December 6, 2017 / 3:03 PM / 11 days ago

Breakingviews - Hadas: The mystery of lost competition

LONDON (Reuters Breakingviews) - The American debate about lowering taxes on corporate profit teaches an important lesson about the contemporary economy. It does not work in the way introductory economics courses say it should.

Elementary textbooks discuss what happens when an expense declines at the same pace for all the producers of a particular product. Competition will ensure that lower costs are passed through to customers in the form of lower prices. Resistance is futile in efficient markets. For example, any airline which tries to keep prices steady when fuel costs fall will end up losing customers to rivals. Its revenue and earnings will take a hit.

Taxes are a bit different, because they affect the return on a company’s capital rather than its profit margin. Still, the principle is the same. In a functioning competitive market, lower tax rates will normally lead to lower prices. If most of the gains are actually retained by shareholders, the logical conclusion is that companies face limited price competition.

To judge by most serious economic research, that is the situation in the majority of American industries. The academic consensus is that the proposed cut in the main U.S. corporate tax rate to 20 percent from 35 percent, approved by the U.S. Senate on Saturday, would boost earnings. For this sort of tax “the burden falls on capital income”, as Jane Gravelle, a senior specialist at the Congressional Research Service, put it in a September report.

Her conclusion is opposed by some economists, who claim that lowering the tax will lead to higher wages. The disagreement is serious, but what is more significant is that Gravelle and her opponents both accept that, in practice, a lighter tax burden will not lead to lower prices.

In some parts of the U.S. economy, the profit-boosting lack of competition is glaring. The pricing power of Google’s search engine and Facebook in social media is almost monopolistic. However, competition is still quite lively elsewhere. Though smaller producers are often squeezed by companies with global expertise, buyers of most goods and services can still choose from at least two commercially strong rivals. These customers care about prices, so bosses can hardly charge what they want.

So how can companies turn lower taxes into higher earnings? The best explanation is that most industries operate as what might be called informal cartels. While explicit price-fixing is illegal, half-coordinated pricing restraint is not.

Often, one or more successful firms set prices and the rest basically follow the leaders. These so-called price umbrellas keep less efficient players in the game. The smaller companies cannot match the profitability of the leaders, but high prices allow them to stay more or less competitive. The wider the gap in efficiency, the more profit flows to the leaders.

This semi-failure of market forces, sometimes called tacit collusion, can at times be helpful for the economy. When prices are under too much pressure, managers are tempted to skimp on investment. The result can be declines in the value of capital – not just factories, but also workers’ skills, accumulated expertise and brand image.

On the other hand, tacit collusion has a large downside. Companies can easily become lazy money-machines for some insider group. In finance, highly paid workers take most of the gains. More often, it is the shareholders who receive the bulk of the benefits from price non-competition. American companies’ profitability has widened dramatically since 1980. One measure of the average economic profit margin – the excess of the price charged over the marginal cost of production – has increased to 67 percent from 18 percent, according to a recent study by economists Jan De Loecker and Jan Eeckhout.

In an economy where companies already wield so much pricing power, a reduction in corporate taxes will do little good. In theory, the ready availability of higher returns on capital should prompt companies to pursue new investments. In reality it is likely to reduce the interest of managers in developing new and improved products. Corporate tax cuts will also probably increase economic inequality, since shareholders, who are typically already fairly well off, pocket most of the gains. Among the workers, only the already highly paid top bosses are likely to share in the bounty.

If the purpose of all corporations is simply to maximise “shareholder value”, then profit-boosting tacit collusion is a short-cut to success. For anyone with a broader view of corporate purpose, though, there is a problem when equity holders gouge workers and customers. Tacitly colluding oligopolies would serve society better with a broader understanding of corporate purpose.

Unfortunately, corporate conversions to the cause of the common good look unlikely right now, especially in the United States. The Republican majority in the U.S. Congress and President Donald Trump are actually pleased at the prospect of channelling more money into the profit stream. They would serve the nation better by reviving an apparently discarded part of their populist heritage – the trust-busting mistrust of giant companies.

Breakingviews

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