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Growing wage dispersion increases income inequality

Carlos Mulas-Granados. Professor of Applied Economics at the Computense University

In the past five years, concerns about increasing income inequality have been at the centre of economic policy debates. There is one area though that has remained relatively unexplored. This is the area that deals with the relationship between the labour share of income and personal income inequality. Income inequality refers to the personal distribution of income, and the labour share refers to the remuneration of employees in total factor income (value added) in a given year. When one looks at these two series, the visual impact is striking. For example, between 1970 and 2012 the labour share in G7 countries declined on average by 12 percent while income inequality increased by 25 percent.

The analysis of factor shares (labour and capital) of national income was considered the principal problem of political economy by classic economists like David Ricardo. Up until the 1960s, this topic was given great pre-eminence in economic textbooks and academic research. When Kaldor famously summarized the long-term properties of economic growth in the 1960s, he stated that the shares of national income received by labour and capital were roughly constant over long periods of time. The analysis of factor income shares was the subject of ninety percent of the papers presented at the conference of the International Economic Association in 1965. The dominant theme was that factor shares were important for the macroeconomic performance of economies, as they were linked to the potential problem of profits squeeze or real wages growing above productivity.

However, since the 1970s the analysis of factor shares has no longer been at the centre of economic debates, given their lack of volatility and reflecting the fact that the division of income could be easily explained by a Cobb-Douglas production function. Those concerned with personal income distribution started to emphasize that there was no direct (or mechanical) link between factors shares and inequality, and that differences in personal income were related to differences in educational attainment.

Citizens are not benefiting from the economic expansion

In addition, a broader spectrum of everyone was starting to enjoy some kind of capital income. As home ownership, financial assets holdings and capital-funded pensions expanded in advanced economies between 1970 and 1990, the division into (pure) workers receiving only wages and (pure) capitalists/landlords receiving only profits/rents became blurred, thus contributing to the decline in attention paid to this theme.

However, the interest in the analysis of factor shares returned in the early 2000s. Atkinson cited in 2009 three reasons to explain this renovated attention: first, the analysis of factor shares was useful to understand the link between incomes at the macroeconomic level (national accounts) and incomes at the individual/household level; second, factor shares could potentially help explain inequality in the personal income (at least partly, if certain types of income were mainly received by some type of economic agents); and last but not least, they addressed the concern of social justice with the fairness of different sources of income.

Initially, researchers returning to work in this area focused on explaining the shifts in the labour share, its gradual but constant decline and the relationship between wages and productivity. The perception that citizens were not fully enjoying the fruits of the long period of economic expansion of the late 1990s and early 2000s also attracted the attention of national policy-makers and international organisations.

In 2006 Ben Bernanke, the Fed's Chairman expressed the hope that "corporations would use some of those profit margins to meet demands from workers for higher wages" and in 2007, Germany's finance minister asked European companies to "give a fairer share of their soaring profits." The IMF, the European Commission, the Bank of International Settlements and the OECD all published reports in the mid 2000s that documented the decline in the labour share of income and provided several explanations of this trend, mainly linked to the impact of globalisation and technological change on labour skills, international capital mobility, and wage bargaining. The interest in this field returned after the financial crisis, because the decline in the labour share of income and the sharp increase in personal income inequality ran in parallel and this led many analysts to think that they were strongly correlated.

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