Forecast based on assumption that capacity grows at same rate as in 1971-76 and real GNP grows 6 percent per year from 1976:4 to 1978:1. Source: Federal Reserve Board and Bureau of Labor Statistics (Historical Data). In considering the implications of the above chart, one might be tempted to describe the current stock of plant and equipment as adequate. However, it is important to keep in mind that, although indicated idle capacity in 1968 and 1973 was 13.2 percent and 12.3 percent, respectively, the economy was operating during both periods at close to full effective capacity. Much, if not most, of the idle capacity in those years was comprised of over-aged and inefficient equipment and facilities which were maintained for standby use only in emergencies or to meet other special situations. As a result, and particularly in 1973, as the nation's utilization of its plant capacity approached 90 percent, inflationary bottlenecks and shortages, as noted previously, occurred in a number of key industries. However, in both 1968 and 1973, the nation's stock of plant and equipment was such that as the capacity utilization rate approached 90 percent, or effective capacity levels, the jobless rate declined to 3.4 percent in 1968 and 4.8 percent in 1973. This picture has now changed. As a result of the lag in capital investment in recent years, it now appears that the country will run out of capacity before it runs out of unemployment. This may be as early as the end of 1978 when, according to some forecasts, the economy will again hit "full" capacity (utilization rate approaching 90 percent) and "bottleneck" situations may again occur. However, the unemployment rate then is expected to be still above 6 percent. This means that it can no longer be assumed that an economy operating at full capacity will result in full employment. Present economic recovery The lag in capital spending has continued during the present economic recovery and represents the principal weak spot in the present economic outlook. As noted by Arthur Burns, in testimony before the House Committee on the Budget (March 2, 1977), real business capital spending has only increased 3 percent during the current recovery versus an average of 15 percent during the corresponding period of previous post-war recovery cycles (more recent estimates put the spending gap at about 8 percent for the first quarter of 1977). Key financial indicators—improved but still a long way to go Key financial indicators are improved since the depths of the recession in 1974; however, in general, they still have a long way to go to regain the levels attained during the 1960's. The trend in profits, before and after tax, since 1965, of nonfinancial corporations, as reported and adjusted for underdepreciation and inventory profits due to inflation, is shown in the following table: ADJUSTMENT OF REPORTED PROFITS OF NONFINANCIAL CORPORATIONS 1 The sum of the excesses of current costs over tax costs with respect to depreciation and inventory. 2 Since this is a retrospective recomputation of profits, it takes as given the corporate income taxes actually paid. If tax liabilities had been figured on the adjusted pretax profits, the aftertax effect of the adjustment would, of course, have been reduced by the tax saving resulting therefrom. But since they were actually figured on the reported profits throughout, there were no such tax savings. Adjusted after tax profits are simply adjusted pretax profits minus actual taxes on reported profits. Source: Department of Commerce. As these data indicate, corporate profits after tax, both as reported and after adjustment for inflation, have recovered significantly since 1974; however, adjusted after-tax profits which were about the same as the reported figures in 1965 were only 45 percent as large as reported profits in 1976. To put it another way, since 1965, reported after-tax profits have increased 94 percent whereas adjusted after-tax profits have declined 10 percent. Corporate liquidity (defined as the ratio of liquid assets to short-term liabilities) for nonfinancial corporations shows a similar picture: Corporate liquidity reached its low point in 1974 when the liquidity ratio dropped to 26.6 percent; by the end of 1976 it had risen to 34 percent. However, this leve is only about the same as in 1968 and is well below the ratios achieved in the late 1950's and early 1960's. Moreover, the economic risks are, or at least are perceived to be, greater today than they were in 1968. In this connection, the recent experience of two severe "cash crunches" coming close together in 1967-70 and again in 1974-75 (the previous crunch occurred in 1957-58) have had a severe and negative impact on management attitudes with respect to risk investment. Business does not want to get caught short again, some predict another cash crunch could come again as early as 1979, and this concern, as noted previously, has been an important factor in holding down capital spending. Perhaps the single most important consideration in capital spending decisions, return on investment, remains at depressed levels. Although after-tax return on investment for nonfinancial corporations increased to 3.7 percent in 1976 from a low of 2.4 percent the year before, this key indicator remains far below the levels achieved in earlier years. As the following chart shows, the after-tax rate of return on investment, which was 7.3 percent in 1955, reached a high of 9.9 percent in 1965; as recently as 1972, the rate was about 5 perecnt. RETURN-ON-INVESTMENT* AFTER TAXES *After tax profits, excluding inventory profits, and adjusted to reflect economic depreciation (double declining balance, .75 Bulletin F service lives) as a percent of plant, equipment, and inventories valued at replacement cost. Source: Calculated from Commerce Department data. Effective corporate tax rate The effective corporate tax rate (all corporations) adjusted for phantom inventory profits and underdepreciation, shows a drop from the 1974 high of 59.7 percent. However, the 1975 and 1976 rates of 51.6 percent and 51.2 percent, respectively, are the highest since the 1950's. 1Taxes paid as a percent of reported before-tax profits minus inventory gains and an allowance for under-depreciation (the difference between historic cost depreciation and replacement cost depreciation calculated on the basis of double declining balance, .75 Bulletin F service lives. The effective rate was larger during the early 1950's because of Korean war excess profits tax. However, aside from expiration of the excess profits tax, corporate tax cuts enacted over the years have been insufficient to offset the ravages of inflation. Earnings for reinvestment down The decline in real corporate profits (as discussed above) has resulted in a dramatic decline in retained earnings available for reinvestment by business. Undistributed profits of nonfinancial corporations after restatement for the effects of inflation on inventory values and depreciation, declined from about $19 billion in 1965 to about $5 billion in 1973-this despite an increase of 36 percent in the real Gross National Product during the same period. In 1974, undistributed profits were a negative $18 billion and by 1976 they had recovered to only $1 billion. Increased interest costs The deterioration of real business profits and retained earnings has been reflected in the equity markets. The state of the stock market has made it difficult for other than the most credit worthy companies to raise funds in the equity markets. Venture capital companies have found it particularly difficult to acquire such funds. As a result of this and the status of real corporate profits, corporations have been forced to rely more heavily on borrowings to meet their current working capital requirements and capital investment needs. With profitability still depressed and depreciation falling short of replacement costs (estimated to be in excess of $24 billion in 1976), industry has had to turn increasingly to outside sources for its capital funds. Over the past 20 years, new equity shares have provided only 3.5 percent of the total new funds raised by nonfinancial corporations. New debt, on the other hand, has been used to meet a growing share of corporate financial needs, averaging 41 percent during the past five years compared with 33 percent during the first half of the 1960's. This reflects the preference for savers to lend their money instead of risking it in equities that offer a small and uncertain return. There is also a strong bias in the tax structure. Interest and dividends are both costs of capital-fees paid to people for the use of their savings; however, interest is tax-deductible and dividends are not. Hence, the tax structure is pushing corporations toward debt financing, and the Tax Reform Act of 1976 made equity financing even more difficult by increasing the taxes on disposition of capital assets. Energy and environmental problems have also aggravated the situation. The increased cost of petroleum products alone has significantly increased the cost of doing business. Industries that rely heavily on oil usage have been hit particularly hard. However, virtually all business operations have been adversely affected to some degree. The critics Some critics have expressed the view that, one way or another, corporations have received sufficient incentives and generated adequate funds for capital investment; they do not need further incentives, i.e., corporate tax cuts or other tax "breaks". However, flow of funds data do not support the critics' related claim that corporate "savings" currently exceed corporate investment. Although sharp cutbacks in plant and equipment and inventory spending boosted cash flow above business capital spending during 1975, this is no longer true as 1976 data indicate (capital expenditures were $16 billion higher than cash flow in 1976). CORPORATE CASH FLOW AND INVESTMENT (FEDERAL RESERVE FLOW OF FUNDS)-NONFINANCIAL CORPORATIONS [In billions of current dollars] 1 Gross internal funds equals the sum of retained earnings minus inventory profits, plus repatriated foreign earnings, plus book capital consumption allowances. Source: Federal Reserve Board. 1 |