Profits and Resource Flows

The right says that taxing profits destroys the incentive to invest, and interferes with the ability of the invisible hand to direct resources to their most productive use. That’s true, but only up to a point and we shouldn’t fear taxing profits that are persistently (and in some cases extraordinarily) high.

In a capitalist system, profits are supposed to signal where resources can be used most effectively. If an industry is making above average profits – and perhaps producing huge mega-bonuses for executives as well – that’s a signal that more resources are needed in that industry. According to standard microeconomic theory, the excess profits will draw resources from industries where profits are lower, e.g. industries with below average profits, and redirect them to higher valued use in the booming industry. As this happens and supply in the booming sector increases, the added competition will reduce profits back to normal levels (and the decline in supply in the failing industries will increase profits back to normal as well). Thus, if there is an increase in demand for a product, prices and profits will increase and that will attract more resources to the industry. Hence, there is an automatic mechanism — an invisible hand — that pushes resources into areas where demand is high and out of areas where demand has fallen. If we interfere with this invisible hand with taxes, resources will not flow to meet changes in demand, costs, etc. as effectively as before.

Thus, we should accept that high profits are necessary to direct resource flows. If we never allow above average profits, then resources will not be directed to their best (i.e. most profitable) use.

But that doesn’t mean that we should accept persistently high profits. Incumbent firms do not want more competition. If more firms enter, the added competition will reduce their high incomes and these firms will do all they can to construct barriers to entry and protect their advantage. Sometimes the barriers are legal, sometimes they are economic, and sometimes the structure of the markets protects the advantages of incumbent firms without them having to do anything active to protect their market power. Thus, while short-term profits are necessary, if we see persistent above average profits that’s a sign that entry into an industry is not as free as it should be. Profits that remain high for long time periods are not doing the job of directing resource flows, they are simply putting more money in the profits of owners and there’s no reason to defend them on this basis (they are producing less and charging higher prices — the source of their high profits — than they would if competition were more robust).

And even in the short-run, incentives are subject to diminishing returns. Would the promise of $300 million dollars per year create less willingness to work hard than the promise of $301 million per year? Would you reduce your effort to any noticeable degree if you only stood to gain $300 million instead of $301? The incentives created by the first million in profits are much higher than the marginal incentive provided by the 301st million dollars, and at some point the marginal effect that additional profit has on incentives is practically zero.

So yes, high profits are necessary to direct resource flows, no argument on that point. But, (1) if profits are persistently high — if entry and competition do not reduce profit to normal levels — that’s a sign of excessive market power and regulators ought to take a hard look a the industry. The first choice should be to remove the barriers to entry to allow more competition. But if the barriers cannot be fully removed, then taxing the excess profit away (or requiring lower prices) will not reduce the incentive of incumbents to remain in the industry. (2) In the short-run, we shouldn’t fear taxes on profits over a certain level — taxing away massively excessive profits will not change incentives to any noticeable degree. If higher taxes reduce profits to, say, a $40 million return instead of a $50 million return on an investment of $100 million, the effect on the incentive to enter that industry will be very small — these taxes will not distort incentives enough to make any difference. Profits are still high enough by a considerable margin to encourage the effort needed to enter the industry.

We can tax high and persistent profits without fear that we will snub out the incentive to move resources around in a way that best meets the demands of consumers, and we can also increase taxes when profits are extremely high without worrying we are destroying the incentive to enter particular industries. Above average profits are an important signal in markets, but profits that remain high for long time periods, or profits that are extraordinarily high in the short-run can be taxed without fear that it will distort the allocation of resources in an important way, or reduce long-run economic growth.

This post originally appeared at Economist’s View and is posted with permission.