Record Corporate Profits vs. New Firm Creation

Corporate Profits Are at a Historic High

The economic malaise characterizing the years after the financial crisis has largely bypassed corporate America. Corporate profits are currently at a historic high of 11 percent of GDP (see fig. 1 below). Expert speculation abounds as to the causes and implications of this trend. Many commentators, seeing these record profits as another sign of growing inequality and concentrated wealth, blame an increase in corporate power. There is, however, another explanation – little discussed but worthy of analysis – for this trend: fewer new firms are entering the market.

Fig 1  –  Corporate Profits as a Percentage of GDP

The Economic Process that Has Traditionally Controlled Corporate Profits Has Broken Down

Basic economic theory holds that as sectors of the economy heat up, new entrants, enticed by the prospect of high profits, will move into the sector, capturing profits for themselves, and driving down average profits. In other words, new firms serve to check supranormal corporate profits. The restaurant and technology industries provide great examples of this process. The influx of new firms to profitable sectors of the economy has traditionally kept corporate profits at approximately 6 percent of GDP – around half what it is now.

But this process has broken down over the past several years with fewer new firms entering the market despite the existence of profit signals that would traditionally entice them. At around 750,000 per year, the number of new firms (“establishment births” in Bureau of Labor and Statistics lingo) entering the market is at nearly the same level it was 20 years ago.

When taking into account that the number of working Americans has risen by over 46 million, or 24 percent, over this period, the trend becomes even more pronounced: There are now approximately 3.2 new firms per year per one thousand working age Americans, down from a historical average of about 3.8 (see fig. 2 below).

Fig 2  –  New Firms (Absolute and per 1000 Working-Age Population)

The number of new firms entering the market per year over the number of those exiting (“births/deaths”) is back in positive territory after several years during which more firms exited the market than entered it. However, new firms are not only fewer than usual but also smaller, employing fewer people. New firms now cumulatively employ around three million Americans, down from a historical average of around 4.75 million in the 1990s (see fig. 3 below).

Fig 3  –  New Firms over Exiting Firms and Employment at New Firms

What Could Be Causing Fewer New Firms to Enter the Market?

So why is it that fewer new firms than usual are entering the market at a time of record corporate profits? There is no shortage of speculation across the ideological spectrum. Some experts claim the problem is structural. For example, Tyler Cowen, head of the Mercatus Center, argues that having already harvested “the low-hanging fruit” – that is, the economic opportunities inherent to the country – that new firms could have otherwise tried to exploit, the United States is going through a “Great Stagnation.” Now, because of technology and other structural shifts, the economy is entering a new, more challenging landscape that offers fewer opportunities for new firms – or the middle class.

A more basic explanation for this trend could be that Americans do not face the right incentives to start new businesses. Traditionally, a leading factor preventing entrepreneurial expansion has been economic uncertainty. The National Federation of Independent Businesses ranks “uncertainty over economic conditions” and “uncertainty over government actions” as dominant concerns. The idea that uncertainty is detrimental is shared by other global economic bodies including the International Monetary Fund, which concluded that uncertainty is a primary cause of recent weak economic growth, claiming that it “weighs heavily on the outlook.”

This uncertainty can be quantified: Using an algorithm based on newspaper coverage, expiring tax code provisions, and disagreement among economic forecasters, economists Baker, Bloom, and Davis created the Economic Policy Uncertainty Index. This index reveals that economic uncertainty has remained at historic highs since the financial crisis (see fig. 4 below). Potential new firms may understandably be hesitant to enter such a climate of uncertainty

Fig 4  –  Economic Policy Uncertainty Index

Increased Regulation May Also Be a Culprit

Reams of academic research suggest that regulations disincentivize new business formation. Klapper, Laeven, and Rajan’s findings that “costly regulations hamper creation of new firms, especially in industries that should naturally have high entry” are representative of the research on the topic. As the research indicating a link between regulations and business formation increases, so, too, does the American regulatory burden. The total number of federal regulations has surpassed one million, according to data from the Mercatus Center. In its latest Global Competitiveness Report, the World Economic Forum ranks the United States 80th place in the world in terms of regulatory burden, down from 23rd place just seven years ago. The Fraser Institute’s Economic Freedom of the World report for 2013 shows the U.S. falling from 2nd place to 17th place in this category over a similar period.

In an attempt to quantify the country’s regulatory burden, Clyde Wayne Crews Jr., of the Competitive Enterprise Institute, has been tracking the Federal Register’s number of outstanding “economically significant” rules (those with a negative economic impact of $100 million or more) as well as its number of pages devoted to “final rules.” His research indicates an unprecedentedly high number in both categories, with over 200 outstanding economically significant rules and 25 thousand pages devoted to final rules, since the financial crisis (see fig. 5 below).

Fig 5  –  Economically Significant and Final Regulations

As experts examine the reasons for and implications of historically high corporate profits, they should also consider the causes and effects of fewer new firms on this trend.

Jordan Bruneau is a policy analyst for the Economic Freedom Project, focusing on issues of free trade, economic freedom, and well-being. (c) Charles Koch Institute, republished with permission.