What is an excess profit? Too much, of course. But how much is too much?

Times are getting tougher in New Zealand, as in many countries experiencing high inflation. Increased food and fuel prices hit consumers particularly hard because everyone needs to buy them, and lower earners spend proportionally more of their incomes on these purchases. Consumer New Zealand called the government to curb the ‘excess profits’ enjoyed by supermarkets (‘twice what they should be’). They suggested that the supermarket duopoly (Foodstuffs and Countdown) need at least one more competitor, or to be broken up, or to forced to open their wholesale arms to other competitors to level the playing field.

A Commerce Commission report said that the two supermarket chains would earn $430m less a year if they earned a 5.5% return on capital rather than the 12.9% annual return between 2015 and 2019. Presumably their profits are even higher now but that’s not documented. So is 12.9% profit too much? Is 5.5% profit enough, but not too much? What might one compare against?

I looked up ‘excess profits’ and got lots of hits referring to ‘excess profits tax’. Interestingly, such taxes have been employed in war times. During WWI Australia, Canada, New Zealand, South Africa, France, Italy, and the United States of America all introduced excess profits taxes to help pay for the war and ensure that no one outrageously benefited from the situation. The USA put through a similar tax during WWII, as did New Zealand, and the USA did the same again during the Korean War. The rates of tax on the excess profit, as enacted at different times in the USA, varied from 20% to 60%. Bernie Sanders has introduced legislation in the USA in March 2022 that would tax such ‘windfall profits’ at 95%. He is only proposing that such a tax is levied between 2022 and 2024 so I imagine that the bill will be delayed until the point it is past its use-by date.

Do we think that excess profits are only made during world wars or at other particularly stressed times in world history? I have my doubts. It’s not like the media gives us some running comparative tally of e.g. companies’ annual profits, compared to their 5 year running average – which appears to be a reasonably well accepted method for calculating excess profits (and as used by the NZ Commerce Commission). Perhaps it is something we should be asking our media to do routinely?

It appears that excess profit taxes have as much a role in calming public sentiment as they do in returning money to the country from corporates. They have been enacted at times when the general public is unhappy and restive…that sounds like now, doesn’t it?

How did New Zealand end up in a situation where the supermarkets can make such high profits? Shouldn’t the market manage itself? That was the theory of the 1980s reforms in New Zealand, when many institutions were morphed into company models. Market theory does say that the market will self-regulate profits, because if a company is making ‘excess profit’, another company will set up to offer the same product/service more cheaply on the basis that it can still make a ‘good enough’ profit. Unfortunately this doesn’t work in practice because:

When markets don’t work as they ‘should’, governments must step in. One way governments step in is with taxes. The New Zealand tax system doesn’t currently have any direct mechanism dealing with excess profits and corporate tax is a flat 28%. If I was a supermarket I might be annoyed – the government is sending a clear message in its tax system that all profits are considered equal, then it turns around and says I have been excessive in my profit making? One could wonder why we have a flat rate – shouldn’t we have a sliding scale of taxation, disincentivising the making of large profits? No we can’t, because in a globalised world corporates will simply move their operations/finances to a jurisdiction in which they are taxed less. Damn, that easy answer isn’t available.

Our government is currently choosing to reduce barriers to entry for supermarkets – requiring them to open up their wholesale arms to competitors. There will be challenges – supermarkets have not set up their wholesale arms to supply multiple businesses. And supply chains are complex beasts, possibly more complex than government is choosing to recognise. It will be more expensive for the supermarkets to provide wholesale products to many operations, which will reduce their excess profits perforce but might not make Foodstuffs and Countdown keen on reducing their prices! The impact of the requirement remains to be seen – economic modeling and reality often reach different conclusions.

I’m relieved that the government didn’t bring another supermarket competitor into the mix. I hear lots of people saying that we need a cheaper supplier, e.g. Aldi, and assuming that another competitor will bring prices down. Competition between two supermarket chains hasn’t controlled prices – why would a third chain be cheaper? There would be the same barriers to entry that allow the current two chains to keep prices high…all three chains could have high prices and a new offshore competitor could simply siphon more profits out of New Zealand!

In summary, the disquiet and struggles are very real but the solutions are far from obvious. When much power is vested in the hands of the few the general populace rarely benefits. My crystal ball suggests more high prices ahead.