Labour share of income (Part 1 – Theories and measurement)

Labour share of income (Part 1 – Theories and measurement)

Phuah Eng Chye (26 May 2018)

At the macroeconomic level, the impact of landscape change on labour can be gauged by changes in the labour share of income or the share of national income paid in wages. Noah Smith notes “for decades, macroeconomic models assumed that labor and capital took home roughly constant portions of output – labor got just a bit less than two-thirds of the pie, capital slightly more than one-third. Nowadays it’s more like 60-40.” This has overturned the “long tradition of assuming a constant labor share of income in growth and other macroeconomic models, and thus raised complex questions about the rising role of capital in production and its implications for the future of employment and labor income.”[1]

Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian notes “in advanced economies, labor income shares began trending down in the 1980s, reaching their lowest level of the past half century just prior to the global financial crisis of 2008–09, and have not recovered materially since.” In addition, “between 1991 and 2014, the labor share declined in 29 of the largest 50 economies; those 29 economies accounted for about two-thirds of world GDP in 2014. Across industries, labor income shares have declined in 7 of the 10 major industries, with the sharpest declines occurring in the more tradable sectors, such as manufacturing, and transportation and communication.”

In relation to sectoral transitions, Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian observed “the decline in the labor share of income between 1993 and 2014 appears to result from within-industry declines, rather than a shift from high-labor-share sectors to sectors with relatively lower labor shares. A shift-share decomposition, which separates such within-industry changes and between-industry changes, reveals that more than 90 percent of changes in labor income shares reflect within-industry changes rather than sectoral reallocation. An important exception is China, where reallocation from agriculture to other industries accounts for the majority of the decline in the labor share of income.”

In the US, R. Armenter notes the manufacturing sector averaged a labour share of 62 percent while the services sector had a lower labour share of 48 percent in the 1950s. During the transition from manufacturing to services, “the aggregate labor share should have fallen but it didn’t.” This was because “the labor share of the service sector rose sharply, from 48 percent in 1950 to 56 percent in 1987. Education and health services went from labor shares around 50 percent to the highest values in the whole economy, close to 84 percent…the forces affecting the labor share across and within sectors just happened to cancel each other.”

But this experience was not repeated over the period 1987 to 2011. “While the manufacturing sector kept losing ground to the service sector, the differences in labor share between the two sectors were much smaller by the early 1990s, and thus the shift from manufacturing to services had only small downward effects on the overall labor share.” R. Armenter states “instead, it was the change in the labor share within manufacturing, which dropped almost 10 percentage points. Virtually all the major manufacturing subsectors saw their labor shares fall; for nondurable goods manufacturing it dropped from 62 percent to 40 percent…had the labor share of income in manufacturing stayed constant, the overall labor share would have barely budged.” In turn, “the precipitous decline in the labor share within manufacturing” was caused by labour productivity taking off while wage growth was very sluggish. “The gap between productivity and wages has kept growing, depressing the labor share.”

The declining labour share of income is significant because it results “from the failure of product wage growth to keep up with weak productivity growth” and is “concomitant with increases in income inequality”. Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian notes “lower-skilled workers have borne the brunt of the fall in labor share amid evidence of persistent declines in middle-skill occupations and income losses for middle-skilled workers in advanced economies”. In addition, “an increase in the share of income accruing to capital tends to raise income inequality”. The risk is that “as the global economy continues to struggle with subpar growth, an increasing recognition that the gains from growth often have not been broadly shared has strengthened a backlash against economic integration and bolstered support for inward-looking policies”.

Many theories have been put forward to explain the decline in the labour share of income. I have clustered the overlapping theories as it provides a useful holistic perspective on wage theories.

  • Technology. Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian notes “empirical analysis suggests that about half of the total decline in labor shares can be traced to the impact of technology. Importantly, for a given change in the relative price of investment, economies with high exposure to routinization experienced about four times the decline in labor income shares than those with low exposure.” Valentin F. Lang and Marina Mendes Tavares found “income gains are substantial for countries at early and medium stages of the globalization process, but the marginal returns diminish as globalization rises, eventually becoming insignificant. Within countries, these gains are concentrated at the top of national income distributions, resulting in rising inequality”. Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian observed “global integration – in particular, participation in global value chains and financial integration – is estimated to have contributed about half as much as technology.” “While overall trade in goods and services does not appear to matter much for labor shares…Participation in global value chains is estimated to have exerted a strong negative effect on the labor share of income in both advanced economies and emerging markets, supporting the notion that offshored tasks are labor-intensive for the former group of countries but raise capital intensity in the latter. The empirical estimates indicate that an increase in intermediate goods imports of 4 percent of GDP is associated with a 1.6 percentage point decline in the aggregate labor share, on average, with a significantly larger impact in emerging markets.” “International financial integration has contrasting effects…depressing labor shares in advanced economies while raising them in emerging markets.”
  • Capital accumulation. The declining labour share fits into the long-run dynamics of wealth and income inequality. Thomas Piketty argues the combination of low (demographic and economic) growth, a political shift in relation to taxation and finance and relatively high returns on capital will increase the ratio of the capital stock to income and lead to a structural increase in capital’s share of income. Matthew Rognlie provides the counter-argument that the increase in the net capital share “once disaggregated this increase turns out to come entirely from the housing sector: the contribution to net capital income from all other sectors has been zero or slightly negative, as the fall and rise have offset each other.” “The long-term increase in capital’s net share of income in large developed countries has consisted entirely of housing” is used to challenge the validity of the capital accumulation hypothesis.
  • Financialisation. Engelbert Stockhammer found “financialisation[2], rather than technology, was the main cause of the decline in the wage share”. He explains financialisation expands the investing options and mobility of firms. It also “empowered shareholders relative to workers by putting additional constraints on firms and the development of a market for corporate control has aligned management’s interest to that of shareholders”. His research also showed globalisation did not benefit workers in developing economies, in contradiction to some theories[3]. Engelbert Stockhammer says the findings “suggest that income distribution is not primarily determined by technological progress, but rather depends on social institutions and on the structure of the financial system”.
  • Industry concentration and superstar firms. The falling labour share of income is often correlated to rising concentration in industries. David Autor, David Dorn, Lawrence F. Katz, Christina Patterson and John Van Reenen point out “industries are increasingly characterized by a winner take most feature where a small number of firms gain a very large share of the market.” “Since these superstar firms have higher profit levels, they also tend to have a lower share of labor in sales and value-added. As superstar firms gain market share across a wide range of sectors, the aggregate share of labor falls.” Hence, the fall in the labor share is largely due to the reallocation of sales between firms (those with low headcount at the expense of labour-intensive companies. Using a different approach, Simcha Barkai shows “the decline in competition that generates these profits are potentially large enough to generate large declines in the shares of labor and capital, as well as large gaps in output, wages, and investment…Taken together, the evidence shows that increases in industry concentration can explain the decline in the labor share, under-investment and a large rise in corporate profits.”
  • Winner-Take-All (WTA) society[4]. Philip Cook and Robert Frank explains the existence of “markets in which a handful of top performers walk away with the lion’s share of total rewards” are the result of “the spread of markets in which the value of production depends primarily on the efforts of only a handful of top players who are paid accordingly”. WTA, common in entertainment and sports, has proliferated to other industries due to “developments in communications, manufacturing technology, and transportation costs that have enabled the most talented performers to serve ever broader markets, which has increased the value of their services; and changes in implicit and explicit rules that have led to much more open competition for top performers, which has made it more likely that they will be paid their economic value as determined by the marketplace.” “In today’s market, the top player who doesn’t receive his due can simply move to another team.” WTA will aggravate inequality as for every highly-rewarded individual, there will be “thousands of others, many of them as talented, who never manage even to support themselves”. The WTA hypothesis overlaps with the concentration-superstar and the fissured workplace theories with the observation that successful firms with highly-paid staff and low headcount will expand their market share at the expense of firms with high headcount. The subtle point to note is that the WTA postulates unequal wage distribution as arising from increasing rather than decreasing Another noteworthy feature of WTA is its explanation that the high rewards for a few winners will attract large numbers willing to work for low wages in that industry; which contributes to worsening wage inequality.
  • The fissured workplace[5]. Fissuring involves the shifting of work out of the firm to third parties and subcontractors. This leads to breakup of ownership-operator and employee-employer relationships and transform work from being an employment relationship to being a contracted or market transaction and for job fragments to be transacted at a price rather than a wage. The work arrangement flexibilities allow the lead firms to get out of the social norms for standard pay and to set labour costs closer to marginal productivity. Hence, the lead companies enjoy the ability to exercise control over their brands, products and services while reducing their responsibilities and legal liabilities for their subcontracted workforce.
  • Labour market monopsony. This is the most theoretically rigorous framework that explains how concentration increases the ability of employers to dictate terms in the labour market. [6] “The basic idea of monopsony is that if employers don’t have to compete with one another for workers, they can pay less, and workers will be stuck without the outside job offers that would enable them to claim higher wages. The monopsony story is consistent with a wide range of observed labor market phenomena: wage stagnation, declining geographic and job-to-job mobility, deterioration of the job ladder, especially for low-wage and young workers, and declines in entrepreneurship and business dynamism.”[7]

There is thus a large number of theories to explain the labour share of income trends. They are overlapping but yet are, at the same time, competing theoretical explanations for the decline in the labour share of income. Determining the validity of these theories is complicated by measurement problems and the use of different datasets and methodologies. R. Armenter points out “measurement problems in relation to how income is divided between labour and capital could distort our understanding of what has happened to the labor share over time.” In this regard, R. Armenter notes “distinguishing between labor and capital income is not always an easy task”. “In some cases, we can easily see whether our income comes from labor or capital: when we earn a wage or a bonus through our labor or when we earn interest from our savings or investment account, which is attributed to capital income. However, it is not always immediately apparent that all income eventually accrues to either capital or labor.”

He explains the necessary detail to split some components of the income data between labor and capital returns is lacking. “For example, compensation of employees clearly accrues to labor, while corporate profits, rental income, and net interest income are returns to capital. Of the three remaining components, the main challenge is proprietor’s income. Proprietor’s income is defined as the income of sole proprietorships and partnerships – in other words, the income of self-employed individuals. There is no question that their income is the result of both labor and capital.” In addition, “the housing and the government sectors have their total income arbitrarily assigned as labor and capital income, respectively, in the national income accounts.”

Due to this, the US Bureau of Labor Statistics (BLS) goes to “great lengths to disentangle proprietor’s income into its labor and capital income components”.  R. Armenter notes “until 2001, the BLS’s methodology assigned most of proprietor’s income to the labor share, a bit more than four-fifths of it. Since then, less than half of proprietor’s income has been classified as labor income…suggests that at least one-third and possibly closer to half of the drop in the headline labor share is due to how the BLS treats proprietor’s income.”

Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian adds “the depreciation of capital, which should arguably be discarded from the calculation of factor income shares because it cannot be consumed by either workers or capital owners. Adjustments for self-employment and depreciation would, in general, raise the level of the labor share. However, these measurement issues could also affect the evolution of labor shares over time. For instance, all else equal, falling self-employment rates would make the labor share decline steeper, while rising capital depreciation rates would make the decline less pronounced.”

Overall, there is still little agreement on what specifically caused the decline in labour income share. As R. Armenter acknowledges, the findings have been “quite inconclusive: Economists do not yet have a full grasp of the underlying determinants.” In addition, there is also confusion on causation; i.e. whether the structural changes are inducing the macroeconomic outcomes or vice-versa.

References

Council of Economic Advisers (October 2016) “Labor market monopsony: Trends, consequences, and policy responses”. Council of Economic Advisers Issue Brief. https://obamawhitehouse.archives.gov/sites/default/files/page/files/20161025_monopsony_labor_mrkt_cea.pdf

David Autor, David Dorn, Lawrence F. Katz, Christina Patterson, John Van Reenen (May 2017) “The fall of the labor share and the rise of superstar firms”. National Bureau of Economic Research.  NBER Working Paper. http://www.nber.org/papers/w23396

Engelbert Stockhammer (2013) “Why have wage shares fallen? A panel analysis of the determinants of functional income distribution.” International Labour Office. Conditions of Work and Employment Series No. 35. http://www.ilo.org/wcmsp5/groups/public/—ed_protect/—protrav/—travail/documents/publication/wcms_202352.pdf

Heather Boushey (22 June 2017) “Equitable growth in conversation: David Weil”. Washington Centre for Equitable Growth. http://equitablegrowth.org/labor-markets/equitable-growth-in-conversation-david-weil/

Mai Chi Dao, Mitali Das, Zsoka Koczan, Weicheng Lian (April 2017) “Understanding the downward trend in labour income shares”. International Monetary Fund, World Economic Outlook April 2017. file:///C:/Users/user/Downloads/text.pdf

Marshall Steinbaum (18 December 2017) “How widespread is labor monopsony? Some new results suggest it’s pervasive.” Roosevelt Institute. http://rooseveltinstitute.org/how-widespread-labor-monopsony-some-new-results-suggest-its-pervasive/

Matthew Rognlie (Spring 2015) “Deciphering the fall and rise in the net capital share: Accumulation or scarcity?” Brookings papers on economic activities. https://www.brookings.edu/wp-content/uploads/2016/07/2015a_rognlie.pdf

Noah Smith (24 April 2017) “Cracking the mystery of labor’s falling share of GDP. Bloomberg. https://www.bloomberg.com/view/articles/2017-04-24/cracking-the-mystery-of-labor-s-falling-share-of-gdp

R. Armenter (2015) “A bit of a miracle no more: The decline of the labor share.” Business Review. Federal Reserve Bank of Philadelphia Research Department. https://www.philadelphiafed.org/-/media/research-and-data/publications/business-review/2015/q3/brq315_a_bit_of_a_miracle_no_more.pdf

Robert Frank (1994) “Talent and the Winner-Take-All society”. Prospect.org. http://prospect.org/article/talent-and-winner-take-all-society

Simcha Barkai (2016) “Declining labor and capital shares”. Working Paper, University of Chicago. http://home.uchicago.edu/~barkai/doc/BarkaiDecliningLaborCapital.pdf

Thomas Piketty, Emmanuel Saez (23 May 2014) “Inequality in the long run”. Vol. 344 Issue 6186. sciencemag.org. https://eml.berkeley.edu/~saez/piketty-saezScience14.pdf

Valentin F. Lang, Marina Mendes Tavares (March 2018) “The distribution of gains from globalization.” IMF Working Paper. file:///C:/Users/user/Downloads/wp1854.pdf

[1] Mai Chi Dao, Mitali Das, Zsoka Koczan and Weicheng Lian

[2] “Increased role of financial activity and rising prominence of financial institutions…are often referred to as financialisation and include rising indebtedness of households, more volatile exchange rates and asset prices, short-termism of financial institutions, and shareholder value orientation of non-financial businesses”. Engelbert Stockhammer

[3]The Stolper-Samuelson theorem.

[4] Philip Cook and Robert Frank. Based on article by Robert Frank

[5] David Weil’s hypothesis. Based on his interview by Heather Boushey.

[6] Council of Economic Advisers “Labor market monopsony: Trends, consequences, and policy responses”.

[7] Marshall Steinbaum.

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