RoyaltyStat Blog

Quem mostrá esse caminho longe? Sung by Cesária Évora (1941-2011).

Corporate profits should concern policymakers, including tax legislators and tax administrators.

In economic theory, high profits converge toward an entrepreneurial average because of the expected inter-industry flow of investments. According to Stigler’s (1963, p. 54) hyperbole: “There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries.”

Reality is not abiding to economic romantics (like Stigler).

Despite longstanding anti-trust institutions, economic concentration and the existence of oligopolies are facts of life.

An adverse effect of oligopolies is the persistence of high profit markups (or high profit margins), that is, the non-convergence of high profit ratios towards the romantic profit of enterprise equality in all industries.

In this blog, I selected a group of 29 major US corporations engaged in researching, producing and distributing chemicals and allied products (including pharmaceuticals) and show that their operating profit markup is high and stable over 70 years. I created the relevant dataset using the canonical criteria:

     a) Standard Industrial Classification (SIC): 2800-2891;

     b) Country of Incorporation: United States;

Subsets of companies within this group can show that corporations producing and distributing pharmaceuticals report extremely high profit markups. [Companies with such public influence showing persistent high profit markups should be regulated like utilities.]

Operating profits would be higher than the reported accounts if research and development (which create “trade” intangibles such as patents) and detailing and advertising expenses (which create marketing intangibles such as trademarks and customer lists) become capitalized on the company’s balance sheet. See OECD (2017), ¶ 6.7. 

Profit Markup

I estimated the profit markup per company by using an econometric model that can be traced to Cournot in 1838. See Stigler (1957), footnote 19.

My interest in studying corporate profits started in 1986, inspired by the published research of Mueller (1986, 1990). However, Mueller utilized a first-order autoregressive model that breaksdown if the regression slope coefficient is close to one. See Goldberg (1958), § 2.4 (Linear first-order difference equations) regarding the mathematical properties of a first-order autoregressive model. 

Another disadvantage of the first-order autoregressive model, adopted by Mueller (1986, 1990) and his research colleagues, is that this model lacks economic content because it can be converted into a series of moving average random errors.

As praxis, I use Standard & Poor’s Global (Compustat) data, we let revenue R = REVT, total cost C = XOPR, and operating profit before depreciation P = OIBDP (same account as EBITDA).

Total cost (XOPR = COGS + XSGA) is the sum of the cost of goods sold (COGS) and selling, general and administrative expenses (XSGA).

To simplify exposition, I have not adjusted COGS to remove the effect of the change in inventory profit or loss to make the accounting concept of COGS more consistent with the microeconomic concept of variable cost.

The Compustat annual company data are distributed under paid subscription in the RoyaltyStat website, to which I have added important online transfer pricing analytical tools, including the regression function that produced the calculations written on the table below.

I combined the specified Compustat mnemonics to obtain:    

     (1)      R = C + P

     (2)      P = µ R + U, where µ is the profit margin and U is a random uncertainty. 

     (3)      R = λ C + V

where the profit markup λ = (1 − µ)⁻¹ and V = (1 − µ)⁻¹ U.

After estimating λ using regression analysis, the profit margin can be obtained by indirect least squares (ILS):   

     (4)      µ = (λ – 1) / λ.

See https://blog.royaltystat.com/transfer-pricing-methods-based-on-operating-profits

The table below shows the operating profit markups of the selected 29 companies in alphabetical order, and the bar chart shows the operating profit markups sorted from high to low. I do not report the intercept because they tend to be insignificant.

The t-Statistics of the profit markup (λ) are corrected by using the Newey-West algorithm. See Zeileis (2004) and Hill, Griffiths & Lim (2018), § 9.5.2 (HAC [heteroskedasticity and autocorrelation consistent] Standard Errors), pp. 448-450.

Tax authorities should monitor the persistence of high oligopoly profits to establish a group ceiling as a test of reasonableness of inter-group transfer pricing adjustments. The US group ceiling is equivalent to taxing the combined (country consolidated accounts in which intra-group transactions are eliminated) US operating profits before a reasonable allowance for depreciation.

References

Carter Hill, William Griffiths & Guay Lim, Principles of Econometrics (5^th edition), Wiley, 2018 [2007].

Dennis Mueller, Profits in the Long Run, Cambridge University Press, 1986.

Dennis Mueller (editor), The Dynamics of Company Profits (An International Comparison [Canada, France, Germany, Japan, United Kingdom, United States]), Cambridge University Press, 1990.

Samuel Goldberg, Introduction to Difference Equations, John Wiley, 1958. 

OECD, Transfer Pricing Guidelines (2017). https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm

Tibor Scitovsky, Papers on Welfare and Growth, George Allen & Unwin, 1964. (P. 202: “I should like to recall to you the meaning of oligopoly power. We think of competition as a force that tends to eliminate [excess] profits; and of monopoly or oligopoly power as something that restrains competition and thereby prevents the elimination of [excess] profits. Oligopoly power, therefore, is the power to restrain competition.”)

George Stigler, “Perfect Competition, Historically Contemplated,” Journal of Political Economy, Vol. 65, No. 1 (Feb., 1957). Stable URL: http://www.jstor.org/stable/1824830?origin=JSTOR-pdf

George Stigler, Capital and Rates of Return in Manufacturing Industries, Princeton University Press, 1963.

Achim Zeileis, “Econometric Computing with HC and HAC Covariance Matrix  Estimators,” Journal of Statistical Software, Vol. 11, Issue 10, November 2004. Accessed: https://www.jstatsoft.org/article/view/v011i10/v11i10.pdf