Labour share of income (Part 4 – Does wage inequality matter?)

Labour share of income (Part 4 – Does wage inequality matter?)

Phuah Eng Chye (16 June 2018)

It is widely recognised that “in advanced economies, the gap between the rich and poor is at its highest level in decades.” Hence, many regard “widening income inequality is the defining challenge of our time.”[1] Income inequality raises policy concern because of the perceived macroeconomic and social consequences. But while many agree inequality is bad, there seems to be difficulty finding empirical evidence to support the different hypotheses on the consequences of inequality. “For all the brain power thrown at the problem since then, however, specific evidence about inequality’s effects has been hard to find.”[2]

The most basic question is whether rising inequality can adversely affect economic growth. Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat and Evridiki Tsounta found “an inverse relationship between the income share accruing to the rich (top 20 percent) and economic growth. If the income share of the top 20 percent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth.”

Jared Bernstein suggests otherwise; noting that “empirical evidence of a causal relationship between higher inequality and slower growth…is generally quite elusive, as might be expected. Both inequality and growth are complex phenomena with many moving parts”. While many perceive that distributing income from those with higher consumption propensities (low wage earners) to those with lower consumption propensities (the rich) should lead to slower growth in aggregate demand, “this was not at all the case in the previous economic expansion of the 2000s, in part because easy access to credit and a housing bubble were intervening variables.”

Hence, “many middleclass homeowners experienced sharply increased housing wealth. This higher wealth effect – the extra spending that occurs when assets you hold appreciate – drove consumer spending higher in recent years, even while real incomes, excluding wealth effects, were flat. Of course, when the bubble burst, this wealth effect reversed, leading to the deep and long recession from which the U.S. economy is still recovering.” Jared Bernstein concludes “these dynamics make it difficult to find evidence to support the most commonly cited negative growth impact of higher inequality: that in a highly consumption-driven economy such as ours, the upward distribution of growth to those with lower propensities to consume should lead to slower growth.”

Jared Bernstein notes instead “there is circumstantial evidence to support this connection between inequality, financial instability, and credit bubbles. There is no smoking gun, but recent work, both theoretical and empirical, reveals potential linkages between high levels of inequality that appear to have interacted with underregulated financial markets, contributing to overleveraging, the housing bubble, the Great Recession, and its aftermath.” Hence, income inequality expands demand from the poor and their ability to consume is assisted by the demand from the wealthy for debt assets.

Similarly, Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat and Evridiki Tsounta notes “studies have argued that a prolonged period of higher inequality in advanced economies was associated with the global financial crisis by intensifying leverage, overextension of credit, and a relaxation in mortgage-underwriting standards, and allowing lobbyists to push for financial deregulation.”

In fact, Adrien Auclert and Matthew Rognlie suggest “most general equilibrium macroeconomic models that were used to evaluate the effects of rising inequality were built under the assumption that the U.S. Federal Reserve would immediately accommodate increases in income inequality by lowering interest rates”. If monetary policy did not respond to a rise in inequality, “then the outcome for GDP looks more concerning. Lower consumption lowers employment and individual incomes, feeding back into even lower consumption. Firms disinvest because they anticipate lower employment in the future, and this lowers incomes even further.”

Adrien Auclert and Matthew Rognlie also argue “the key determinant of the effect of inequality on GDP is its effect on asset demand”. They highlight a temporary increase in inequality that “lasts for only a year, then the effect on output is negative but small-less than two-tenths of a percentage point of GDP. The reason is that marginal propensities to consume are negatively correlated with individual incomes, but this correlation is small…Hence there is a small effect on asset demand, and a small effect on output.”

However, “a permanent increase in inequality…our model predicts that the level of output could fall permanently by around 2 percentage points as a result. The reason is that inequality causes individuals’ asset demand to rise permanently by a large amount. In our model, this is because inequality leads individuals to face more risk and volatility in their incomes – and that of their offspring – going forward, leading them to increase savings for precautionary and income smoothing purposes. In general equilibrium, employment has to fall by a substantial amount to restore equality between the demand and the supply of assets. Similarly, monetary policy can respond by lowering interest rates. In fact, the decline in U.S. interest rates that we have observed since the 1980s could have been a response, in part, to rising inequality.”

Adrien Auclert and Matthew Rognlie suggests “not all forms of income inequality have the same effect on equilibrium interest rates: Inequality that raises future risk depresses the natural rate of interest, but technological advances that raise the capital share can have the opposite effect”. They add “central banks should keep track of income inequality over time because it influences the decisions that central banks ought to take”.

Outside of the relationship with economic growth and financial stability, inequality has been associated with a host of social ills such as poverty, worsening social mobility, declining access to opportunities and social support, a deterioration in well-being, rising social injustice and worsening social cohesion. “One problem with these analyses is that they are based on correlations between levels of inequality and variables like life expectancy or the odds of poor children climbing the income ladder. But such correlations can’t prove inequality causes other social ills. They can’t disentangle inequality from the myriad things pushing American society this way and that”.[3]

To avoid misleading correlations and to improve isolation of inequality’s impact, Lane Kenworthy “studied its evolution over time, comparing how changes in income concentration across the world’s industrialized nations related to changes in a whole set of social and economic outcomes, from growth and employment to health and educational attainment…finds no meaningful impact of inequality on growth one way or the other…found no significant relationship between increasing inequality and life expectancy, infant mortality or college graduation rates, among others.”

Broadly, income inequalities are associated with macroeconomic risks relating to growth, employment and financial stability and with causing social ills such as poverty, social stratification and injustice (discrimination and access) and personal well-being. From a policy perspective, it is unlikely that measures to address wage inequality can sort out so many macroeconomic and social ills. In addition, inequalities are private sector-driven[4] but yet can only be addressed through government intervention. The conflicts from multiple objectives thus places public policy in a quandary.


Adrien Auclert, Matthew Rognlie (19 February 2018) “Income inequality and aggregate demand in the United States”. Washington Center for Equitable Growth.

Eduardo Porter (25 March 2014) “Income equality: A search for consequences.” New York Times.

Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat, Evridiki Tsounta (June 2015) “Causes and consequences of income inequality: A global perspective”. International Monetary Fund.

Jared Bernstein (December 2013) “The impact of inequality on growth”. Center for American Progress.

Phuah Eng Chye (26 May 2018) “Labour share of income (Part 1: Theories and measurement)”.

Phuah Eng Chye (2 June 2018) “Labour share of income (Part 2: The difficulty of overcoming wage stagnation)”.

Phuah Eng Chye (9 June 2018) “Labour share of income (Part 3: Causes of wage inequality)”.

[1] Era Dabla-Norris, Kalpana Kochhar, Frantisek Ricka, Nujin Suphaphiphat and Evridiki Tsounta.

[2] Eduardo Porter.

[3] Eduardo Porter.

[4] Phuah Eng Chye “Labour share of income (Part 3: Causes of wage inequality).

Leave a Reply

Your email address will not be published. Required fields are marked *