<Standard E.2.4 .................................................................................................................................................................Standard E.2.6>

Explain the function of profit in a market economy as an incentive for entrepreneurs to accept the risks of business failure.

John D. Rockefeller by John Singer Sargent, 1917
John D. Rockefeller by John Singer Sargent, 1917

Focus Question: What are the roles of risk, profit, income, wealth and taxes in the American economy?

Topics on the Page
  • What is Profit?
  • Wealth, Income and Power in American Society
  • The Role of Taxes
    • The 16th Amendment and the Income Tax

What is Profit?

Profit = Total Revenue – Total Cost

Profits come from investments made by individuals, companies and governments that make possible the production of goods and service that people want to purchase.

The Role of Profit in an Economy, from EconomicsHelp.org

High profit Enables:

  1. Investment in Research & Development. This leads to better technology and dynamic efficiency. This profit is particularly important for some industries such as oil exploration and car manufacture. Without this investment the economy will stagnate and lose international competitiveness, leading to job losses in some sectors.
  2. Reward for Shareholders. Shareholders are given dividends. Higher profit leads to higher dividends and encourages people to buy shares. Shareholders are an important source of finance for firms. Profit is important to be able to remunerate shareholders.
  3. High Profit should attract new firms into the industry. For example, the high price of oil and hence profits for oil companies should encourage firms to develop new oil fields. This assumes the market is contestable and new firms can actually enter.
  4. Risk Bearing Economies. Profit can be saved and provide insurance for an unexpected downturn, such as recession or rapid appreciation in the exchange rate.
  5. Tax Revenues. Governments charge corporation tax on company profits and this provides several billion pound of tax revenue per year.
  6. Acts as Incentive. Higher profit acts as an incentive for entrepreneurs to set up a business. Without the reward of profit, there would be less investment and less people willing to take risks. For example, it is argued higher corporation tax, which reduces a firms post tax income may deter inward investment.

Evaluation of Importance of Profit.
  • Though profit plays an important role in an economy. It is worth bearing in mind.
  • Pursuit of profit may damage environment
  • Higher profit can lead to greater inequality in society.
  • Pursuit of short-term profit can encourage risk-taking and reckless behavior. For example, commercial banks took more risks in the 1990s and early 2000s; this contributed to the credit crunch.
  • Firms may pursue other objectives apart from profit-maximization. These objectives can include: growth maximization, cultural / social objectives / sales maximization, profit satisfying.

Screen Shot 2016-02-13 at 11.47.54 AM.pngFor a view of the function of profits, read Profits in a Capitalist Economy—Where Do They Come From, Where Do They Go? from Philip Pilkington's blog, The Naked Capitalist.

rotating gif.gifFor background, see United States History II.1 on the roles of business leaders and entrepreneurs in the Glided Age.

Wealth, Income and Power in American Society

rotating gif.gifFor an historical perspective, see United States History II.1 on the role of business leaders, entrepreneurs, and inventors during the second Industrial Revolution

What is the difference between wealth and income?
  • Wealth is what you own minus what you owe and income is money that flows in.

external image Red_apple.jpg11 Things the Wealthiest Americans Can Buy for the U.S.

Hetty Green, 1900, richest woman in America
Hetty Green, 1900, richest woman in America

Screen Shot 2016-02-13 at 11.47.54 AM.png
The Wealthiest Americans Ever from The New York Times (information as of 2007). John D. Rockefeller is the wealthiest person in United States history.

The Wealthiest Man Ever was Mansa Musa of Mali (1312-1337)

10 Richest Women of All Time
  • Empress Wu of China (625-705) tops the list

29 Richest People in America (January 2016)
  • Bill Gates and Warren Buffett lead the list

Top 25 Highest-Paid Athletes Visualized (2016)
  • Cumulative earning are displayed by salary and by endorsements

Fortune 500 Annual Ranking of America's Largest Corporations (2012)

100 Highest-Paid CEOs from Executive Pay Watch from the AFL/CIO.
  • CEOs from largest American corporations are paid 354 times what the average worker makes in salary.
  • CEOs on average earned $12.3 million compared to $34,645 for average private-sector worker.

game_icon.svg.pngFor more, explore Executive Paywatch: CEO Pay and You

Income Inequality

Income includes the revenue streams from wages, salaries, interest on a savings account, dividends from shares of stock, rent, and profits from selling something for more than you paid for it. Income inequality refers to the extent to which income is distributed in an uneven manner among a population. In the United States, income inequality, or the gap between the rich and everyone else, has been growing markedly, by every major statistical measure, for some 30 years.

More on income inequality can be found at Inequality.org.

Who are the 1 Percent?

Bill Gates, 2006
Bill Gates, 2006

From World War II to the 1980s, noted former Secretary of Labor Robert Reich, "the richest 1 percent of Americans received only about 9 percent of the nation's total income."

Since then however, their has been a substantial income redistribution in favor of wealthy Americans.

"From 9 percent in 1980, the top 1 percent's take has increased from 23.5 percent in 2007. CEOs who in the 1970s took home 40 times the compensation of average workers now rake in 350 times. . . the 25 best-paid hedge-fund managers took in an average of $1 billion each. (Their marginal income tax, by the way, was barely over 17 percent, while the typical family paid a marginal tax far higher)."
"Confessions of a Class Worrier," Robert Reich, Valley Advocate, August 19, 2010.

The top 1 percent?averageincome2001.gif
  • 1.4 million families who made an average of one million dollars in 2009 are the top 1 percent.
  • Their share of the nation's total adjusted gross income was 17 percent in 2009. Those people are earning more than the entire bottom half of the population.
  • Since the mid-1980s, the top 10 percent has increased their share at the expense of the rest of the population. The greatest gains have been by the richest 1 percent, with half of those gains going to the top 0.1 percent.
  • Financiers--bankers, fund managers and other money professionals--are just 14 percent of taxpayers at the top of income distribution, but their share has been growing dramatically to the point where it is almost equal that of doctors and lawyers combined. ("Wall Street Protesters Hit the Bull's-Eye," The New York Times, October 30, 2011, p. 10).

Multimedia.pngSee also Wealth Inequality in Americaon YouTube (authored by Politizane) that shows what Americans think wealth inequality looks like, what they think is ideal, and what it actually is (top 20% own 84 %).

Multimedia.pngClick here to see a 2016 CNN video report on how income inequality keeps getting wider.

The Racial Wealth Gap
multicultural.pngThe Faces of American Power: Nearly as White as the Oscar Nominees from The New York Times (February 28, 2016)
  • This website looks at 503 of the most powerful people in government, education and business and found just 43 are minorities.
  • Click here to see an article about the widening racial wealth gap in the United States.
  • Click to read an article on how race-based economic inequality is a legacy of slavery.

Screen Shot 2016-04-21 at 9.41.38 AM.pngFinancial Inequality in Massachusetts

A town by town look at income in Massachusetts

Median State Living Wage with Poverty Threshold and Minimum Wage

  • Top 1 percent of incomes earn an average of $537,100 in 2009 (up from $234,752 in 1979, a gain of 128.8%).
    • Those without a high school diploma earn an average of $36,081 (down from $54,564 in 1979, a loss of 34%).
  • Sherborn, the state's wealthiest community had an median 2009 income of $186,058 in 2009 with a 4.5% unemployment rate.
    • Springfield, one of the state's poorest cities, had an median 2009 income of $41,476 in 2009 with a 11% unemployment rate.

Wealth, Income and Power by sociologist G. William Domhoff presents historical information on income distribution in American society.

game_icon.svg.pngSpent, an online game from the Urban Ministries of Durham puts players in the role of a single parent who must make choices to survive a month on a limited income.


external image Fig6_Potential_profit_archetypes.jpg
Multimedia.pngHow Incentives Affect Innovation

The chance of things not turning out as expected. Risk taking lies at the heart of capitalism and is responsible for a large part of the growth of an economy.

*In general, economists assume that people are willing to be exposed to increased risks only if, on, average they can expect to earn higher returns than if they had less exposure to risk.

Role of Taxes in American Society

The United States has a market economy-an economic system based on free enterprise.
  • In a market economy, money moves from the consumer to businesses when consumers buy goods and services. The government relies on tax revenue from the market economy.
    • Businesses pay sales tax, based on the purchase price of the goods. Other taxes include corporate income tax, based on business profits. In general, when a business's sales grow, so do its tax payments.
      • Taxpayers pay income taxes and payroll taxes to the federal government and may also pay income tax to state and local governments. Generally, the greater the income, the more a taxpayer will pay. Taxpayers pay sales taxes on goods purchased.
  • The government impacts the economy through the goods and services it purchases and provides. About one-third of the nation's economy is based on government spending. Most revenue for government spending comes from the collection of taxes.
    • When the economy is growing, consumers earn more and make more purchases. This increases business profits and boosts sales and corporate income tax revenue. Consumers may buy bigger homes (thus increasing revenue from property tax), travel more (thus increasing revenue from gasoline tax), and so on. In this way the government collects more taxes and has more money available to spend.

See Economics 4.5 for more on progressive, regressive and proportional taxation

See United States History II.29 for the Reagan Presidency and Reaganomics

Screen Shot 2017-02-24 at 12.30.24 PM.pngSee more including lesson plans and educational activities from the IRS Understanding Taxes Teacher website.

Average income taxes by country in year 2005.
Average income taxes by country in year 2005.

History of the U. S. Tax System from the Department of the Treasury.

In 2010, the National Archives released a Treasury Department report from the1940s that showed wealthy Americans paid a much higher proportion of the income in taxes than they do at the present time.
  • In 1941, Americans in the top income bracket paid up to 81 percent in taxes.
  • As World War II continued, the rate rose to 94 percent by 1944 and 1945.
  • During the Korean War, the top rate was 91 percent
  • It fell to a low of 28 percent during the Reagan presidency, rising to 39.6 percent under Presidents Clinton and Bush I.
  • In 2010, the Congress extended the Bush II-era tax cuts, keeping the top rate at 35 percent. (Taxes: What History Tells Us, Stephanie Kraft, Valley Advocate, December 16, 2010, p.8.)

Where do our federal tax dollars go? from the Center on Budget and Policy Priorities
  • In the fiscal year 2015, the US government spent 3.7 trillion dollars, which amounts to 21% of the nations Gross Domestic Product or GDP.
    • 24%(888 billion dollars) of this 3.7 trillion paid for Social Security which provided monthly benefits averaging 1,342 dollars to retired workers and their families.
      • 25%(938 billion dollars) went towards funding primarily Medicare and Medicaid, which provides health coverage to the elderly and poor.
        • 16%(602 billion dollars) went towards defense and international security assistance. Transportation infrastructure, education, and science/medical research are woefully unsupported by federal tax dollars.
primary_sources.PNG16th Amendment to the Constitution established the right of Congress to impose an income tax.

Map of the United States showing in red states that have no state income tax as of July, 2005.
Map of the United States showing in red states that have no state income tax as of July, 2005.

external image 500px-Map_of_USA_highlighting_states_with_no_income_tax.svg.png

Works Cited:
Economics A-Z http://www.economist.com/research/economics/alphabetic.cfm?letter=R#risk