What accounts for the growth of the corporate sector surplus?
As with the savings of individuals or households, the UK corporate sector surplus can be higher either because income is higher or because spending and other outgoings are lower. In the case of companies, ‘income’ is mainly operating profit, ‘spending’ is mainly investment that creates new physical assets (‘fixed capital formation’) while ‘other outgoings’ comprise mainly dividend, interest and rental payments plus taxes.
Looking at how changes in the corporate sector surplus reflect changes in these different components leads to three conclusions. First, although the surpluses for the two parts of the sector (non-financial corporations and financial corporations) have moved in line with one-another the components of the change are very different in each case.
Second, while the rise in the surplus of the non-financial sub-sector during the recession is in line with what economics would expect, the rise in the preceding five years is not and is in need of explanation.
Third, over nearly a quarter of a century, the financial sub-sector’s once orderly pattern has given way to a profoundly unbalanced one. But it was not 2007 when this breakdown occurred but during the boom years of the late 1990s, when the financial sub-sector was running a record deficit.
Accounting for the growth of the corporate sector surplus
Any attempt to present changes in five variables for two sub-sectors over a long period is bound to be complicated. With one important exception, which we shall come too later, the graph in exhibit 1 shows all the elements needed to grasp what has been going on. Since it is fairly condensed, it is worth explaining in detail what is going on.
Results are presented for three five year periods (1992-96, 1997-2001, 2002-06) plus one three year period (2007-09) up to the point for which the latest data is available. They are shown for the non-financial corporations and financial corporations (sub-sectors) separately.
What the results show is the change, for the period in question compared with the previous five years, in the size of the surplus and its components expressed as a percentage of GDP. The points joined by the lines show the changes in the overall surplus for each sub-sector. So over the five years 1992-96, the surplus of the non-financial sub-sector was 1.7% higher as a share of GDP than it had been in the previous five years (1987-91). In 1997-01, it was 1.2% lower than five years earlier. In 2002-06 it was 2.6% higher than in 1997-01. In 2007-09, it was 1.1% higher still.
The financial sub-sector follows a similar pattern: 1.1% higher in the first period, 1.9% lower in the second, 2.4% higher in the third and another 2.1% higher in the fourth.
Graph 1: changes in the corporate sector surplus and its main components
The bars show the changes in the four major components that go to make up the overall change in the surplus. The four are: profits; dividends, interest and rent; taxes on corporate income; and fixed capital formation (that is, investment as the creation of physical assets). In 1992-1996, for example, profits, taxes and investment were all down for non-financial corporations as a share of GDP while dividends etc were up. The overall rise of 1.7% reflects the net effect of lower taxes and investment (which raise the surplus) and lower profits and higher dividends (which reduce it).
Although these three are the main components of the corporate surplus they are not the only ones. Of those not shown, the largest is the reinvested earnings on direct foreign investment. The revenue earned from overseas subsidiaries (which is part of UK national income and expenditure) and the use that is made of it, especially physical investment overseas (which is not), does contribute to an explanation of what has happened to the non-financial sub-sector, although on a smaller scale than the factors shown here.
So what messages does the graph convey?
Starting with 1997-2001, which was a period of strong economic growth the surplus of the non-financial sub-sector was lower by 1.2% of GDP compared with five years earlier. The biggest single factor behind this fall was an increase in investment. This reflects investment’s role as both cause and consequence of a higher rate of economic growth. The fall in the surplus was offset by a slight rise in operating profits but then strengthened by higher taxes and higher dividend, interest and rent payments. All this seems reasonable.
All this changed in 2002-06. Despite a sharp fall in operating profits, the non-financial sector’s surplus was higher by 2.4% of GDP. Lower taxes reflect lower profits. But this fall in profits was more than offset by even larger falls in both dividends etc and investment. What is striking here is the strength of the reaction. Although there had been a slowdown in UK economic growth, there had been no recession. Yet the rise in the surplus in this period was bigger than the one ten years earlier (1992-96) which did follow a recession. In the last period, 2007-09, the further rise in the surplus in 2007-09 was almost entirely driven by a further sharp fall in investment.
Turning to the financial sub-sector, it too recorded a sharp drop in its surplus in 1997-2001. Here, however, investment played almost no part in this. Instead, the surplus was down because profits were down while both dividends and taxes were up. This pattern, where profits move in the opposite direction to each of the other three components is repeated, albeit the other way round, in 2002-06. Here, the surplus was up sharply, due mainly to higher profits, lower dividends and lower investment. In 2007-09, the further rise in the surplus was due entirely to yet higher operating profits and yet lower dividends, interest and rent.
There are two main messages here. First, despite the similarity in the paths followed by each sub-sectors overall surplus, the factors that lie behind them are very different. Simplifying as far as possible, while operating profits have been the crucial factor for financial corporations, it is swings in investment spending that have played the leading role for the non-financial corporations.
Second, while the drop in investment spending by non-financial corporations during the recession would be expected, what was happening to these companies in the five years prior is much more puzzling. Even if we guess that the fall in dividends etc is a reaction to the fall in profits, that still leaves the question of why profits fell so much – and indeed why investment fell in a manner that is more reminiscent of a recession than a slowdown.
The break in the behaviour of financial corporations
What about financial corporations? The consistency in the behaviour of the different components across the four periods means that that none of them look anomalous. But focused as it is on the changes from one period to the next, this graph conveys nothing about the level of each factor. and how they stand in relation to one-another. This information is provided in the graph in exhibit 2 which shows the annual values of the financial sub-sector’s operating profits, dividends etc, taxes, investment and surplus, as a percentage of GDP. Apart from some small other factors, the surplus is represented here as the difference between the line (profits) and uses to which it is put.
What stands out here is how different the later years are from the earlier ones. In one sense, this just another way of saying that the financial sub-sector has been running a large and growing surplus which once upon a time it did not do. Yet there is more to it than that. For while the temptation is to date the break in behaviour to 2003 when the surplus reached a new record, the first year when this balance (between profits and the use made of them) moved into new terrain was 1999 – when this balance was a deficit. In 2000 the deficit was more than a percentage point higher.
A year later, it was still above the 1999 level. One sign of degree of the imbalance is that in 2000 and 2001, dividends, interest and rent exceeded operating profits even before tax had been paid. This must be – and was – unsustainable. Hence our third observation, that it was as long ago as the boom years of the late 1990s when the financial sub-sector’s behaviour began to go haywire.
Graph 2: Financial sub sector gross profits and their principal uses
Source data: As Graph 1
While we are approaching the limits of what can be said on the basis of the patterns followed by the income and expenditure flows in the national accounts, the differences, anomalies and breaks lead to several conclusions.
The first, by way of a series of questions, relates to the balance (surplus/deficit) of the financial sub-sector: in particular, how should it behave over an economic cycle, how should its components move and what is a reasonable long term average for it? While economics has answers to these questions for non-financial corporations, financial corporations have evidently behaved quite differently.
The second is how the main findings here might link up. How far is the aberrant behaviour of the financial sub-sector, dating back to the late 1990s, itself a cause of the weak performance of the non-corporate sub-sector in the early and middle 2000s? Were the problems created by the bursting of the dot-com/technology bubble of the late 1990s still afflicting companies all the way through to the eve of the recession – or alternatively, did that bubble and its immediate aftermath usher in what have turned out to be permanent changes in corporate behaviour?
The final point is political. If it is understandable that coalition politicians should blame Labour for today’s fiscal problems, away from the microphones it ought to be recognised that things were going wrong with the corporate side of the economy long before the recession. Not only did this contribute to the problems they inherited but, unless something is done about it, it may do as much damage to this government’s economic reputation as it did to its predecessor’s.