8-2:  Shares of the Income Pie

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How Factor Income Shares Are Determined

Labour income is, of course, only one component of Net Domestic Income (NDI).  Of the other three major components, corporate and government enterprise profits, proprietors' income and investment income, profits are the most sensitive to the demand cycle.  Chart 8-5 illustrates the fluctuations of labour income, profits and investment income as percentages of total NDI since 1981.  (Proprietors’ income, which accounted for about 8% of NDI, was relatively stable, and is not illustrated.)  The profit share and the labour share both fluctuated sharply during the period, largely at each other's expense.  On average, the labour share is five times as large as the profit share (labour income has averaged about 70% of NDI since 1981, profits have averaged 14%).  Since the labour share rises sharply in recessions (e.g. 1982, 1991) and falls sharply in booms, the result is an absolutely huge proportional swing in profits.  In other words, although the rate of increase of real wages remains relatively steady during the business cycle, labour income and profit shares do not.  (See also Chart 8-7, below).


In the 1980s, investment income averaged almost 11% of NDI; since 2000, it has averaged only 6%.  Two developments account for the decline.  First, government debt grew very rapidly in the 1980s and early 1990s, much faster than GDP, then began to shrink.  Second, nominal interest rates, influenced strongly by reduced inflation expectations, have fallen sharply.  In the 80s, the combination of rapidly rising debt with relatively high rates of interest escalated the investment income share to a range which was high by historical standards.  The great loser from this was, of course, the taxpayer, who has to service the debt.  (But the situation is complex, because the household sector has also been the chief buyer of the government’s debt, and in this role has evidently benefited from the situation.) The enterprise sector was made unreservedly worse off by high interest rates, because it is not only a taxpayer but also a net borrower.  High interest rates hit enterprises, especially highly-leveraged ones, very hard.  In the last decade, on the other hand, the relatively low interest rates have been a major boon to borrowers, and the corporate profit share of NDI has increased accordingly.  The declining share of investment income in NDI, while a major boon to the enterprise sector and its shareholders and to young homeowners with mortgages, has been difficult to cope with for individuals such as retirees who depend on investments for much of their income.

How Factor Income Shares Vary Over The Business Cycle

Here is a brief summary of income-side events during a typical "business cycle."  Let’s suppose that aggregate demand begins to fall for some reason.  GDP and NDI both drop.  In the short run, since firms have relatively fixed costs, especially for labour and interest on debt,  corporate profits drop sharply.   Enterprises respond, not so much by cutting the real wage they offer as by letting people go (Chart 8-6).  As employment drops, some workers begin to drop out of the labour force, but not as quickly as jobs disappear, so the unemployment rate goes up.  Despite this, labour income rises to its highest share of NDI during these recessionary episodes.  The reason for this is that the real wage remains relatively stable, and employment drops less rapidly than output.  In other words, profits take most of the strain of response to falling demand, which permits the labour share (of the shrinking pie) to rise. 



When aggregate demand picks up again, things work more or less in reverse.  Profits rise very quickly, being highly sensitive to the upshift in output.  More slowly, employment growth begins to pick up; the real wage does not rise much if at all.  Labour force growth speeds up in turn, in response to better perceived employment opportunities.  This tends to keep the unemployment rate from falling rapidly, but it does gradually fall.



Implications for corporate planners are clear: the inflexibility of labour market conditions makes profitability extremely sensitive to fluctuations in demand.  Firms thus do well to plan for an entire business cycle at a time, forming strategies to deal with contingencies and unexpected shocks and, even more important, anticipating monetary and fiscal policy measures that may from time to time impose severe trading conditions in the course of enforcing inflation or debt management targets.

Although it is not easy to adopt this medium-term perspective, it is extremely important to plan with the entire cycle in view.  By the time events are becoming obvious, it is usually too late to take the most effective action.

Why Real Wages Are Unresponsive To Business Conditions

Let's suppose that the unemployment rate is high.  Let's suppose that there is a group of unemployed workers who are desperate for work, and they are indeed willing to work for less than the going real wage.  In other words they would accept whatever nominal or real wage it takes to get a job.  Unfortunately for them, from the employer's point of view, this may not be as easy to implement as it sounds.  To reduce the real wage for the new hire may mean doing the same for all the current workers as well.  In other words, there is typically a pretty fixed proportionality between all the job rates in the firm, depending on the skill and experience required and so on.  But the current workers will strongly resist a cut in their real wages, since they are still employed.  And if there is a union involved, it can be even more difficult to change the wage offer, not only because of their organized resistance but also because the current collective bargaining agreement may have a number of years to run.  In the meantime, neither the firm nor an individual worker can really make a deal to work for less.  So, even though there may be plenty of people willing and able to do the job for less, they may not be able to make themselves attractive enough to hire, at least, not in the short run -- and the short run can be pretty long.

Sometimes there can be a problem in the labour market because the two sides have different inflation expectations.  Suppose firms observe that the prices of their products are falling, and that this leads them to reduce their inflation expectations for future periods.  From their point of view, it would be reasonable to offer a lower nominal wage.  But the workers' own inflation expectations probably reflect a very broad range of consumer prices, for example, those measured by the Consumer Price Index.  If the CPI as a whole has continued to rise, then the workers will not be willing to settle for a lower nominal wage, because for them it will imply a lower real wage than it does to the firm.  The difference in the two sides' inflation expectations can lead to bargaining problems.  If they cannot agree, layoffs can result.

For these reasons and more, what we actually observe in the labour market is a high degree of stickiness in the real wage, and thus considerable volatility in the level of employment.  But chart 8-4, "Inflation and Labour Compensation", shows that the stability of the real wage does not come about because the nominal wage or the price level are stable.  Far from it.  We have had dramatic swings in price inflation, but they have been matched by the swings in wage inflation.  So it appears that workers have not been able or willing to use the real wage as a tool to stay employed in bad times.

Some people might describe this as a pathological situation, because of the severity of the costs imposed on those who are unemployed against their will.  You might think that it should be relatively easy for people to remedy the situation simply by offering to work for less.  But the evidence shows that this has not worked out very successfully in practice. In fact, far from going down, the real wage went up, of all things, in the recession year 1991.  What seems to have happened was that the drop in inflation that year caught bargainers by surprise.  Wage agreements that had been bargained in previous periods (and reflected relatively high inflation expectations) were still in effect, producing high nominal wage gains and therefore, much higher real wage increases than had been anticipated by either side. 

In the end, we have to agree that Keynes put his finger on a hugely important fact of life, namely that wages are "sticky" and that unemployment can be a highly persistent reality.  Keynes, in the 1930s, argued that in such circumstances it would be appropriate to increase government spending or transfers, or cut taxes, to stimulate aggregate demand.  Some followers of Keynes in the 1950s and 1960s, dismissing inflation as a minor issue, encouraged policymakers to stimulate aggregate demand even beyond potential, which resulted in major inflation in the 1970s and 1980s.  In turn,  central banks reacted by bringing about major output gaps to reduce inflation, even though they recognized that this would generate unemployment.  At this time, policymakers appear to have few effective means for reducing the volatility of employment, except to the extent that they can achieve a more stable growth rate for output itself.

This discussion has not dealt with the many causes of secular unemployment, that is, unemployment that arises for reasons unrelated to the demand cycle as such.  Issues such as skill obsolescence, long distances between labour markets, and the generosity of transfers to the unemployed are highly important micro-economic concerns, but cannot be dealt with here.

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