RoyaltyStat Blog

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 today.

One of the adverse effects of oligopolies is the persistence of high profit markup (or high profit margin), that is, the non-convergence of high profit ratios towards the romantic profit of enterprise equality in all industries.

In this blog, we 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. The dataset was created using canonical criteria:

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

     b) Country of Incorporation: United States 

We can create subsets of companies within this group and show that corporations producing and distributing pharmaceuticals report extremely high profit markup. [Companies with such public influence showing persistent high profits 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), detailing and advertising expenses (which create marketing intangibles such as customer lists) were capitalized on the balance sheet. See OECD (2017), ¶ 6.7.

Profit Markup

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

Our interest in studying corporate profits started in 1986, inspired by the published research of Mueller (1986). 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), is that this model lack economic content because it can be converted into a moving average random error algorithm.

Using Standard & Poor’s Global (Compustat) data, we let revenue R = REVT, total cost C = XOPR, and operating profit P = OIBDP.

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

We distribute Compustat in our RoyaltyStat website, and we have added important transfer pricing online tools, including the regression function that produced the calculations written on the table below.

We combined the specified Compustat mnemonics, and obtain:    

     (1)      R = C + P

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

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

After we estimate λ using regression analysis, we can obtain the profit margin by indirect least squares:     

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

The table below shows the selected 29 company profit markup in alphabetical order, and the bar chart shows the profit markup sorted from high to low.

We do not report the intercept; and the t-Statistics of the profit markup (λ), or the slope coefficient of equation (3), 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 group ceiling is equivalent to taxing the MNE group combined (country consolidated accounts in which intra-group transactions are eliminated) operating profits.

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

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