Labour share of income: (Part 7 – The roles of wages and profits)

Labour share of income: (Part 7 – The roles of wages and profits)

Phuah Eng Chye (7 July 2018)

Wages have an important role in an economy. The International Labour Organization (ILO) notes they “are a major source of household income in both developed economies and emerging and developing economies. In developed economies, wages represent about 70 to 80 per cent of total pre-tax, post-transfers income for households”. In developing economies, “the contribution of wages to household income is smaller.” Wages can account for 80 percent or more of the income of middle-and upper-income households while social transfers are more important to low-income households in developed countries. In contrast, low-income households rely mostly on self-employment in developing economies. [1]

The persistent decline in the labour share of income, wage stagnation and widening income differentials are signs that the role of wages is changing. In this context, landscape changes may be undermining the role of wages as a lever for the macroeconomy, labour market efficiency and social responsibilities.

  • Macroeconomic role

The central role of wages in the macroeconomy is unmistakeable. Changes in wage levels impacts on production through its effect on costs, prices, competitiveness and profits. Wages are the main source of household income and changes in wage expectations impacts household behaviour, consumption and social stability. Changes in wage levels also impacts on investment through its effects on inflation, asset prices and rates of return. In particular, it is thought worsening income inequality will weaken the multiplier effects of wages because it shifts income from individuals with high propensity to consume (the low-income) to those low propensity (the rich) with deflationary effects.

I would like to frame this perspective differently. The declining labour share of income represents a rewiring of the macroeconomy. The traditional relationships between income, output, labour and capital are being decoupled as the sensitivities of consumption, wages and employment to economic growth falls. Wage stagnation and income inequality operate as a form of demand rationing. The counterpart of declining labour share is the expansion of the share of capital or profits in national income. Corporations have driven economic growth by expanding their profit margins. “This is achieved by reducing the share of physical resource costs (raw materials, capital investments and labour) and increasing the contribution of financial transactions (trading, leveraging and reducing tax payments) to increase the share of profits in income.”[2] Profit, and economic growth, is therefore not driven by capital investment and higher productivity but by reducing tax payments and labour costs (including benefits). The rising profit share is therefore strengthening the relationships between profits, fiscal expenditures and economic growth and increasing the influence of asset prices relative to wages on economic activities. Fiscal stimulus such as tax cuts will have a stronger impact on asset prices, exports and savings[3]. Under these conditions, economies can turn anorexic because it is accompanied by a weakening in private sector (household and corporate) demand. This increases reliance on fiscal stimulus to sustain profit-led economic growth. If governments were to reduce fiscal stimulus, this would lead to a fall in profit share and a rise in labour share with a negative impact on economic growth.

  • Labour market efficiency

Intuitively, wages function as a price to allocate labour and balance supply and demand. In this regard, falling labour participation and wage stagnation are signs that the labour markets are becoming increasingly inefficient. Conversely, the rising profit share of income reflects a situation of excess profits. This is a textbook anomaly because if markets were efficient, excess profits should have been eliminated by rising labour costs.

Another consideration is the dichotomous behaviours in different labour market segments. The top end of the labour market is highly competitive. Philip Cook and Robert Frank[4] explains “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.” In the Winner-Take-All (WTA) segments, the bidding for top talent has kept escalating upwards to the point where talent-based firms (in the past investment banks; and currently football clubs and technology start-ups) became unprofitable.

This is in contrast with the mass market segment where employers seem stubbornly reluctant to bid wages up. It wasn’t always like this. Wages stickiness is a well-known phenomenon but it used to be associated with the inability of wages to go down rather than up. Wages now seem to face difficulty moving up even when economies are recovering and unemployment is falling. It is a moot question as to why can’t wages keep pace with profits. The worsening wage inequality suggest the ability of markets to distribute income evenly has been damaged. This is not only due to labour monopsony but also to information effects such as concentration-fragmentation, modularity, transience, obsolescence, polarisation, commoditisation and autonomy.

The dichotomy in pricing behaviour has indirect implications for talent allocation and public institution cultures. First, there is much criticism that open bidding diverts talent from research, teaching, manufacturing and public service into entertainment, sports and finance. Second, the optics of outsized remuneration and pay-for-performance differentials degrades the status of other similar but lower-paying jobs to the extent of disrupting the traditional middle-class wage structures. Teachers and medical staff in “ordinary” schools and hospitals would feel left behind (and subject to higher risks of job cuts and wage freezes) in comparison with the “talent” in the “top-performing” institutions.

  • Social responsibilities

The constancy of the labour share of income in the past perhaps reflected an equilibrium in income distribution between wages and profit and this underpinned social cohesion. The decline in labour income share thus augurs a rise in social tensions. In this regard, the increasing transformation of wages from long-term employment into an autonomous, transient and unbundled (from benefits and other labour protections) transaction priced on demand has several adverse consequences. The use of incentives for performance and the unbundling of social protection from work erodes the sense of values and relationships. The uncertainty of work and income contradicts our view of work as a basic social good and is thought to have contributed to a decline in household formation and labour participation. Unequal income distribution opens the door to the re-emergence of social stratification and increases the sense of social injustice. Hence, the question of what work and wages is supposed to do for society is an important one.

Hence, wages have a broad role in sustaining macroeconomic growth, ensuring efficient labour allocation and strengthening social cohesion. Essentially, they achieve these objectives by acting as a balancing mechanism between the need for business efficiency and social obligations. The decline in the labour share of income could signify that the ability of wages to effectively fulfil these broad roles is diminishing. This means that the influence of profits in the economies is rising. But can profits replace the broad role of wages in the economy? There are important differences between wage-driven and profit-driven growth.

Profits plays an important role in achieving business efficiency by weeding out operations unable to generate sufficient revenues (demand) to cover their expenses. Profits or returns to capital is generally regarded as the best mechanism to guide the efficient allocation of capital and promote economic growth.

However, profit today is not the same as profit before. The role of profit has been enhanced by information improvements (e.g. accounting standards and disclosures). Over the years, profit has become synonymous with shareholder interests with the consequence that firms have shedded a large part of their social responsibilities in relation to households – such as living standards, risks and future income. Except where businesses may make concessions either because of legal requirements, public pressures or personal beliefs, advocates strongly insist that firms single-mindedly focus on the task of compounding returns to capital.

Profit-driven growth also operates through different channels. Unlike wages which operate through households, profits operate through corporates, markets and the financial industry. They therefore generate different types of cycles. Rising wages generates cost-push inflationary pressures while rising profits generate deflationary effects on aggregate demand which can be offset by growth in debt or financial assets. Profits will also tend to skew the allocation of talent to the activities with the highest revenue potential, cause underinvestment in human capital development and undermine cultures based on equality.

Overall, the discussion on the labour share of income extends well beyond labour bargaining power. It is as much a discussion on the role of profit. Countries that become overly dependent on profits to drive its economic growth will eventually find a widening of social gaps. A tipping point is possibly reached when economies face difficultly in generating private sector growth largely due to weak household income. Perhaps is it time to revive discussions about excess profits and the broader role of profits in relation to the macroeconomy, labour allocation and social responsibilities. From a societal viewpoint, increasing return on capital without increasing the returns to labour makes the goal of pursing profit irrelevant to society. Profits are important to society only to the extent they can ensure a vibrant and cohesive society.


International Labour Organization (2015) “Global wage report 2014/15: Wages and income inequality”.—dgreports/—dcomm/—publ/documents/publication/wcms_324678.pdf

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)”.

Phuah Eng Chye (30 June 2018) “Labour share of income (Part 6: The missing big picture)”.

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society

Robert Frank (1994) “Talent and the Winner-Take-All society”.

[1] ILO 2014/5

[2] Phuah Eng Chye Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.

[3] Lower taxes will improve export competitiveness which increases the current account surplus which, if not reinvested, increases savings.

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

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