Faster Productivity Growth: Who Benefits?

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

Productivity growth is generally understood to be a good thing. An increase in the production of
goods and services that does not require more work raises incomes and is the source of rising
living standards. Productivity growth may vary over time, but improving productivity is widely
taken for granted as a normal characteristic of the U.S. economy. For the nation, faster
productivity growth would be hard to characterize as anything but good. But, while average labor
productivity and average incomes have been rising more rapidly since 1995 than during the
previous 20 years, that may not mean that everyone is reaping benefits from faster productivity
growth. Like current income, productivity gains may also be unequally distributed. If income
gains from productivity are less equally distributed than is current income, productivity growth
could exacerbate inequality.
In theory, increases in labor productivity make it profitable for firms to hire more workers, as
long as they have a market for increases in their production. Other things being equal, this
increase in the demand for labor tends to push wages up. If conditions are such that labor demand
does not increase, say in a shrinking market, then the productivity gains will either accrue to
consumers in the form of lower prices or to the owners of the firm in the form of higher profits.
The rate of growth in real compensation rises and falls with the rate of productivity growth, but
growth in real compensation lags productivity, and the gap between the two increased after 1973.
In part, the difference may be because the available measure of average labor productivity is not
the one theory tells us determines the wage rate. The increase in the gap between productivity
growth and real compensation growth may also be because of labor’s declining bargaining power.
But even given that gap, the rate of increase in real compensation rose significantly along with
productivity growth after 1995. Between 1995 and 2003, the average annual growth rates of both
average labor productivity and real compensation rose by 1.6 percentage points over their rates of
increase between 1973 and 1995. Given that, it would be hard to argue that labor has not
benefitted from the post-1995 acceleration in productivity growth.
However, several studies have shown that labor’s gains from faster productivity growth have not
been equally distributed. In fact, most of the gains in labor income due to faster productivity
growth have gone to those in the upper half of the earnings distribution. One study concluded that
the top 0.1% of the income distribution accounted for as much of the gain in real income between
1997 and 2001 as the bottom 50%. Numerous studies have investigated this phenomenon, which
is referred to in the literature as “skill-biased technical change.” As an example, those workers
who have more education and training are more likely to benefit from the productivity gains
made possible by increased investment in computers and IT equipment.
This report will not be updated.

Introduc tion ..................................................................................................................................... 1
What is Productivity?......................................................................................................................1
The Link Between Productivity and Wages....................................................................................2
Measuring Labor Income................................................................................................................3
Labor’s Share of National Income...................................................................................................4
The Distribution of Labor’s Gains From Faster Productivity Growth............................................9
Conclusion ..................................................................................................................................... 10
Figure 1. Wages and Salaries as a Percentage of Compensation.....................................................4
Figure 2. Fixed Capital per Employee, Private Sector....................................................................5
Figure 3. Labor Share of National Income, BEA............................................................................6
Figure 4. Labor Share of Income, BLS...........................................................................................7
Figure 5. Growth Rates of Compensation and Production..............................................................8
Author Contact Information...........................................................................................................11

Productivity growth is generally understood to be a good thing. An increase in the production of
goods and services that does not require more work raises incomes and is the source of rising
living standards. Productivity growth may vary over time, but improving productivity is widely
taken for granted as a normal characteristic of the U.S. economy.
Overall, economic growth, usually measured as change in gross domestic product (GDP), is
ultimately determined by growth in the labor force and growth in the productivity of labor. Since
1995, as has become widely recognized, productivity has increased at an accelerated rate
compared with the previous 20 years, which means that the economy can now grow more rapidly
than before without risking a faster rate of inflation.
For the nation, faster productivity growth would be hard to characterize as anything but good.
After all, incomes are rising faster and that presents consumers with greater choices. Higher
incomes also have consequences for the federal budget. They, along with progressive income tax
rates, will yield higher tax revenues and reduce the budget deficit.
Although average labor productivity and average incomes are rising more rapidly, it may not
mean that everyone is reaping benefits from faster productivity growth. Like current income,
productivity gains may also be unequally distributed. If income gains from productivity are less
equally distributed than is current income, productivity growth will exacerbate inequality. This
report examines the acceleration in productivity that began in the mid-1990s, and who has reaped
its benefits.

Productivity is a ratio. It is a measure of the quantity of output (goods and services) produced
relative to the amount of work required to produce it. It is expressed as the ratio of inflation-
adjusted output, based on real GDP, to the number of labor hours required to produce that output.
Mathematically, it is expressed this way:
output
pri cesproduct i vi ty =
hours
Measured productivity will rise any time inflation-adjusted output increases more rapidly than
hours. Even with constant output a decline in hours worked would indicate an increase in
productivity, which would reflect an increase in leisure time.
The production of all the goods and services accounted for by GDP yields income to each of the ¹
factors involved, namely labor and capital. Since total income of all factors of production must
equal the value of that production, income can be substituted for output in the previous equation:

¹^T^h^is^dis^c^us^sⁱ^oⁿ^igⁿ^o^r^e^s^la^{nd f}^o^r^pur^pos^e^s^of^sⁱ^m^p^lic^it^y^.

()labor income capit a l i ncome+
p ricesproduct i vi ty =
hours
This equation shows that, since equality must be maintained, an increase in productivity must
result in an increase in either labor or capital income, a decline in the price level, or a decline in
hours worked (an increase in leisure). In theory, any income gains will accrue to the factor
responsible for the productivity gains. If prices fall, then the gains will accrue to consumers of
those goods and services that have become cheaper. Whether income gains accrue to labor or
capital can have an effect on the distribution of income as well. Because wealth is much less
equally distributed than labor income, an increase in the share of income accruing to capital
would be likely to increase the overall inequality in the distribution of income. The following
section discusses the theoretical connection between productivity and labor income.

To understand how productivity growth affects labor income, consider the behavior of an
individual firm. A single firm in a competitive market has little influence and sells its goods at
prevailing prices and hires workers at prevailing wages. Most economic models also make the
assumption that each additional worker hired is less productive than those hired before. In the
jargon of economics, this is referred to as “diminishing marginal productivity.” There are at least
two justifications for that assumption. One, it is in the best interest of a firm to hire the most able
workers first, meaning that each additional worker is less productive; and two, without additional
investment each addition to the labor force reduces the amount of capital per worker.
As long as the contribution to output produced by the last worker hired (i.e., the price of the good
multiplied by the quantity produced per hour) exceeds the cost of his labor (i.e., the hourly
compensation rate), a profit-maximizing firm will continue to hire more workers. As the
productivity of each successive hire declines, the value of the additional production also falls.
Eventually, the value of the goods produced by the last worker hired will be just equal to the cost
of the additional labor. At that point, the profit-maximizing firm will stop hiring more workers.
Now suppose a technological innovation raises the productivity of all the workers at a firm. If
each worker is now able to produce more than before, that will raise the total value of the output
each worker can produce. Now, the value of the production of that last worker hired exceeds the
cost of his labor.
Assuming the firm will continue hiring as long as the value produced by each additional worker is
greater than the additional labor cost, the increase in productivity will increase the firm’s demand
for labor. Hiring more labor is again profitable to the firm. Other things being equal, an increase
in the demand for labor will tend to push up the wage rate. In this way, increases in labor
productivity increase labor income. Once the firm again reaches the point where the cost of
additional labor is more than the value of goods one more worker can produce, it will stop hiring.
There are circumstances where an increase in productivity might not necessarily lead to an
increase in employment. Suppose, for example, that worker productivity rises faster than does
demand for the good those workers produce. Because the supply of the good rises relative to the
demand for it, the price of the good will tend to fall. The fall in the price of the good will offset
the effect of higher productivity on the value of goods produced by workers. If the drop in price

exactly offsets the increase in productivity, there will be no change in the value of each worker’s
production to the firm and there will be no increase in the firm’s demand for labor. In that case,
the firm will neither hire more workers nor will wages increase.
In this case, the benefits of higher productivity will accrue to consumers. Because consumers can
now buy the same quantity of the good with less of their income, they have more to spend on all
of the other goods (and services) they want. That increase in demand will tend to push up the
price of those other goods. When those prices rise, the demand for labor at firms producing those
goods will increase. That will tend to push up both employment and wages at those firms.
There is also the possibility that an increase in productivity will simply increase the profits of the
firm. If there is no possibility for the firm to increase sales, and if wages are inflexible, the firm
may reduce the number of workers it employs and thus reduce its overall labor costs. In that case,
higher productivity will increase the profitability of the firm.
In the short run, prices and wages may be somewhat “sticky” or inflexible. For example, wages
may be slow to respond to changing market conditions because of long-term labor contracts. The
rapidity with which prices and wages respond to changes in productivity will determine, in part,
who gets the benefits. To the extent that prices fall, consumers will benefit. To the extent that
wages rise, workers will benefit. To the extent that neither changes, profits will rise and the
benefits will go to the stockholders. Over the long run, history has shown that prices and wages
tend to respond to changes in supply and demand and that the benefits will be shared.
Capital also contributes to the production of goods and services and earns income for its owners.
The demand for capital is determined in the same way that demand for labor is. Firms will add
capital as long as each new investment yields more in revenue than it costs the firm to use.
Suppose there is an innovation that raises the productivity of a firm’s capital equipment. Just as in
the case of an improvement in the productivity of workers, the value produced by that equipment
rises and so it becomes profitable for the firm to invest in more equipment.
The income of both factors of production is based on the value of their contribution to the total
value of the goods and services produced. But they are interdependent. An increase in the amount
of capital available to each worker is likely to increase his or her productivity, which would tend
to increase the firm’s demand for labor and push up wages.

Most accounts in the popular press regarding labor income refer to wages specifically. But wages
account for only a portion of labor income, and focusing exclusively on wages can be ²
misleading. Compensation is a more comprehensive measure of labor income. Compensation
includes wages and salaries, employer contributions for social insurance, pensions and insurance, ³
profit sharing, and unemployment compensation.

²^W^a^g^e^{s an}^d^sal^a^ri^{es i}ⁿ^t^h^eⁿ^a^tⁱ^oⁿ^a^lⁱⁿ^co^m^e^an^d^p^r^o^d^u^c^t^acco^un^t^s^pub^lⁱ^s^h^e^{d b}^y^t^h^{e Co}^mm^erc^e^Dep^a^rt^men^t^ref^e^{rs t}^o^t^h^e
^m^one^ta^r^y^r^e^m^une^r^a^{tion of}^e^m^ploy^e^e^s^inc^l^uding^c^o^m^m^is^sⁱ^ons^{, tips}^,^bo^nus^e^s^{, a}ⁿ^{d v}^o^l^unta^r^y^em^ploy^{ee c}^ontrⁱ^but^io^ns^to
^c^e^r^ta^{in de}^f^e^r^r^e^{d c}^o^m^p^eⁿ^s^a^{tion pla}ⁿ^s⁽^s^uc^{h a}^s⁴⁰¹⁽^k⁾^plaⁿ^s⁾^.
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⁽^c^onti^nue^d.^..)

Over the long run, wages and salaries have been declining as a share of total compensation. Even
in the short run, variations in wages may not be indicative of variations in compensation because
wages are an incomplete measure of labor income. Figure 1 shows wage and salary income as a
percentage of total compensation since 1929.
As the data make clear, using wages alone as a measure of labor income would be misleading. A
decline in wages is not necessarily indicative of trends in labor income, but may just be part of
the long-term shift in how labor is paid for its services.
Figure 1. Wages and Salaries as a Percentage of Compensation
^Source:^Depart^{ment of Comme}^{rce, Bureau}^{of Economic Analysis}^.

Most discussions of income distribution address what is known as the size distribution of income.
The size distribution of income describes how the incomes of individuals or families are
distributed. The functional distribution of income refers to how income is shared among the
different factors of production, mainly labor and capital. The income for both factors of
production is determined by the quantity employed and the price for their use. Relative income
shares may vary either because of changes in the relative quantities employed or in their prices.
Over the long run, the trend has been for the quantity of capital employed to rise faster than the
quantity of labor. In other words, the capital-labor ratio tends to rise. To understand why, consider

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^pr^o^duc^ti^on.

that output growth is determined by growth in productivity and the labor force. If investment is a
fairly stable share of total output, then the capital stock will grow at the same rate as the economy.
Because the economy is growing faster than the labor force (because of rising labor productivity),
the capital stock will grow more rapidly than the labor force and so the capital-labor ratio will
rise. Figure 2 shows the rise in the capital-labor ratio since 1945.
Figure 2. Fixed Capital per Employee, Private Sector
^Sources:^Depart^{ment of Comm}^{erce, Bureau}^{of Economic Analysi}^{s; Departmen}^{t of Labor, Bu}^reau^{of Labor}
^Statistics.
Because the capital stock has increased relative to labor, it may be presumed that capital’s share
of income has also been increasing. Unfortunately, measuring shares of income accruing to labor
and capital is somewhat complicated.
Published measures of compensation are broadly defined and some may not consider all of the
forms of compensation that are included to be part of their definition of what constitutes “labor
income.” Most of compensation comes from wages and salaries, but it also includes fringe
benefits such as employer contributions for insurance and also the realized value of stock options.
All earnings are included in compensation, from those working for the minimum wage to those at
the top of large corporations.
It would seem easy enough to calculate labor’s share of income by simply dividing labor
compensation by total national income. But in the national income accounts, there is a separate
accounting for the income of proprietors, mostly small business owners. That income is
attributable to both labor and capital. It is important to account for the labor share of proprietor
income because proprietor income has been falling as a share of national income and leaving it
out would lead to an increasing upward bias in the estimated labor share. There is no clear cut

way to identify the labor share of proprietor income, but many studies make the simple ⁴
assumption that it is about two-thirds in order to minimize the bias.
Figure 3 shows estimates of the labor share of income since 1947, using the simplifying
assumption that two-thirds of proprietor income is attributable to labor. This estimate is based on
national income data published by the Bureau of Economic Analysis (BEA) of the Department of
Commerce.
Figure 3. Labor Share of National Income, BEA
^Source:^Depart^{ment of Comme}^{rce, Bureau}^{of Economic Analysis}^.
If there is a discernable trend in these data, it is one of modest increase from the late 1940s to the
early 1970s, but since then the ratio has fluctuated without any clearly discernible trend up or
down. That may seem counterintuitive given the increase in the capital-labor ratio. One reason
this may have occurred is that, as was assumed in the case of labor, there generally are also
diminishing returns to each addition to the capital stock. That would tend to reduce the value of
the output produced by each increment to the capital stock and so push down its share of income.
Another reason why labor’s share might not fall over time is that the characteristics of the labor
force are changing. Education, training, and other labor skills, what economists refer to as ⁵
“human capital,” are continually improving. If this human capital per worker rises more rapidly ⁶
than the physical capital per worker, that could explain an increase in the labor share of income.
As long as wages keep pace with the productivity of labor, and the return to capital keeps pace

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^R^o^w^P^u^blis^he^r^s^{, 19}⁸⁴⁾^,^{pp. 35}^4-³^59.
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³⁶⁰^.

with the productivity of capital, the relative income shares of labor and capital will depend on
changes in the relative growth in labor and capital productivity. If labor productivity rises at the
same rate as capital productivity, then the labor share of income will tend to be fairly stable.
There is another measure of labor’s share of income, published by the Bureau of Labor Statistics
of the Department of Labor (BLS), and it indicates that the labor share of income for the non-
farm business sector has been falling. Figure 4 presents this series (an index with 1992 set equal
to 100). These data suggest that the labor share has been falling steadily since at least the early

1980s, and is now at its lowest point over the entire history of the series.

Figure 4. Labor Share of Income, BLS
^Source:^Depart^{ment of Comme}^{rce, Bureau}^{of Economic Analysis}^.
Which of these two measures is correct? Economists Gomme and Rupert, in a study published by
the Federal Reserve Bank of Cleveland, point out that the BLS series is the only one of the three ⁷
measures of labor’s income share they examine to show a decline. The other two persist around
their historical averages. They also argue that if the share has declined recently it may be due to
the fact that labor’s share is countercyclical. In other words, the labor share of income tends to
fall during economic expansions and rise during contractions. If that is what has happened, then
any decline in the labor share below historical levels is likely to be temporary.
The decline in the BLS measure seems unlikely to be sufficient cause for most economists to
abandon one of the so-called “stylized facts” of economic growth. Economist Nicholas Kaldor, in
a 1958 lecture, presented a list of givens that any economist would have to take into account in
any economic theory. Among them was the observation that the labor share of income had been

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^Dⁱ^s^c^us^sⁱ^on^P^a^pe^r^,ⁿ^o^.^{7, N}^o^v^.²⁰⁰⁴^{, 1}⁰^pp.

relatively constant over time, and not just for the United States but for other countries as well.⁸ A
constant labor share of income is a key assumption of many current macroeconomic models. That
the BLS time series shows it declining may be due to peculiarities of that particular measure or
may be the result of temporary factors.
Another way to approach the question is to compare growth rates in productivity and labor
compensation. Figure 5 shows annual rates of growth for three periods defined by distinctly
different trend rates of growth in productivity. Two things are apparent. First is that after 1973
growth in compensation fell behind growth in labor productivity. Second is that after 1995, both
growth rates increased by the same amount.
Figure 5. Growth Rates of Compensation and Production
^3.⁵
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^pr^o^duc^tⁱ^vⁱ^t^y
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⁰
¹⁹⁴⁸^-¹⁹⁷³¹⁹⁷³^-¹⁹⁹⁵¹⁹⁹⁵^-²⁰⁰⁵
^Sources:^Depart^{ment of Comm}^{erce, Bureau}^{of Economic Analysi}^{s; Departmen}^{t of Labor, Bu}^reau^{of Labor}
^Statistics.
One reason why compensation seems to lag productivity growth may be the result of changes in
labor’s “terms of trade.” In this context, labor’s terms of trade refers to the difference between the
rate of change in the prices of those things workers buy, and the rate of change in the prices of the
things workers make. In other words, worker pay is based on the prices of the goods they
produce, not on the prices of the goods they consume. The compensation growth rates shown in
Figure 5 are adjusted for inflation using a price index for consumer goods and services. The
measure of real output used to calculate productivity is adjusted for inflation using a more
comprehensive price index which reflects not only consumer goods and services but also the
goods and services purchased by government, as well as business investment. If the prices of the
goods workers produce rise more slowly than the prices of the goods they consume, then it is
unlikely that labor income, in real terms, will keep pace with rising productivity.

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Economists Bosworth and Perry suggest that this effect is enough to account for both the
difference between compensation and productivity growth and the increase in the gap between the ⁹
two. They constructed a measure of real compensation based on the same price index used to
calculate productivity and found that measure to follow productivity much more closely.

Since productivity growth and labor income have accelerated, there remains a question of how
those gains have been distributed. How has faster productivity growth affected the size
distribution of income? There are indications that some have benefitted more than others.
A study published by the Federal Reserve Bank of Minneapolis examined the changing ¹⁰
distribution of earnings since 1961. Economists Eckstein and Nagypál found that, for men, there
was a substantial increase in the inequality of the earnings distribution beginning in the mid
1970s. Between 1973 and 1995, the real earnings of men in the bottom 25% of the earnings
distribution fell. Over that same period, the real earnings of men in the top 25% of the distribution
made significant gains. They also found that beginning in 1995, the year productivity growth
picked up, the real earnings of men in the bottom 25% of the distribution began to rise along with
earnings all across the distribution. However the earnings of men at the top of the distribution
grew more rapidly. While the distribution continued to grow more unequal after 1995, the rate of
increase in that inequality slowed. Women’s earnings exhibited similar although less pronounced
changes in inequality.
Economists Dew-Becker and Gordon examined the relationship between labor income and
productivity and concluded that the benefits of productivity growth have been even more ¹¹
unequally distributed than the Eckstein and Nagypál study. Dew-Becker and Gordon looked at
Internal Revenue Service (IRS) income data from 1966 to 2001. They concluded that over that
entire period only the top 10% of the distribution experienced income gains equal to or greater
than the overall rate of productivity growth. Further, they found that the top 1% of the distribution
accounted for 21.6% of the income gains for that period and for 21.3% of the gains between 1997
and 2001, after productivity growth had accelerated. Finally, they found that the top 0.1% of the
distribution received as much of the real rise in earnings as the bottom 50% between 1997 and ¹²

2001.

What explains this increased inequality in the distribution of labor income in a period of faster
productivity growth? Among the candidates that have been suggested are the declining real value
of the minimum wage, increasing globalization, and the decline in unionization of the labor force.

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^p^u^r^ch^asiⁿ^g^p^o^w^{er o}^f^al^l^w^o^rker^s.

But the one factor that most economists consider to be important is the role of technological ¹³
change.
Much of the acceleration in productivity growth that began in 1995 has been attributed to ¹⁴
investment in computers and other information technology (IT) equipment. But even before

1995, investment in computers may have been affecting the distribution of labor income.

Economists Autor, Levy, and Murnane argue that the introduction of computers affected different ¹⁵
jobs in different ways. In the case of jobs involving routine and repetitive tasks computers
served as substitutes for labor and reducing the demand for it and putting downward pressure of
wages. The authors suggest as examples clerks, cashiers, bank tellers, and bookkeepers. In the
case of jobs involving non-routine problem solving, computers serve as complements to labor.
The authors suggest as examples of non-routine problem solving, tasks such as medical
diagnoses, legal research, management, and sales. In the case of these jobs, where computers are
a complement to labor, increased investment in computers increases the demand for labor and
tends to push up wages. Increased use of computers, as both substitutes for and complements to
labor, has tended to increase push wages up at the upper end of the distribution and hold wages
down at the lower end, thus increasing the inequality in the distribution of wages.
Numerous studies have investigated this phenomenon, which is referred to in the literature as
“skill-biased technical change.” Those workers who have more education and training are more
likely to benefit from the productivity gains made possible by increased investment in computers
and IT equipment.

Since 1995, the United States seems to have experienced an acceleration in the trend rate of
growth of productivity. While productivity growth is widely understood to be the means by which
living standards improve, those standards may not be improving at the same rate for everyone.
Some have argued that labor has not been reaping the rewards of faster productivity growth and
that instead those gains have gone to the owners of capital. However, if labor’s share of income is
down, it seems likely to be a short-term phenomenon and not part of any permanent shift in
income shares.
Whether labor’s income share has fallen, however, may be moot insofar as changes in the income
distribution are concerned. Evidence shows that labor’s gains from faster productivity growth
have been concentrated in the upper half of the earnings distribution. For workers at the bottom of
the earnings distribution, whether labor’s overall share of income has fallen is of little
consequence. Their earnings have not kept up with those at the top of the distribution, neither
would they stand to gain much from any increase in the share accruing to the owners of capital.

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