Recent Declines in Labor's Share in US Income: A Preliminary Neoclassical Account

Lawrence, Robert, "Recent Declines in Labor's Share in US Income: A Preliminary Neoclassical Account,"NEBR, June 2015. Available at:http://www.iie.com/publications/interstitial.cfm

"....despite a rise in measured capital-labor ratios, labor-augmenting technical change in the United States has been sufficiently rapid that effective capital-labor ratios have actually fallen in the sectors and industries that account for the largest portion of the declining labor share in income since 1980.In combination with estimates that corroborate the consensus in the literature that is less than 1, these declines in the effective capital-labor ratio can account for much of the recent fall in labor’s share in US income at both the aggregate and industry level. Paradoxically, these results also suggest that increased capital formation, ideally achieved through a progressive consumption tax, would raise labor’s share in income....It is quite possible that improvements in equipment and software could increase the marginal product of labor by more than they increase the marginal product of capital and thus induce a decline in the effective capital-labor ratio used to produce a given quantity of output. It is also paradoxical to think that enhancing labor’s productivity could reduce labor’s share in income and reduce W/R ratios. This finding should not be surprisingonce it is recognized that technical change that doubles each worker’s productivity is equivalent to doubling the number of workers in the labor force.Just as in the face of inelastic demand an increase in the supply of a product could reduce its price by enough to reduce total revenue, so, too,an increase in the effective labor-capital ratio could reduce labor’s share in income, and even wages per worker, when labor and capital are not easily substituted.In the Hicks terminology, labor-augmenting technical change, which at the margin encourages the use of labor rather than capital, is termed “capital saving.” Thus another implication of labor-augmenting technical change is that less capital is required to produce a given amount of output. This implies that if output is constrained by inadequate demand, for example, investment would be weaker. The conventional wisdom is that there have been huge breakthroughs in IT that might have been expected to lead to unusually strong investment. Yet investment has been weak. This could be part of the explanation. The issue of whether capital and labor are gross complements or substitutes is crucial for determining the impact of measures that seek to aff ect the functional distribution of income.The leading proponent of these factors as substitutes, Thomas Piketty (2014), argues that to address a development that he regards as inequitable, governments should slow capital formation by imposing higher taxes on capital and wealth.This paper suggests that such measures could be counterproductive and actually reduce labor’s share in income by further lowering the eff ective capital-labor ratio. The evidence presented here corroborates the findings of many others in concluding that in the United States the elasticity of substitution between capital and labor is less than 1. Given this low elasticity, the cause of labor’s recent falling share is the weakness of investment in the face of faster labor-augmenting technical change rather than more capital deepening. This finding suggests that measures that boost investment and capital formation would lead to higher wages, raise labor’s share in income, and reduce income inequality...."