Arthur M. Okun

George L. Perry

English

Research Papers in Economics

ARTHUR  M.  OKUN  and GEORGE  L.  PERRY* 
Brookings  Institution 
Notes  and  Numbers 
on  the  Profits  Squeeze 
DURING  1969, CORPORATE  PROFITS  averaged  9.2 percent  of gross na- 
tional  product  (GNP),  a dramatic  contrast  to the 11.0  percent  share  of 1966. 
Still  more  striking,  the indicated  share  in 1970  of 8.0 percent  is much  lower 
than that of the recession  years  1961  (9.1 percent)  and 1958  (8.7 percent), 
even after  adjustment  for the depreciation  reform  of 1962.1 
The puzzling  recent  behavior  of the corporate  share  is important  in a 
great  many  economic  issues,  ranging  from the calculation  of full employ- 
ment  revenues  (which  depend  on the estimated  profit  share  at full employ- 
ment)  to the explanation  of fluctuations  in equity  prices.  This  note  attempts 
to pull together  some calculations  and clues on recent  experience,  and to 
offer  a few tentative  judgments  on their implications. 
The Magnitude  of the Squeeze 
During  the 1955-65  decade,  the share of corporate  profits  was a well- 
behaved  function  of economic  activity.  A growth  of GNP greater  than  that 
* We would like to thank Nancy Hwang for her research  assistance. 
1. All profits figures cited throughout  are before taxes and inclusive of inventory 
valuation adjustment,  as reported by the Department of Commerce in the national 
income accounts, with the exception of a depreciation  adjustment  for 1954-61. The 
reform  of depreciation  guidelines  in 1962  is estimated  to have subtracted  from corporate 
profits  $2.4 billion, or approximately  0.5 percent  of GNP. Official  figures  on the profit 
share  for 1954-61  are adjusted  downward  by 0.5 percent  of GNP to put the entire  post- 
Korean-war  time series  on a consistent  depreciation  basis. 
466 Notes and  Numbers  on the  Profits  Squeeze  467 
of potential  raised  profits  more  than  proportionately,  and  a very  rapid  rise 
in GNP had an extra-large  temporary  impact  on profits.  Thus,  the profits 
share  of GNP (R/ Y) could  be estimated  from  the current  and lagged  size 
of the gap between  potential  and actual  GNP, expressed  as a fraction  of 
actual  (G/ Y). On an annual  basis  for the period  1954-66,  this relationship 
was summarized  by the following  regression  equation: 
(1)  R/ Y =  0.1086 -  0.269 G/ Y +  0.081 (G/ Y)-1. 
(0.021)  (0.022) 
IZ=  0.937, standard  error  of estimate = 0.00193. 
Figures  in parentheses  here and in subsequent  equations 
are standard  errors  of coefficients. 
According  to equation  (1), profits  would  absorb  10.9  percent  of GNP in a 
steadily growing  full employment  economy. The positive impact of the 
lagged  gap shows  that the share  would be temporarily  larger  on a quick 
runup  to full employment.  The large negative  effect of the current  gap 
shows the extreme  short-run  sensitivity  of profits:  At any given  point in 
time and, hence,  at a given  potential  GNP, an extra  dollar of GNP pulls 
profits  up by some  38 cents  (the sum of 0.109 and  0.269). 
"Reduced-form,"  or rule-of-thumb,  profits  equations  like (1) were de- 
veloped  shortly  after  the concept  and  measurement  of potential  GNP were 
set forth  by the Council  of Economic  Advisers  in 1961.  For several  years 
this aggregative  method  yielded  good predictions,  better  than many  more 
elaborate  and  more  ambitious  efforts  to tackle  step  by step  the movements 
of the key items  in the corporate  income  statement.  Equation  (1) fits the 
data of 1954-66  remarkably  well, as shown in Table 1, typically  coming 
within  0.2 of a percentage  point (or $1.0 billion to $1.5 billion) of truth 
during  that period.  It is reasonably  clear how this shorthand  technique 
managed  to track  the real  world  during  this period.  Years  of large  gains  in 
real GNP raised  the profits  share  in two ways.  First,  they permitted  over- 
head charges  to be spread  across  a larger  volume  of output;  second,  they 
yielded  above-average  gains  in output  per manhour.  Since  real  compensa- 
tion of labor per manhour  did not vary greatly  with the annual  size of 
productivity  gains,  most of the bonus of extraordinary  productivity  per- 
formance  was captured  in the profits  share.  Conversely,  years  of sluggish 
growth in real GNP typically  meant a lower profits  share as both unit 
fixed  costs and unit real  labor  costs tended  to increase. 
While  the empirical  regularity  of the full employment  profits  share  could 468  Arthur  M. Okun  and George  L. Perry 
Table  1. Corporate  Profits Share, Error  in Predicted  Share, and Gap in 
Gross  National  Product,  1954-70 
Percent  of gross national product 
Corporate  profits  Corporate  profits  plus 
share  of GNP  net interest  share  of GNP 
Error  in pre-  Error  in pre- 
dicted  share  dicted  share  Gap  in GNP 
usiig  equiation  using equation  as percent 
Year  Actual  (1)a  Actual  (2)a  of GNP 
1954  9.88  0.22  9.47  0.21  4.20 
1955  11.25  0.11  10.78  -0.01  0.21 
1956  10.48  0.10  9.95  -0.06  1.84 
1957  9.82  -0.14  9.35  -0.21  3.87 
1958  8.67  -0.15  8.26  -0.04  8.74 
1959  10.16  0.15  9.62  0.10  5.80 
1960  9.38  -0.10  8.83  -0.17  6.85 
1961  9.15  0.01  8.67  0.05  8.47 
1962  9.93  -0.17  9.47  -0.16  5.36 
1963  9.98  0.03  9.57  0.08  4.99 
1964  10.48  0.11  10.09  0.14  3.32 
1965  11.11  0.20  10.82  0.27  0.81 
1966  10.99  -0.38  10.86  -0.20  -1.67 
1967  9.91  -0.90  9.89  -0.60  -0.33 
1968  9.88  -1.23  9.98  -0.82  -1.05 
1969  9.21  -1.53  9.42  -1.00  0.11 
1970b  8.00  -1.68  8.25  -1.01  4.42 
Sources: U.S. Department of Commerce, Office of Business Economics, The  National Income and  Product 
Accounts of the United States, 1929-1965: Statistical Tables (1966), Tables 1.1, 1.10, 1.14; and Survey of 
Current  Business,  various issues, Tables 1.1, 1.10. 1.14. 
a.  Actual minus predicted. See text for description of the equations. 
b.  Average of second and third quarters. 
not be expected  to endure  forever,  neither  was there  any good reason  to 
anticipate  a major breakdown  in the relationship.  Yet it did collapse 
abruptly.  After  1966,  the equation  seriously  and  increasingly  overestimates 
the profits  share  by amounts  ranging  up to an indicated  1.7 percentage 
points  (a huge $16 billion)  in 1970. 
One  source  of error  is readily  identified  and  corrected.  That  is the major 
shift  in net interest  payments  by the corporate  sector  in recent  years.  Be- 
tween 1954  and 1965,  financial  and nonfinancial  corporations  taken as a 
group  were  net  lenders  to the noncorporate  economy  and  annually  received 
net interest  ranging  between  0.3 and  0.6 percent  of GNP ($2 billion  to $3 
billion).  Given  the stability  of the interest  component,  it did not need  to be 
separately  considered.  After 1965, however,  the corporate  sector moved Notes and  Numbers  on the  Profits  Saueeze  469 
steadily into a position as a net payer of interest; the net payment is cur- 
rently $2.5 billion a year. 
Any analytical view of shares of factor income would suggest that profits 
plus net interest of the corporate sector should show more stability in rela- 
tion to output than profits taken separately. Both interest and profits are 
incomes earned on property. To be sure, an important legal distinction 
separates the two types of income. But the division of property income 
between the holders of claims and holders of equities results from decisions 
of corporate finance. By any theory of maximizing behavior in product and 
financial markets, a shift by corporations toward greater debt financing 
would be reflected  in a lowering of profits as a fraction of gross product or 
sales, although not as a fraction of equity. Similarly, greater interest pay- 
ments reflecting higher yields on securities would cut into  profits. This 
analytical judgment is confirmed by refitting equation (1) to explain the 
share of profits plus net interest paid by the corporate sector (S/I'): 
(2)  SlY =  0.1052 -  0.287 G/ Y +  0.076 (G/ Y)-1. 
(0.019)  (0.019) 
]Z=  0.956, standard  error of estimate = 0.00173. 
Equation (2)  improves results for  the  sample period  and does  con- 
siderably better in estimating the 1967-70 period, as Table 1 reveals. De- 
spite the improvement, equation (2) leaves a puzzle of major proportions. 
The GNP gap and the interest shift explain 2 points of the 3 percentage 
point drop in the profits share from 1965-66 to 1970; or, alternatively, 0.8 
point of the 1.8 percentage  point drop in the profits share from the 1965-66 
average to  1969, when the gap impact was slight. It is worth emphasizing 
that the drop of 1.2 percentage points from 1969 to 1970 is fully explained 
by equation (2). For both 1969 and 1970, the unexplained profits squeeze 
is 1.0 percent of GNP-a  squeeze of $9 billion to  $10 billion. 
It  is clear that  the  squeeze is  centered in the  domestic nonfinancial 
corporate  sector. Financial and foreign corporate earnings expanded stead- 
ily from 1966 to 1969-their  sum rising from $13.0 billion to $16.4 billion. 
Even when the large negative interest payment of the financial corporate 
sector is netted out, the figure rises from $4.7 billion in 1966 to $5.7 billion 
in 1969. That is roughly par for the course. In sharp contrast, the domestic 
earnings of nonfinancial corporations were $69.4 billion coincidentally in 
both 1966 and 1969. The sum of profits plus net interest paid for the sector 
rose only moderately from $76.7 billion to  $82.0 billion. The nearly $10 
billion squeeze is here. 470  Arthur  M. Okun  and George  L. Perry 
Shares  within  the Nonfinancial  Corporate  Sector 
In order to investigate the recent performance of profits in this sector in 
terms of costs, prices, and productivity, the shares of gross product origi- 
nating in the domestic nonfinancial corporate sector are shown in Table 2. 
It is clear that both labor's share and the share of other costs have bitten 
into the share of profits plus interest in recent years, reversing  the situation 
from 1960 to 1966, when both fell and contributed to a rising profits share. 
Some reverse shift of shares was to be expected between 1966 and 1969. 
Equation (2) would have been right on track in 1969 if the share of profits 
plus net interest f6r this sector had been 18.0 percent-down  0.6 from the 
18.6 percent of 1966; but the actual share in 1969 was only 16.2.2 A share 
of  18.0 percent might reasonably have been expected to be accompanied 
by 18.4 percent for the share of nonlabor ("other") cost components (com- 
pared with the actual 18.2 percent in 1966) and 63.6 percent for labor's 
share (compared with 63.2 percent in 1966). Thus, the actual 18.7 percent 
share of nonlabor costs in 1969 was larger than one might have expected 
Table  2. Profits  and  Labor  Shares  of Gross  Product  Originating  in the 
Nonfinancial  Domestic  Corporate  Sector,  Selected  Years  1955-70 
Percent 
Profits plus  Compensation 
Year  net interest  of employees  Othera 
1955  18.6b  63.9  17.6b 
1958  14.5b  65.9  19.6b 
1960  15.1b  65.5  19.4b 
1963  16.6  63.9  19.5 
1966  18.6  63.2  18.2 
1967  17.2  64.0  18.8 
1968  17.2  64.1  18.7 
1969  16.2  65.1  18.7 
1970r  14.4  66.1  19.5 
Source: Table 1.14 in the sources listed for Table 1. Apart from rounding differences,  the rows add to 100 
percent. 
a.  Capital consumption allowances plus indirect business taxes plus transfers  less subsidies. 
b.  For 1955, 1958, 1960, the profits share was moved down 0.8 percent and "other" up 0.8 percent to 
adjust for 1962 depreciation reform. 
c.  Average of second and third quarters. 
2. The ratio of nonfinancial  corporate gross product to GNP is about 55 percent 
typically. It has a slight cyclical tendency-rising from 54.2 percent in 1960 to 55.1 
percent  in 1966 and retreating  to 54.4 percent  in 1969. Notes and Numbers on the Profits Squeeze  471 
by perhaps 0.3 percentage  point ($1.5 billion). The big move in labor's share 
up to 65.1 percent in 1969 represented a rise in compensation $7.8 billion 
larger than one might have expected. The main source of the profits squeeze 
is clearly this extra rise in labor's share from 1966 to 1969. 
That unexpectedly large increase in labor's share implies that (a) pro- 
ductivity did worse than normally and/or (b) prices rose less than normally 
in relation to hourly compensation. Unpublished data on manhours worked 
in the nonfinancial corporate sector have been made available to the au- 
thors by the Office of Business Economics. These data permit some disen- 
tangling of the two elements making up labor's share. They show that, 
during the postwar years, the average annual percentage increase in com- 
pensation per manhour has exceeded the  average increase in the  price 
deflator for the domestic nonfinancial corporate sector by roughly 3 per- 
centage points, just about matching the trend productivity of the sector 
and holding labor's share approximately  constant over the longer run. But 
years of above-average  productivity gains widen the excess of wage increase 
over price increase only slightly, and years of poor productivity gains nar- 
row it only slightly. Thus, labor's share falls in years of good productivity 
gains while it rises in poor ones. A fully "normal" performance thus in- 
volves (a) trend growth of productivity-3.0  percent a year for this sector, 
and (b) hourly compensation outpacing the price deflator by that same 3.0 
percent a year. 
In fact, from 1966 to 1969, the wage-price ratio rose 10.4 percent rather 
than the 9.3 percent implied by (b). In this respect, 1968 was the one un- 
usual year, with an extraordinary spread between a 7.2 percent gain in 
hourly compensation and a 2.6 percent rise in the price deflator. This kept 
the profit squeeze on in 1968 despite its fine productivity performance (a 
gain of 4.3 percent in this sector). Hourly compensation then outpaced the 
price deflator by a rather normal amount (6.7 versus 3.4 percent) in 1969, 
and appears to  be doing much the same in  1970 (7 versus 4). Over the 
period, the above-normal rise in the wage-price ratio added $3.3 billion to 
labor's compensation in 1969. 
The remaining $4.5 billion of the abnormal rise in labor's compensation 
is  attributable to  the particularly disappointing record of  productivity. 
Productivity rose 7.0 percent from 1966 to 1969, instead of the 9.3 percent 
par for the course. The resulting  productivity shortfall of a little more than 
2 percent added $7 billion to corporate labor costs in 1969. Allocating $4.5 
billion of the rise in labor's share to a disappointing productivity perfor- 472  Arthur  M. Okun  and George  L. Perry 
mance implies that about one-third of the total productivity shortfall was to 
be expected because of the subnormal growth of output during the period. 
So far as we can see, the sag in productivity during 1967 and 1969 does 
not require a lower estinmate  of the level or slope of the long-term trend 
line for productivity. Rather, it seems attributable  to transitory factors like 
labor hoarding that characterize an economy slowing down after an ex- 
tended period of  rapid growth and tight labor markets. The year 1956 
provides an historical analogy to this view. Then, a slowdown in the growth 
of real output was not promptly accompanied by a cutback in employment 
growth; and productivity actually declined for the year. Yet the economy 
got back on its productivity trend path with especially large gains in sub- 
sequent periods of brisk growth in 1959 and 1962-65. And the encouraging 
returns on productivity during the second and third quarters of  1970- 
quarters of very little output growth-support  the hypothesis that the sag 
of the late 1960s was transitory. 
Thus, it seems reasonable to expect a "make-up" of productivity in non- 
financial corporations amounting to 4 percent (the 2 percent shortfall of 
1969 and an extra 2 percent in 1970) when this nation returns to full em- 
ployment. We find it more difficult  to make a judgment on the $1.5 billion 
deviation in nonlabor costs and the $3.3 billion wage-price bump discussed 
above. If capital spending remains sluggish in the upswing, the share of 
nonlabor costs could well retreat. It does not seem likely that the extra 
wage (or substandard  price) hike of 1968 is built into the economy forever- 
more. More likely, prices began to lag behind wages at that stage in the 
inflationary process and have not yet caught up because of the weakening 
economy. Yet, we cannot dismiss these recent shifts as entirely transitory. 
If we assume that the bump in the ratio of wages to prices is maintained 
and that compensation per manhour rises simply 3 percent faster than 
prices in this sector from now on, we would adjust equation (2) downward 
by about 1/3 of 1 percent of GNP, so that the profits plus interest share at 
steady full employment would become 10.2 percent. Assuming no further 
major change in the debtor-creditor balance of the corporate sector, 10.0 
percent would be a good round estimate of the profits share at full em- 
ployment. If, happily, 1973 should turn out to be a full employment year, 
corporate profits would probably be in the neighborhood of $125 billion, 
about 60 percent above their level of mid-1970. Notes and  Numbers  on the  Profits  Squeeze  473 
Discussion 
BARRY  BOSWORTH  SUGGESTED that one reason that the GNP-gap equa- 
tion overpredicted  profits in recent years was that the relationship between 
the  GNP  gap  and  the  utilization  of  capital  had  changed  drastically. 
Operating rates in 1969 were far below those of 1966, while the GNP gap 
had changed only modestly. Investment has been very strong in recent 
years, and has tended to push down the return to capital. 
The authors replied that excessive capital accumulation should be pri- 
marily reflected  in a higher share of nonlabor cost, rather than in a jump 
of labor's share, such as actually occurred. Alan Greenspan noted, how- 
ever, that excess capital could add to labor's share by increasing the need 
for nonproduction workers, that is,  by requiring more  overhead labor. 
Bosworth also felt it was no  mystery that  a simple relationship that 
worked when most of the increase in GNP represented real growth would 
break down in a period when most of the increase reflected  inflation. More 
generally,  Lawrence  Klein joined Bosworth in arguing  that the report really 
pointed to the desirability of a structural explanation of profits in terms of 
the key items affecting the income statements  -of corporations on both the 
revenue and cost sides. The group could not agree on whether structural 
approaches had been successful in tracking profits during recent years. 
There was agreement that any set of relationships that accurately ex- 
plained prices, wages, and productivity in the corporate sector would sup- 
ply good answers on profits taken as a residual. The authors said that if 
the productivity and wage-price behavior that accounted for the recent 
overpredictions by the profits equation could,  in  fact, be  explained by 
structural relationships, they would feel even more confident in projecting 
a rebound in the profits share. 
R. A. Gordon reminded  the panel that Wesley Mitchell had, even before 
the First World War, discussed the encroachment of costs on profits as a 
normal feature of late stages of  a boom.  In view of the unprecedented 
length and strength of the boom in the late sixties, he was not surprised 
that the usual cyclical buildup of costs on profits has been especially and 
increasingly intense. 

Notes and Numbers on the Profits Squeeze

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Notes and Numbers on the Profits Squeeze

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