Conclusion No one with an appreciation of the fallibility of these measures will wish to draw any but the broadest and most general inferences from their use. A few such inferences are worth noting in conclusion. Normalization The period prior to the great depression saw a vigorous and persistent expansion of capital goods activity. The next 15 years was a period of contraction and stagnation in this area. The early part of the postwar era, now 25 years in length, was devoted in large part to normalizing the situation--to repairing the damage left by depression and war. By normalizing we do not mean restoring the situation to what it would have been if the depression and the war had not occurred. These two calamities have doubtless left permanent scars on the economy, and on capital goods in consequence. We mean restoring a normal relation, both qualitative and quantitative, between capital goods and contemporary economic activity--actual activity, not what would have been without the misfortunes of 1930-1945. By this test, the normalization appears to be well along, if not virtually complete. Output per dollar of gross investment in capital goods has substantially exceeded the 1925-29 average. The ratio of net to gross investment has attained a new high. This means that the capital goods industries have been living recently, and will have to live hereafter, on currently accruing needs, without benefit of the restoration or normalization process. This should not be too disturbing a thought; apparently it is years since they have derived any major benefit from this process. The adjustment has already been made. Beyond Normalization Normalization of the quality and quantity of the capital goods stock does not imply that the present situation is satisfactory, or that current levels of capital expenditure are adequate. There are several important considerations that argue to the contrary: the increase in the growth rate of the labor force; the forced expenditures for antipollution equipment; the essential expenditures for energy; the present high percentage utilization of capacity; and the economic competition worldwide. All of these considerations argue for higher ratios of capital formation to national product than we have heretofore considered normal. To assure adequate performance in the future, government must maintain and even increase measures to augment the flow of funds as a means of stimulating business capital investment. This means, of course, that the present realistic depreciation allowance and the investment tax credit should remain a permanent part of our tax law. Beyond this, it is essential that we eliminate or reduce the present bias in our tax structure against private saving and capital formation. Finally, because of the recent rapid rate of inflation, it is more than ever necessary that the government adopt an alternative to historical cost depreciation. The moral is clear. If we are at all right in predicting higher levels of demand for plant and equipment, since the enlargement of business investment depends primarily on an increased flow of funds available for the purpose, there is a pressing need to assure that tax policy encourages private saving and capital formation. This is the surest way to achieve and maintain the higher rate of economic growth which is essential to our national well-being. M MACHINERY & ALLIED PRODUCTS INSTITUTE AND ITS AFFILIATED ORGANIZATION, COUNCIL FOR TECHNOLOGICAL ADVANCEMENT, API COMMUNICATION AND COMMERCE), IN ADVANCING THE TECHNOLOGY AND FURTHERING THE ECONOMIC PROGRESS OF THE UNITED STATES INFLATION AND PROFITS It The effect of rising price levels on the accounting of profits is not a new subject. During the sharp postwar inflation of 1946-48 it generated a lively discussion in accounting and management circles. This was revived, on a lesser scale, by the price run-ups of 1950-51 and 1956-57. But under the relatively stable price level of 1958-64 interest waned. was widely believed that inflation was a thing of the past, that the aftereffects of earlier inflation would gradually wear off, and that no corrective action was needed. This proved to be an illusion. By 1965 inflation was under way once more, and it has continued at a distressing pace ever since. It is now high time to take another look at the problem. The Principle The overstatement of profits during and after a period of inflation arises from the practice of charging only the historical cost of physical asset consumption (fixed assets and inventory). When the purchasing power of the dollar is shrinking, the charging of historical costs--reflecting earlier, and hence lower, price levels--is insufficient for the restoration of the real assets used up in production. A proper reckoning requires the restatement of previously incurred costs in the dollars of realization, that is to say, in the revenue dollars against which they are charged. Only when costs and revenue are measured in the same dollars can the difference between them (profit) be correctly determined. It follows that when the real cost of physical asset consumption is undercharged the shortfall is accounted as profit. It follows also that this much of the reported profit is fictitious, representing simply the understatement of costs. The Project What we intend to do is to translate into current-dollar equivalents (equivalents in the dollars of revenue) the costs of physical asset consumption now accounted on an historical basis. We can then see what difference the conversion makes in the profit figures. The study is limited to the corporate system because profit as such is not available for the unincorporated sector, and more specifically to nonfinancial corporations, the category principally concerned with physical asset consumption. It is limited also to the inflation of 1965-73. In doing this we rely for both fixed assets and inventory on data compiled by the Department of Commerce--in the case of fixed assets, on its computations of current-cost depreciation; in the case of inventory, on its "Inventory Valuation Adjustment."/1 1/ In both its depreciation and its inventory adjustments the Department uses specific price indexes to compute the current-dollar equivalents of historical costs. While we prefer a general index of the purchasing power of the dollar for this conversion, its use would not alter the results fundamentally. For a discussion of this issue see Realistic Depreciation Policy, MAPI 1954, Chapter 12. I. FIXED ASSETS The Department computes annually current-cost depreciation on the fixed assets of nonfinancial corporations, using two writeoff methods (straight-line and double-declining-balance) and a variety of servicelife assumptions./1 It is noncommittal on the choice of depreciation methods, but does have a preference on service-life assumptions (85 percent of Bulletin F lives). We shall use that assumption in conjunction with the double-declining-balance writeoff. A word on the choice of writeoff. Notwithstanding the Department's neutrality on the issue, we entertain no doubt that the straight-line writeoff is in most applications a grievously retarded measure of capital consumption, and that the double-declining-balance method is in general more realistic. This is not the place to argue the issue, which we have done at length elsewhere./2 Suffice it to say that this writeoff conforms quite well to both theoretical and empirical evidence on the typical course of capital consumption, especially for capital equipment (as distinguished from structures), which accounts for around five-sixths of corporate depreciation. The following table compares the Department's computation of current-cost double-declining-balance depreciation with its estimate of the depreciation allowed for income tax purposes. Table 1 Comparison of the Current-Cost Double-Declining-Balance Depreciation a The Department's "Current-Cost 2." This employs a more conservative index of construction costs than "Current-Cost 1." b/ Differences may not check exactly because of rounding. c/ Our estimate. d/ Average of second and third quarters at annual rate. 1/ Both writeoffs are extended over estimated full service lives. The double-declining-balance method is applied with a straight-line switch. 2/ Realistic Depreciation Policy, MAPI 1954, Chapters 3, 4, and 5. |