Profits are never normal. They appear only where there is a maladjustment, a divergence between actual production and production as it should be in order to utilize the available material and mental resources for the best possible satisfaction of the wishes of the public. They are the prize of those who remove this maladjustment; they disappear as soon as the maladjustment is entirely removed. In the imaginary construction of an evenly rotating economy there are no profits. There the sum of the prices of the complementary factors of production, due allowance being made for time preference, coincides with the price of the product.
The greater the preceding maladjustments, the greater the profit earned by their removal. Maladjustments may sometimes be called excessive. But it is inappropriate to apply the epithet “excessive” to profits.
People arrive at the idea of excessive profits by confronting the profit earned with the capital employed in the enterprise and measuring the profit as a percentage of the capital. This method is suggested by the customary procedure applied in partnerships and corporations for the assignment of quotas of the total profit to the individual partners and shareholders. These men have contributed to a different extent to the realization of the project and share in the profits and losses according to the extent of their contribution.
But it is not the capital employed that creates profits and losses. Capital does not “beget profit” as Marx thought. The capital goods as such are dead things that in themselves do not accomplish anything. If they are utilized according to a good idea, profit results. If they are utilized according to a mistaken idea, no profit or losses result. It is the entrepreneurial decision that creates either profit or loss. It is mental acts, the mind of the entrepreneur, from which profits ultimately originate. Profit is a product of the mind, of success in anticipating the future state of the market. It is a spiritual and intellectual phenomenon.
The absurdity of condemning any profits as excessive can easily be shown. An enterprise with a capital of the amount c produced a definite quantity of p which it sold at prices that brought a surplus of proceeds over costs of s and consequently a profit of n per cent. If the entrepreneur had been less capable, he would have needed a capital of 2c for the production of the same quantity of p. For the sake of argument we may even neglect the fact that this would have necessarily increased costs of production as it would have doubled the interest on the capital employed, and we may assume that s would have remained unchanged. But at any rate s would have been confronted with 2c instead of c and thus the profit would have been only n/2 per cent of the capital employed. The “excessive” profit would have been reduced to a “fair” level. Why? Because the entrepreneur was less efficient and because his lack of efficiency deprived his fellow-men of all the advantages they could have got if an amount c of capital goods had been left available for the production of other merchandise.
In branding profits as excessive and penalizing the efficient entrepreneurs by discriminatory taxation, people are injuring themselves. Taxing profits is tantamount to taxing success in best serving the public. The only goal of all production activities is to employ the factors of production in such a way that they render the highest possible output. The smaller the input required for the production of an article becomes, the more of the scarce factors of production is left for the production of other articles. But the better an entrepreneur succeeds in this regard, the more is he vilified and the more is he soaked by taxation. Increasing costs per unit of output, that is, waste, is praised as a virtue.
The most amazing manifestation of this complete failure to grasp the task of production and the nature and functions of profit and loss is shown in the popular superstition that profit is an addendum to the costs of production, the height of which depends uniquely on the discretion of the seller. It is this belief that guides governments in controlling prices. It is the same belief that has prompted many governments to make arrangements with their contractors according to which the price to be paid for an article delivered is to equal costs of production expended by the seller increased by a definite percentage. The effect was that the purveyor got a surplus the higher, the less he succeeded in avoiding superfluous costs. Contracts of this type enhanced considerably the sums the United States had to expend in the two world wars. But the bureaucrats, first of all the professors of economics who served in the various war agencies, boasted of their clever handling of the matter.
All people, entrepreneurs as well as non-entrepreneurs, look askance upon any profits earned by other people. Envy is a common weakness of men. People are loath to acknowledge the fact that they themselves could have earned profits if they had displayed the same foresight and judgment the successful businessman did. Their resentment is the more violent the more they are subconsciously aware of this fact.
There would not be any profits but for the eagerness of the public to acquire the merchandise offered for sale by the successful entrepreneur. But the same people who scramble for these articles vilify the businessman and call his profit ill got.
The semantic expression of this enviousness is the distinction between earned and unearned income. It permeates the textbooks, the language of the laws and administrative procedure. Thus, for instance, the official Form 201 for the New York state income tax return calls “earnings” only the compensation received by employees and, by implication, all other income, also that resulting from the exercise of a profession, unearned income. Such is the terminology of a state whose governor is a Republican and whose state assembly has a Republican majority.
Public opinion condones profits only as far as they do not exceed the salary paid to an employee. All surplus is rejected as unfair. The objective of taxation is, under the ability-to-pay principle, to confiscate this surplus.
Now one of the main functions of profits is to shift the control of capital to those who know how to employ it in the best possible way for the satisfaction of the public. The more profits a man earns, the greater his wealth consequently becomes, the more influential does he become in the conduct of business affairs. Profit and loss are the instruments by means of which the consumers pass the direction of production activities into the hands of those who are best fit to serve them. Whatever is undertaken to curtail or to confiscate profits impairs this function. The result of such measures is to loosen the grip the consumers hold over the course of production. The economic machine becomes, from the point of view of the people, less efficient and less responsive.
The jealousy of the common man looks upon the profits of the entrepreneurs as if they were totally used for consumption. A part of them is, of course, consumed. But only those entrepreneurs attain wealth and influence in the realm of business who consume merely a fraction of their proceeds and plough back the much greater part into their enterprises. What makes small business develop into big business is not spending, but saving and capital accumulation.
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
Article by Ludwig von Mises, Mises Institute