Labour share of income (Part 6: The missing big picture)

Labour share of income (Part 6: The missing big picture)

Phuah Eng Chye (30 June 2018)

Economists are increasingly concerned about the persistent decline in the labour share of income. This is because they anticipate wage stagnation and worsening inequalities will weaken household consumption. This will impede prospects for an economy recovery and lead to rising social instability. There have been many studies but they mainly focus on explaining the causes of the decline. Labour policy is unable to address this as it is conflicted by the concessions made to accommodate business demands for labour flexibility.

Hence, despite the academic and policy attention, the labour share of income has continued to decline. This suggests something is missing in the traditional analytical and policy frameworks. I think what is typically omitted from the analysis are the big picture trends relating to the labour share of income. Here are some interesting questions to consider.

  • Has the declining trend in labour share of income been positive or negative for economic growth? Generally, the declining trend in the labour share of income is perceived as a negative. It is not so straightforward. In earlier decades, the decline was accompanied by strong global growth; which hints that declining labour income share drove growth initially. It is only since the millennium that the labour income share declined together with an economic growth slowdown. Hence, the relationship between economic growth and the labour share of income changed in different time periods. It is difficult to formulate policy interventions without differentiating the circumstances under which the declining labour share has positive effects and when it has negative effects on growth.
  • Is there an optimal level for the labour share of income? This question may not have been relevant in the past because the labour income share was stable. But labour income share levels have been declining for a couple of decades. There is a need to understand issues in relation to the optimal level for labour income share; such as how comparable economies with high labour share fare compared to those with low labour share. In addition, it would be useful to establish whether there are natural ceilings and floors for the labour share of income and the significance of these levels.
  • Can the decline in the labour share be reversed? I have not come across studies highlighting instances where the labour income share increased or that provides an explicit macroeconomic explanation of how the labour income share can be made to rise. In theory, the labour income share cannot be expected to continue to decline forever but how does one induce a reversal in trend? The answers would shed some light as to the types of policies that could be effective in reversing the decline in labour share of income.

Simplistically, it would seem that overcoming the decline in labour share is a relatively easy task such as by raising minimum wages. But mandated wage increases don’t seem to have the same effects on consumption, investment and inflation that it used to. And labour income shares have continued to decline despite massive macroeconomic stimulus; suggesting it is an extremely difficult task.

Maybe we are looking at the problem wrongly. The accounting-based perspective suggests that for the labour share of income to rise, wages must outgrow profits. But a scenario where output and wages can outpace profits is inconceivable in a market economy where the highest rewards are reserved for management teams most capable of achieving profit increases and containing wage costs. It is now culturally acceptable to tell workers not to expect continually rising wages without improving productivity but yet to defer to investors expectations for continually higher profits. This leads to a situation where wage increases will almost certainly lag productivity growth. The profit imperative is thus a major roadblock to overcoming wage stagnation, addressing wage differentials and reversing the declining labour share of income.

Even when the government mandates minimum wage increases, firms would respond by reducing their direct headcount and increasing their reliance on flexible labour arrangements to cap the overall wage bill. “The share of self-employed and temporary workers in total employment in the Netherlands has grown – steadily – from 16.6% in 1980 to 25% in 2000 and further to almost 38% in 2016”. Researchers found “a statistically significant negative association between the wage share and the incidence of temporary employment; specifically, an increase of 1% in the share of temporary employment is associated with a decline in the wage share of 0.23 percentage points”. The researchers singled out “the incidence of temporary employment and alternative working arrangements (mostly in the form of self-employment) as a main driver of low wage growth and a declining wage share”[1]. Firms also have the option of reducing the quality of the product and service or resizing their offerings.

Direct government intervention is therefore required to redistribute income from profits to wages to reverse the declining labour share of income. But government policy has been moving in the opposite direction. Instead of raising taxes to fund programs to address inequality and poverty, governments have favoured cutting taxes on the basis that this would create jobs and eventually increase wages.

The logic of the backward bending curve suggests tax cuts have a significant impact on output when taxes are at high levels but it loses its power to incentivise output at the lower range. Even when the tax cuts have a positive effect on income, firms may not be inclined to raise wages because of the windfall nature of the income gains. In addition, the tax cuts will reduce the fiscal base which may require the government to downsize its workforce and to freeze public sector wages. It is perhaps worth mentioning that a “good” tax cut is one that stimulates the economy so much that it generates sufficient fiscal revenue to cover the initial revenue loss. In other words, a “bad” tax cut should be defined as one that necessitates public sector wage cuts. Overall, tax cuts increase profits rather than wages and this will aggravate the labour income share decline.

In any case, the macroeconomic relationships[2] seems to have changed such that fiscal and monetary stimulus seem to be finding its way into profits rather than wages. This suggests that stimulus by itself is insufficient and that additional policy measures (e.g. labour policies, wages and transfers) are needed to ensure wages grow more quickly than profits.

Another perspective is to view wage stagnation as a problem caused by the growing profits or capital share of income. This means that the wage-profit imbalance can be resolved by reducing profits. There are two possibilities. One is for the government to intervene by increasing taxes or mandating firms to pay higher wages (raise minimum wage). Government interventions to raise taxes or wages has the drawback that it will cause firms to reconfigure (such as moving their operations offshore) to minimise the impact. The other adjustment is through the market channels by correcting asset prices.

Hence, an increase in wages or taxes and a fall in capital gains or trading profits would instantly stem or reverse the decline in the labour income share. But there are adverse consequences. One outcome is that the fall in profits would seriously affect marginal firms and result in closures or lead to increase in the number of zombie firms[3]. Falling profits would also have knock-on effects on asset prices and this could trigger a financial crisis and a severe economic contraction.

These risks of a market fallout grow with the rising level of financialisation; suggesting there is an inverse relationship between changes in wage levels and asset prices. Hence, in matured economies where profits account for a relatively large proportion of income, the trade-offs between growth, profits and wages become more apparent. When economic growth is anaemic, profits and economic growth are more likely to move in the opposite rather than in the same direction. Attempts to redistribute income from profits into wages will need to consider the trade-offs between asset price effects and wage effects.[4] On this basis, it could also be argued that massive quantitative easing has interrupted the rebalancing of capital-labour share of incomes because it supports asset prices and hence profits.

Overall, it is useful to have big picture context as a reference point as it improves perspective. Past government interventions were not only unable to reverse the decline in the labour share of income but it aggravated the rise in the profit share of income. The question now facing many economies is whether economies can grow if wages don’t. Would it continue to be socially acceptable if firms should make more profits at the expense of workers? What would be the point of pursuing profit-driven GDP growth if it takes place at the expense of workers and government?

There must be some point where the imbalances become economically and socially intolerable. The problem is that there is no theoretical framework to help us figure if such a point exists and more importantly suggest the best approach to managing the potential risks from a policy-induced reversal of the decline. One common error is to introduce a waft of reforms (e.g. higher taxes, withdrawal of tax incentives and higher wages) at the same time that cause corporate profits and asset prices to fall too substantially. This could generate negative wealth effects that could overwhelm the positive consumption multiplier effects. We need a robust policy model to help us understand the mechanisms of the profit-wages share of income. The next article will explore the relative roles of wages and profits.


De Nederlandsche Bank (1 February 2018) “Flexibilization of the labor market leads to decline in the wage share”. DNBulletin.

Phuah Eng Chye (29 July 2017) “Macroeconomic frameworks for the information society”.

Phuah Eng Chye (16 September 2017) “The services economy: Service sector growth and the information society”.

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)”.

Phuah Eng Chye (16 June 2018) “Labour share of income (Part 4: Does wage inequality matter)”.

Phuah Eng Chye (23 June 2018) “Labour share of income (Part 5: The quandary of labour reform)”.

Servaas Storm (26 Feb 2018) “With official unemployment this low, why are wages rising so slowly?” Institute for New Economic Thinking.

[1] Servaas Storm, De Nederlandsche Bank

[2] Phuah Eng Chye “Macroeconomic frameworks for the information society”.

[3]It is argued that zombie firms make economies inefficient.

[4] Phuah Eng Chye “The services economy: Service sector growth and the information society”.

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