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Posted by on Jul 23, 2014 in Educate, Elevate, Inspiration, Resources | 0 comments

The Downside of Profit

The Downside of Profit

For what will it profit a man if he gains the whole world and forfeits his soul… (Matthew 16:26)

written by Anne Riley, Author

In my newest book, Aerie, which came out in June, I included some important thoughts about business inside a suspenseful summer read. An underlying theme relates to the true definition of business success. In a previous article I suggested a business is truly successful when it provides customers quality service at a fair price.

We live in a complicated world, and many, if not most, of the products and services we buy today are so complex we have no hope of understanding them. Cars. Computers. Cell phones. This ‘knowledge gap’ between supplier and user leaves open the possibility that businesses can exploit their customers. Unfortunately, many businesses today do exploit not just their customers, but others as well.

There is a reason for this unhappy situation. This is another major theme I explore in Aerie. Today businesses operate in an environment that places too much emphasis on profit, and such focus on profit drives out quality.

I know what you’re thinking. This statement doesn’t make sense. We have been taught profit is good. Profit means success. Profit means wealth. Profit means happiness. How can profit be bad?

As in many areas of life, too much of a good thing can present problems. Profit is no exception. Reasonable profits are a necessary aspect of good business. But too much emphasis on profit hurts everyone: the customer, the business, and the economy as a whole.

To explain such a counterintuitive position, I need to start with the basics. We need to visit the accounting world for a brief moment.

Profit is an accounting concept, and is defined as the difference between revenues earned (money coming in) and costs incurred (money going out). Thus the term profit is an artificial construct.

To be honest, the whole accounting field is an artificial construct. It is nothing more than a set of rules put into place to allow us to compare the financial activities of businesses across industries. Artificial or not, accounting is useful and definitely has a place in the world. That place is just not always accurate or complete.

Accuracy: There is an old joke in the accounting industry:

Client: What is two plus two?

Accountant: What do you want it to be?

This joke is more true than I would like to admit. The accounting field is not intentionally inaccurate, it just contains so many intricate rules that it becomes difficult to understand the true financial status of a business. For example, a business can legitimately account for inventory in at least four ways, each of which result in different costs, which in turn, result in different profit figures.

The same thing is true for estimating the value of investments, or predicting bad debt loss or calculating the costs of a pending lawsuit. This wide variety of rules makes understanding a business difficult and assumptions about its performance dangerous. What I am saying, to be a little more blunt that is considered tactful, is  that profit, the final figure achieved after the accounting rules are applied, can be . . . well . . . manipulated.

Completeness: Accounting is useful for tracking the financial activity of a company, but the line is drawn there. A company is not required to account for any impacts outside its direct revenue and expenses.

For example, a company is not required to identify any costs related to polluting the environment, or creating dangerous working conditions, or making a dangerous product. There is no easy or fair way to account for such effects, but those effects may exist nonetheless. The practice of accounting just ignores them. The point here is not to berate the field of accounting for its incompleteness, but to understand its limitations: profit does not include ALL the costs or impacts related to the activities of an organization. Profit only includes those transactions directly affecting the finances of the business.

Despite these major drawbacks, accounting is still the best mechanism to allow comparison of businesses across industries. Profit has another advantage as well. It is easy to understand. This is why profit is the preferred tool for the finance industry.

Which is where things go haywire when the whole quality issue comes up.

Okay, time for a short history on the finance industry. Vast quantities have been written on this subject, so I will leave you to research further to your heart’s content. I will stick with the Cliff-Notes version.

1. The purpose of the finance industry is to do one thing: bring people with money (investors) together with people who need money (businesses). The finance industry earns its fees as the middleman between these two parties.

2. Investors desire high returns. Generally, the more profit a business makes, the higher the return for the investor.

3. It wasn’t long before the middlemen in the finance industry became swayed by one side, in this case, the investors.

4. Once investors controlled the finance industry, profit became not just the key measure of business success, profit became the key factor in determining  who received funds to start or grow or operate a business.

5. How did businesses respond to this situation? How do you think? They focused on profits in order to obtain the capital they needed.

6. In the 1930’s, the finance industry ran amok with corruption and ultimately collapsed, bringing on the Great Depression. The federal government stepped in and tightened the rules. The feds forced businesses who wanted to sell their shares on public exchanges (the New York Stock Exchange, for example), to comply with strict accounting rules and undergo annual audits. This was the true beginning of the public accounting industry.

The feds also forced banks to comply with strict lending rules, in exchange for federal deposit insurance. The results are quite startling. Between 1836 and 1945, the United States endured 26 recessions or depressions with an average duration of 21 months and an average decline in economic activity of 22%. After 1945, when the federal rules were fully in place, the U.S. experienced 12 recessions lasting an average of 11 months each, with an average decline in GDP of 3%.

(Source: http://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States)

7. Some investors chafed at the federal banking rules, and over time, many non-banking investment organizations were formed. These were riskier by nature than their federally insured counterparts because they operated outside the federal banking rules and were unprotected by federal deposit insurance. Because the risk was higher, the focus on profits was . . . you guessed it, even more intense.

8. Regulated banks started to lose business to these non-regulated financial organizations, so starting in the 1980’s, the feds began relaxing the rules for the finance industry. The results were predictable. The non-banks didn’t change their behavior. But federally protected banks did. They began to focus more on profit. Today, the finance industry focuses on profits to a greater extent than all other considerations, even after the recession of 2009.

So ends the history lesson. What is the result of the emphasis on profit dictated by the finance industry?

A business can increase profits in only two ways: increase revenue or decrease costs. Increasing revenue is risky and expensive. To increase revenue, a business must expand production and marketing and complete with other companies; in other words take on many more costs and add risk. Cutting costs is much easier. Drive down labor rates. Cut employee benefits. Use cheaper materials in production. Discharge waste from production processes into the air or water rather than spend money on equipment to prevent or clean up pollution.

Do you see the insidious effects of over-emphasis on profits? It’s a race to the bottom. If a business needs capital from the finance industry, and the finance industry demands high profits, a business has no choice but to dance to the finance industry’s tune. And everyone else pays. The employee who breathes in asbestos. The child who gets cancer after ingesting hexavalent chromium in the drinking water. The family that needs food stamps because the minimum wage job held by a parent doesn’t cover both food and rent.

Today, the economic situation is out of balance. Businesses earning high profits, understandably, want to keep those profits, despite the impacts on the broader economy or citizenry. These businesses use their considerable economic power to influence elections, write laws, and lobby legislators in order to retain their advantage. This keeps the focus on profits in place, and pushes the broader community toward a riskier, less livable world.

There is a solution that can avert the race to the bottom. It’s simple, proven, and effective. It’s also attached with so much venom and emotion that, these days, its mere mention will set off a firestorm of vituperation and anger. So here it is. I’m going to lay it on you. Let the screaming begin.

Progressive Income Taxation.

All right. Go ahead. Let it out. Scream. Cry. Wring your hands. Vituperate. Whatever. Take as long as you want.

Now. Listen.

A progressive income tax rate is the most effective way to deter the focus on profit and put the emphasis on quality back into business. Here’s how it works:

1. The progressive nature of the tax rate is the key to change. Progression means small, less profitable businesses will pay very low tax rates, moderately profitable businesses will pay slightly higher rates and VERY profitable businesses will pay even higher rates. In the 1960’s, the highest marginal tax rate was 91%. That rate is a little steep. On the other hand, those were the days when schools were fully funded and our infrastructure was superior to the rest of the world. Still, a marginal tax rate on net incomes of over $500 million should be about 75% to generate the proper impact on businesses. Today’s top rate is 39.6%.

2. Many businesses dislike paying taxes. So, when the marginal tax rates are very high, managers often opt to re-invest earnings into their business where they can control what happens to the money and earn a tax deduction This is exactly what is needed to create jobs and expand the economy. Re-investment injects funds straight into the economy, and often improves the quality of products or services the company provides.

With the low tax rates of today, little incentive exists for businesses to re-invest. The incentive instead is for the company to take the money out of the company and squirrel it away. This money goes out of the economy and doesn’t help the business or the broader community.

3. Highly paid individuals should pay equivalently high marginal tax rates. Such rates will prevent companies from re-investing only in their highly paid management.

4. Tax loopholes and special tax breaks should be eliminated so that all businesses are subject to the same rules. Often very large corporations receive tax breaks that small companies can’t hope to get. This makes a very uneven playing field and forces smaller companies to focus even more on profit just to survive.

Unfortunately, in today’s partisan environment, taxation carries a bad reputation. But bad reputation aside, taxation plays a proper role in keeping capitalists from turning into monopolists. Profit-driven capitalism naturally gives advantage to the profitable entities. After awhile, the power that comes with wealth will be used to keep the advantage in place and remove competition. This is the definition of a monopoly. Monopolies are never good. Under monopolies, prices always rise and quality always goes down. The role of government and taxation is to keep profitability at a reasonable level so capitalism and competition can flourish.

Moderation. Balance. Reasonableness. We strive for these things in our personal lives. It is no different in our lives as members of businesses, communities and society. Think about this as you run your business. Profit is fine, within reason. Quality is the thing to strive for. And don’t be afraid of taxation. If you are paying taxes, you, by definition, have a successful business. And you are actually making the economy stronger. Well done!