Supernormal Return

Supernormal returns are payoffs to investment greater than the typical market rate of return. They are often approximated as company profits that exceed 10 percent. This additional return on capital or labor is above breaking even on an investment relative to the amount of risk and time that investment required.

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How Do Supernormal Returns Happen?

Supernormal returns to capital can happen because of monopoly power, economic rents, innovations, or the return to risk. Companies often earn at least some profits above the normal return to capital when they make an investment.

In some instances, supernormal returns can be an indicator of profits from intellectual property (IP), which requires a large upfront cost but little to no maintenance costs after.

Taxing Supernormal Returns

A tax levied on supernormal returns is essentially an excess profits tax. The supernormal returns approach divides profits into two categories: normal returns to capital in competitive markets, and supernormal returns in cases where the firm has pricing power and returns greatly exceed what is deemed normal.

Under a neutral tax code, the normal return to investment would be exempt, as the costs of those investments would be fully deductible, while the supernormal return to capital would be subject to tax since it is additional income. This would allow the tax to serve as a more stable source of revenue and avoid influencing certain business decisions. Deciding what profits would or would not be taxed is no easy feat. Not all returns that might look on paper like “monopoly” returns are the result of an oppressive behemoth. Instead, they could be the returns to a new invention for which no competitor has emerged. The returns to a massive innovation would look supernormal on paper, but in a few years we could expect them to be competed away.

Economists typically believe that supernormal returns are less responsive to taxation than normal returns, and as such, it makes sense to tax them while exempting normal returns. However, that doesn’t mean taxes on supposed supernormal returns aren’t without their downsides.

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