideration to investors' expectations of growth. Conceptually, it focuses on what investors actually expect: a combination of dividend return plus growth in earnings, dividends, and market price per share. This approach, nonetheless, requires an estimate of what growth rate investors expect—and this is in considerable degree a subjective determination.

In attempting to answer the basic question of what a company should earn on its actual book investment, therefore, real problems are created if attempts are made to use approaches which are oriented toward investor returns in the market. Some advocates assert that D/P and E/P ratios should be applied to book investment per share. This is patently fallacious because it would result in a reduction in the earnings rate on book equity whenever market prices are above book values (as has been the case for many years). Other advocates hold that equity costs developed from market prices can only be applied to market prices.

We must conclude that determining the cost of equity from market prices is hot a simple matter. Further, management of a corporation exerts little direct influence over market prices. The latter are much affected by factors extraneous to management's actions. In short, management's fundamental responsibility is to manage the business in the best long-term interests of the firm's investors, its customers, its employees, and the nation's general welfare. For management to become overly preoccupied in its decision-making process with the movement of stock market prices would be conducive to neglecting its fundamental responsibility of managing the business.

Opportunity Costs Meet Need

Fortunately, the widely accepted opportunity cost principle of economics provides the answer we are looking for. Paul A. Samuelson has described the principle thus:

"The man in the street can clearly recognize costs that are actual cash payments; the economist and the accountant must go well beyond that. But the economist goes even further. He realizes that some of the most important costs attributable to doing one thing rather than another stem from the foregone opportunities that have to be sacrificed in doing this one thing… This sacrifice of doing something else is called 'opportunity cost.'"³

In accord with this principle, we may properly conclude that the true cost of equity capital for a company is the earnings the shareowners' capital could attain in alternative opportunities—i.e., in investments in other similarly situated companies. By focusing on opportunity costs, we are unshackled from the vagaries of stock market prices and the host of related problems.

Opportunity cost affords equitable treatment to the investor because he should receive as much on his investment in one company as he could realize elsewhere in a comparable situation. If a company management has no prospect of achieving such earnings, serious questions are raised concerning the recruiting of equity capital, the reinvestment of earnings, or even the continued employment of existing capital in the business. Additionally, management's function is clarified because, while it cannot control market prices, it can make every effort to manage effectively and to achieve desired earnings rates on the investment in the business.

Using the opportunity cost concept, corporate management can determine the earnings rates required by making a comparison with a broadly representative cross section of alternative investment opportunities. On this basis, projects which seem unlikely to earn at the opportunity cost rate can be rejected.

Objective Measures

Evaluating the earnings achieved elsewhere is a relatively straightforward process. Exhibit IV shows the result of a study of 528 major manufacturing companies included in the Standard & Poor's "Compustat" tapes. These are the companies for which consistent and meaningful data are available for most of the postwar period. The results may be considered typical over the past 20 years. The use of period averages for each company eliminates the effect of short-term swings or year-to-year fluctuations in earnings. These fluctuations are not too important provided the company's average earnings rate is adequate. Since investment is usually a long-term phenomenon (common stock is permanent capital), the use of average earnings rates for a reasonably long period would appear quite appropriate.

Exhibit IV. Earnings of manufacturing companies

As indicated in Part A of Exhibit IV, the average rate of earnings on common equity for all 528 companies in the postwar period was 13.9%. But, as may be observed, the graphic arrangement brings out the presence of a strong central tendency, with about two thirds of the companies falling in a fairly narrow range. The average earnings rate of companies in this range was 12.0% on common equity.

For further perspective, let us look at a shorter and more current period, recognizing that the value of short periods may be limited because of the tendency for manufacturing earnings to fluctuate from year to year. Part B of Exhibit IV presents data on the seven-year period 1959–1965. The chart suffers in that it emphasizes a period of low earnings and years in which national economic performance fell short of needs, however measured. The average earnings rate for all companies for this period of inadequate economic growth was 11.5%, with the majority of the companies again falling in a narrow range; this time they averaged 9.9%.

It is of interest that, following recovery from the "profits squeeze" and relatively higher unemployment levels characterizing the earlier years of this period, earnings rose to 12.1% in the 1963–1965 period and attained a level of some 14% for 1965 alone.

Earnings Goals

We may conclude that the opportunity cost principle indicates an appropriate earnings objective approaching the 13.9% on common equity realized by unregulated industry for the entire postwar period 1946–1965. Manufacturing companies, however, are subject to a fair degree of volatility in earnings and would most likely rise above this level in periods of good earnings and fall below this level in periods of recession.

The earnings attained by manufacturing companies also serve as a guide for the sometimes thorny question of earnings in regulated industry. In years of general prosperity, such as the present period, an appropriate objective for regulated industry might be the average attained in the central tendency of the manufacturing companies during the years 1946–1965. This would recognize the greater volatility of manufacturing earnings and would require earnings approaching 12.0% on common equity. While this is roughly two percentage points below the manufacturing company average of 13.9% achieved in a generally prosperous period, regulated companies might be expected to earn at a rate somewhat above the central tendency of the manufacturing companies in a period of low earnings.

If the regulated companies do not attain earnings of such comparability with nonregulated business, we could witness a long-term misallocation of society's resources, with regulated companies ultimately becoming unable to secure investment capital. The potential danger to society from such a course is pointed up by the experience of the railroads, which have not been able to issue new common equity capital for over a quarter of a century.

Impact of Risk?

It is sometimes asserted that differences in risk among different industries might account for differences in realized earnings. If risk, in fact, determined earnings, it should be expected that the companies in each industry would earn at basically similar rates. However, this does not appear to be the case, as Part C of Exhibit IV shows. Here the 528 manufacturing companies are arrayed in each industry according to their rate of earnings on equity. The spread of earnings rates in each industry is roughly similar to that shown for all manufacturing companies, depicted in Part A, regardless of their industry classification. Thus it appears that there is a general centering of rates of equity earnings and that there is no discernible pattern of returns that might be associated with presumed differences in industry risk. In short, the demonstrated deviations from the central tendency would appear to be attributable to factors other than differences in industry risk.

Benefits of Approach

There are clear advantages accruing to the investor and to society as a whole when management follows the opportunity cost principle.

First, investors benefit because the opportunity cost standard will, over the long run, help to move the company's stock in line with other stocks generally, regardless of stock market psychology at any particular time. The opportunity cost concept is, in essence, the market test of adequate earnings: if a company is unable to earn at competitive rates, its market price will suffer, and selling new shares on terms fair to existing shareowners will become difficult if not impossible.

Secondly, society also benefits because economic resources are allocated in the most efficient manner consonant with the precepts of freedom and free enterprise. Consumers' decisions "to buy" or "not to buy" are signals transmitted through the market system to producers who, in hopes of earning a profit, attempt to satisfy consumers' needs and desires.

Questions for Policy Makers

At this point I would like to raise a number of questions, suggested by the points outlined earlier, that are important to business and political leaders who are responsible for implementing national economic growth objectives.

1. How do corporate earnings rates affect GNP and employment rates?

Part A of Exhibit V presents the postwar earnings record of the 528 manufacturing companies. These companies averaged 14% on common equity. There was a slight gap at about the time of the 1953–1954 recession, with a return above 14% in the prosperity of 1955–1956. Subsequently, a sizable earnings gap began in 1957 and persisted until about 1965, when the gap closed. The low points in earnings of about 10% on common equity were reached in 1958 and 1961.

Exhibit V. Impact of profits on the economy

The decline in the corporate earnings rate cannot be explained by higher depreciation charges in recent years. Admittedly, the absolute amount of depreciation has risen because of greater investment. But the crux of the matter is the trend of depreciation per $100 of plant invested. This moved down from a high of 6.3% in 1955 to a low of 5.5% in 1961 when earnings were likewise at a recession low.

The impact of the gap in corporate earnings is reflected by Part B of Exhibit V. As a result of the closing of the earnings gap, which was brought about largely through recent legislation designed to stimulate corporate profitability and economic growth as well as employment, the GNP gap has been effectively closed. Simultaneously, unemployment has been reduced to the 4% level.

2. Are postwar relationships between earnings and growth likely to continue?

The general lack of data prior to the mid-1920's renders this a difficult question to answer. However, Part C of Exhibit V indicates that the relationship between earnings and growth has been "general" over a period of at least four decades. In this comparison, each of the years 1925–1965 is classified into one of three equal groups:

1. Years of lean profits.

2. Years of average profits.

3. Years of good profits.

In the leanest years, when earnings on equity averaged about 10% , investment in new plant and equipment comprised a bare 7% of GNP. During the middle years earnings on equity averaged 11% to 12%, and spending on new plant and equipment moved up to some 81/2 % of GNP. But in years of highest profitability—when earnings exceeded 13% on common equity, the nation's plant and equipment spending accounted for over 9% of GNP.

To me, this clearly indicates that the public interest will be served if our nation's leaders guard against any imposition of restraints on corporate profitability that might develop in the years ahead.

3. Has government regulation of the earnings of public utilities effectively served as "the law's substitute for competition"?

Exhibit VI suggests that the opportunity cost criterion has been broadly operative for the regulated electric companies. The 128 electric utilities for which data are included in this exhibit account for over 90% of the nation's electric utility industry. As a group, these electrics averaged 12.3% on common equity. This rate is somewhat below the 13.9% averaged for the manufacturing companies, but the great majority of the electrics fall in the central tendency, and the equity earnings rate of 12.1% for this majority is virtually identical with the equity earnings rate of the companies comprising the central tendency of unregulated business. In short, the data suggest that regulation has indeed served effectively as "the law's substitute for competition."

Exhibit VI. Distribution of earnings on common equity for 128 electric companies, 1946–1964

4. What would be the impact of a corporate tax increase on national economic growth?

This is a rather timely question in view of pressures to increase corporate and personal taxes to serve as a brake on inflationary pressures. The question has many facets which cannot be fully explored here, but certain aspects bearing on long-term corporate economic problems are pertinent to our discussion.

The period 1946–1957 witnessed reasonably good growth in the U.S. economy. In these years corporate profits after taxes came to 9½% of disposable personal income. However, during the slowdown in economic growth that commenced after 1957, corporate profits dropped to only 7½% of disposable personal income. In recent years, following the successful implementation of legislation designed to stimulate economic growth, corporate profits are back in better balance with disposable personal income; that is, profits have been averaging about 8½% of disposable personal income. However—in view of the increasing investment required per worker today—it would seem that corporate profits should tend to rise relative to disposable personal income.

As our nation's leaders consider remedies for the recent upsurge in inflation—a short-run problem, it is hoped—recognition might well be given to the long-term impact of any proposals for a corporate tax increase. Disproportionate increases can bring a return to the low corporate earnings witnessed in the years of the "GNP gap" with its high unemployment.

In addition to the basic question of a fair and equitable tax structure, one of the more obvious ways to bring prices into line is to use new plant and equipment to increase output and gain efficiencies.

The Task Ahead

This nation faces human and economic problems of truly staggering proportions.

Prominent among these are the reversal of the persistent gold outflow of recent years and the task of providing employment for the millions of young people who will soon increase the labor force substantially.

Also, as Exhibit VII shows, many young people will be attaining marriageable age during the next 15 years, and a tremendous increase in household formation may be contemplated. All this adds up to an overwhelming need for continued high levels of investment in plant and equipment, schools, housing, public utilities, hospitals, and the like.

Exhibit VII. Growth in the young adult population (Figures in millions)

As businessmen, we must strive to serve the national interests fully in attaining our country's economic goals. This means that as decision makers in the corporate process, we must be alert to remind our nation's political leaders of the fact that any reduction in corporate profitability at this time carries the threat of increasing unemployment and economic stagnation. This is a price our citizenry can ill afford to pay.

1. Joel Dean, Managerial Economics (New York, Prentice-Hall, Inc., 1951), p. 592.

2. "Vitality of the Comparable Earnings Standard for Regulated Utilities in a Growth Economy," Yale Law Journal, May 1965, p. 989.

3. Economics (New York, McGraw-Hill Book Company, Inc., Sixth Edition, 1964), p. 458.

A version of this article appeared in the January 1967 issue of Harvard Business Review.