Comparing Labor and Capital incomes (Past and Present)

Labor and capital both receive income. How do labor and capital consume products or contribute to savings differently? How have these differences changed over the years? What can we learn from the changes?

To answer these questions, I made a model based on the circular flow of the economy, where I separated labor income from capital income. Then using the official data for the National Income Accounts and other key pieces of data, I deduced the differences between labor income and capital income. Capital income refers to corporate profits and income received from capital ownership. Capital income has a primary function to be invested in maintaining and increasing the productive capacity of capital. Labor income refers to income received by people working. Labor income has a primary function to consume finished goods and services.

In the model, GDI (gross domestic income) starts flowing from firms and is paid to labor and to capital. But how does labor use its money? How does capital use its money?

I divided the use of the income into the standard variables of the national income equation…

  1. Consumption on finished goods and services,
  2. Net taxes,
  3. Saving for economy,
  4. Imports and Exports.

As the income flows through the economy, the financial sector is key through its lending and borrowing to turn net taxes into government spending, saving into investment and imports and exports into net exports. As the national income reaches firms in the form of consumption, government spending, investment and net exports, the result is gross domestic product, GDP. GDP is the product produced for consumption, government spending, investment and net exports.

This model shows an equilibrium state for the economy for one specified quarter in time. All numbers are balanced so that the beginning out-going gross domestic income for that quarter equals the money received by firms for their gross domestic product. In reality, the economy is dynamic, where the final GDP will be different than the beginning GDI. However, reducing the economy to an equilibrium model simulates a snapshot in time and allows the differences between labor and capital to be better determined.

Steps to setting up the circular flow model involved…

  • Getting an accounting format to incorporate all variables.
  • Getting the numbers for national accounts. (source)
  • Getting the effective tax rate for capital income. (source)
  • Government net borrowing/lending as a % of GDP. (source)
  • Getting the effective labor share of national income using my research into effective demand. Effective labor share determines effective demand limit upon real GDP.

I made two assumptions in the deduction process…

  • Capital’s consumption is 25% more likely than labor income to purchase imports. The reasoning is that capital money is able to purchase luxury items from abroad which cost more. Also, capital income has more ties to foreign countries. 25% as compared to 0% does not make much difference in the final numbers, but a set percentage improves comparison between years. If research is found that compares capital’s propensity to import as compared to labor’s propensity, then those numbers will be factored in.
  • Personal saving rate applies directly to labor income. This model uses effective labor income to determine the part of labor income that establishes the effective demand limit on the economy. I did not attempt to adjust the personal saving rate into an effective personal saving rate for effective labor income. I just kept the official personal saving rate as a commonly accepted rate for household income, as opposed to domestic business income.

The following models seek to give perspective on the economy. They provide an overall view in the bottom half where labor and capital income combine into national aggregate numbers. The models also provide a focused view of the differences between labor and capital incomes in the top half.

Let’s start by looking at 1985… (all dollar values are in real 2009 dollars in order to compare different years.) (The yellow highlighted boxes are marginal propensity to consume (MPC) and marginal propensity to save without imports (MPC) in relation to disposable income. Disposable income = Income – net taxes.)

CF 85-1Q
Graph of 1985

Some numbers to highlight…

  • 8.8% was the personal saving rate.
  • 4.8% government deficit as percentage of GDP.
  • Marginal propensity to consume (MPC) of 91.2% for labor income. (MPC applies to labor income minus labor net taxes.)
  • $446 billion for labor saving. (The $968 billion under labor saving includes labor saving plus the saving created by import dollars. The import dollars do not belong to labor but are created by labor’s consumption of imports. The same applies to capital saving.)
  • Keep note of the effective tax rate of Capital. In 1985 it was 33%.

Now we jump to 1995…

CF 95-1Q
Graph of 1995

A few highlights…

  • MPC of labor increased.
  • Imports are increasing as a percentage of GDP.
  • Government deficit has decreased.
  • Personal saving rate has decreased to 7.1%.
  • Capital was still using about 6% to 7% of its total income for consumption.
  • Capital’s effective tax rate was still over 30%.
  • Labor’s saving rate declined from 7.4% to 6.0% of total income.
  • Investment was still running 15.0% to 15.5% of GDP. Investment is non-governmental domestic investment. (In the early 1970s and 1960s, government spending was around 30% of real GDP. By 1995, the government was spending 22% of real GDP. Private domestic investment rose from 12% to 15% over that same period. The implication is that the government did more investing in productive capacity back in the 1970s and 1960s than in recent decades.)

Now we jump to the 1st quarter of this year, 2013…

CF 13-1Q
Graph of 2013

A few highlights…

  • Labor is actually saving less than it did in 1985 in real dollar terms, $409 billion as opposed to $446 billion, in spite of real GDP being more than double.
  • Capital income has increased its percentage of consumption from around 7% in 1985 to 20% now. That indicates that ownership of capital is currently producing more income in excess of what is needed for saving and domestic investment.
  • Net taxes on capital have fallen from over 30% in the past to around 15% now. This has allowed capital income to increase its percentage of both consumption and saving over time.
  • Savings rate for personal income has dropped to 3.6% of total income in spite of a lower effective tax rate. On the other hand, capital’s percentage of saving to total income has risen to 65.3%.
  • Labor is now having to use over 85% of its income for consumption, as opposed to 76% to 78% in the past. This indicates that labor is liquidity constrained for consumption, and that their income has not kept pace with prices.
  • Imports as a percentage of GDP continue to increase.
  • Investment has increased a little since 1995 going to 15.8% of real GDP.
  • Total net taxes used to be around 19% of real GDP before 1995. By 2013, it had dropped to 12.1%.
  • From 1995 to 2013, total real effective capital income increased by 99% going from %2,052 billion to $4,078 billion. On the other hand, total real effective labor income only increased 42% going from $8,090 billion to $11,521 billion.

The graphs above reveal a story of how financial power has shifted in favor of capital income.

Is there an unhealthy imbalance in the economy when capital income increases its consumption as a percent of total income from 7% to 20%? Has capital income risen beyond healthy levels for society as a whole?

Other years for reference…

link to 2006.

link to 1980.

link to 1970.

In 1970, labor income was very strong. Labor seemed to provide the savings for investment.

ling to 1960.