Where do US corporate profits come from? As it turns out, the answer to that critical question reveals what the fiscal cliff means for the bottom lines of US companies on a macroeconomic level.
At the beginning of the 20th century, two economists, Jerome Ley and Michal Kalecki, derived the macroeconomic equation for profits that states:
Net Profits = Net Business Investment - Household Saving - Government Saving - Foreign Saving + Dividends
Net business investment (net of depreciation and destruction) includes investment in fixed assets and inventory but excludes security investments. Net business investment adds to corporate profits because it is a source of revenues for the business sector but has no corresponding expense (except annual depreciation which is subtracted).
Household saving is a negative source of profits because it is delayed consumption and does not immediately increase revenues.
The government revenues reduce corporate profits directly through corporate taxes and indirectly by diverting household income to the government sector that otherwise would be spent on goods and services provided by the business sector. The government expenditures add to total revenues and profits in two ways. On the one hand, the government buys goods and services from the firms. On the other, it provides consumers with income via government wages, transfers, etc., which in turn are spent on consumption. So, on balance, the government deficit is negative saving, adding to aggregate profits, and the government surplus is positive saving which reduces profits.
The positive foreign saving implies that the current account of a country is in deficit while the negative foreign saving explains the surplus in the current account. When international payments exceed receipts and the current account is in deficit, payments for goods, services, interest rates, etc., are larger than receipts from foreigners for the same goods and services. The net effect is negative for corporate profits.
In terms of the P&L account, the dividends are not expenses and do not reduce profits. But once distributed and spent by the households and the businesses, they add to total revenues and profits.
In March 2012 James Montier from GMO published a paper called "What Goes Up Must Come Down" which reveals the aforementioned sources of profits for the period between 1952 and Q3 2011. Using NIPA and Flow of Funds data, I made calculations with up to date data that can be seen from the illustration below (quarterly data from Q1 2002 to Q2 2012).
Net business spending has been the main driver of the aggregate US corporate profits before the crisis, but their structure changed dramatically afterwards. Since the end of 2008, the government deficits have "pumped" the bottom lines of the companies to record levels, but the companies' investments in fixed assets and inventories remained well below pre-crises levels.
Unless avoided, the fiscal cliff would result in sudden government budget rebalancing via massive deficit reduction. If this scenario unfolds, a crash of the corporate profits would be inevitable since the government deficit has the highest weight and one cannot expect immediate substantial increase in private investments to compensate for the lost source of profits. Actually, the uncertainty surrounding the final outcome of the fiscal cliff probably has already contained to some extent the business investments and the plans of households to consume.
Illustration 1 - Net US corporate profits (right-hand side) and their macro components (left-hand side) in billions of dollars, seasonally adjusted at annual rates
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.