Profits, Employment, and Labor’s Share of National Income

The graph showing the ratio labor compensation to national income serves a couple of purposes. First, let’s begin with a Bloomberg discussion:

Jan. 17 (Bloomberg) – American workers have rarely taken home a smaller share of the nation’s prosperity, a condition that is undermining bipartisan support for free trade and creating friction between President George W. Bush’s administration and the Federal Reserve. After 16 consecutive quarters of economic growth, pay is rising at a slower rate than in any similar expansion since the end of World War II. Companies are paying less of their cash gains in the form of wages and salaries than at any time since the Great Depression, according to government figures … “There is no doubt that something is happening” to reduce labor’s share of income, says Robert Solow, a Nobel Prize- winning economist and professor emeritus at Massachusetts Institute of Technology in Cambridge. An economy that doesn’t distribute its gains widely is “poorly performing,” he says. From the final quarter of 2001 through last year’s third quarter, total compensation paid to employees by corporations, including health benefits, rose at a 4.3 percent average annual rate, according to government figures. That’s the slowest growth for any similar period in post-war expansions lasting at least four years.

Jerry Bowyer might look at the same facts and conclude that this is good news for employment:

Not all jobs are created equal. Some are volatile and speculative, and some are backed by real, existing profits. As it turns out, the jobs created over the last several years are backed by record levels of corporate profit. From 2001 to 2005, we’ve seen a 1.4 percent increase in payroll jobs. But over that same period of time, we’ve seen corporate profits jump from $767 billion to $1.3 trillion — an increase of more than 70 percent. This is in stark contrast to the job boom of the late 1990s, which greatly outpaced the growth of corporate profits. From 1997 to 2000, corporate profits actually decreased from $868 billion to $817 billion, a drop of almost 6 percent. Over that same time period, payroll jobs increased from 122 million to 131 million – a jump of 7.4 percent. Profits were dropping, but corporations kept hiring new workers anyway. It follows that since today’s jobs are backed by rapidly growing profits, they should be more stable than the ones created in the late 1990s.

Did I say the same facts? My mistake – as corporate profits represent a subset of the profits from American businesses. So there could be several explanations of differences in the growth of corporate profits and payroll employment growth. Our chart, however, looks at overall national income, which is roughly divided between labor income and capital income. It does show that profits have been growing faster than national income, which is the flip side of the declining labor share.
Bowyer wants us to believe that the share of income going to capital income must grow before we see sustained employment growth. We should note, however, that the two periods where the capital share fell – the late 1990’s and the late 1970’s – also saw much higher employment growth than we have seen over the past five years.

Bowyer also offers us no microeconomic or macroeconomic reason to believe that rising profits are necessary for increasing employment growth. Let’s toss a few counterexamples – two from the macroeconomics that Solow is referring to and one from microeconomics. The first macroeconomic counterexample comes from the premise that weak aggregate demand tends to depress wages, which was discussed in the Bloomberg article. The second macroeconomic counterexample comes from long-run economic growth considerations (as in Solow’s writings from the late 1950’s). The fact that national savings and investment have been crowded-out by Bush’s fiscal irresponsibility, the capital-labor ratio would tend to fall, which means less real wage growth and a higher return to the capital stock. The impact on the labor share depends on the elasticity of substitution. If this elasticity of substitution is less than unity, a lower savings rate would suggest a falling labor share over the long-run.

The microeconomic counterexample comes from the comparison of labor demand under competition versus monopsony. Competitive firms hire labor up to the point where the value of labor’s marginal product equals the competitive wage rate. The accounting profits for these entities will cover only the opportunity cost of capital with no economic profit. If these firms, however, can create a monopsony cartel, they could extract economic profits by curtailing employment.