Deficit myths (Part 3): The effect of budget deficits on business profits

Martin Wolf is right in saying that government fiscal tightening will hurt business profits. As Wolf correctly points out: "In order to reduce huge government deficits, surpluses must fall elsewhere".

For the UK, this means that the only way the government can succeed in balancing its budget is if the reduction in the government deficit is offset by a reduction of equivalent magnitude in the surplus of at least one other sector of the economy (i.e. household, corporate or foreign sector). And according to Wolf, the surplus sector that is most likely to be affected by the government's plan to reduce the deficit is the corporate sector because, at the moment, the household sector is not willing to incur additional debt (and fall back into deficit) and UK exporters are unlikely to reverse the flow of wealth currently exiting the UK economy (thereby reducing the surplus of foreigners).*

In a way, Wolf could just easily have argued that, in the UK right now, it is the government deficit that is enabling the corporate sector to run a surplus. And when households are deleveraging and exports are declining, business profits can only be realized if the government runs a deficit. Thus, by cutting the deficit, the government is in effect reducing an important source of business profits.

Proof of this direct, positive relationship between government deficits and business profits is best demonstrated by manipulating the basic national income accounting identity in a manner consistent with the approach of economists John Maynard Keynes and Michal Kalecki. The following arithmetic demonstrates that government deficits have a positive effect on business profits.

Let Y=Total Output; C=Consumption; I=Investment; G=Government Expenditures; X=Exports; M=Imports; T=Taxes; R=Retained Earnings by Firms; Hs=Household Net Savings

Let the combination of the above (X - M) = Current Account Balance or Net Exports; (G - T) = Government Deficit; (Hs + R) = (Y - T - C) = Total Net Private Savings

To start off, here is the basic national income identity, as taught in all macroeconomic textbooks:
Y = C + I + G + (X - M)

Subtract taxes (from both sides of the equation) to achieve an equation "net" of taxes:
Y - T = C + I + G + (X - M) - T

Rearrange the equation to isolate total net private savings on the left side and to subtract taxes from government expenditures:
Y - T - C = I + (G - T) + (X - M)

Since (Y - T - C) can be broken down into household net savings (Hs) and retained earnings by firms (R), the equation can be stated as follows (see Krugman, 1994:313):
(Hs + R) = I + (G + T) + (X - M) 

...and can be rearranged as such:
R = (I - Hs) + (G - T) + (X - M)

In plain English, this translates into:
Firms' Retained Earnings = Investment - Household Savings + Government Deficits + Net Exports

The above equation clearly demonstrates that business profits are positively impacted by government deficits, net exports and private sector investment.* Household net savings, on the other hand, have the effect of reducing firms' retained earnings. Similarly, balanced budgets and government surpluses have either no impact on profits or have the effect of reducing them.

One objection to this line of reasoning often invoked by economists is that government deficits increase the level of private sector savings (as households and businesses reduce consumption in anticipation of future tax increases). This claim is known as the Ricardian Equivalence proposition. However, there is little empirical evidence that this claim holds true and that the impact of government deficits gets neutralized (or offset) by a corresponding increase in private sector savings. As Douglas Bernheim argued in his seminal work on the topic:

...the case for long-run neutrality is extremely weak, in that it depends upon improbable assumptions that are either directly or indirectly falsified through empirical observation...[B]ehavioral evidence weighs heavily against the Ricardian view (1987:213)

To conclude, it should be emphasized that the purpose of economic policy is not to enable firms to realize profits, but to maximize employment and ensure that the product of industry is beneficial to the overall economy. Business profits, by creating an incentive for firms to invest and employ available resources, can help to promote these objectives. In the above analysis, my aim is to show that government deficits cannot be looked at in isolation from the financial positions of other sectors of the economy. Whether it is to stabilize aggregate demand or to provide for much needed public goods, deficits serve an important purpose. Attempting to reduce government deficits without considering its impact on the overall economy is not a sound basis for policy.

* Paul McCulley provided a similar analysis (2010).
** A different, yet equally effective approach to examining the relationship between profits and government deficits is found in Levy et al. (2008:16).

References

Bernheim, D., "Ricardian Equivalence: An Evaluation of Theory and Evidence", NBER Macroeconomics Annual 1987, S. Fischer, ed., Vol. 2, pp. 263-316, (Mass: MIT Press), 1987

Krugman, P., International Economics: Theory and Policy 3rd Ed., (New York:Harper-Collins), 1994

Levy, D., et al., Where Profits come from? Answering the Critical Question that Few Ever Ask, The Jerome Levy Forecasting Center, LLC, 2008

McCulley, P., Facts on the ground, Policy Note, Levy Institute of Bard College, 2010