MICHAEL KEATING- Wages, Profits and Economic Growth.

Feb 28, 2018

This article summarises the analysis in a new book, Fair Share: Competing Claims and Australia’s Economic Future, which examines the interrelationship between the stagnant economic growth experienced by most developed countries over the last decade and the increasing inequality in the distribution of income.

In the last decade since the Global Financial Crisis (GFC) economic growth has been very slow and halting – averaging less than half the previous annual average rates of growth for the developed countries. Although, global economic prospects seem to be improving over the last 12 months, in its most recent Economic Outlook the OECD still concluded that the current recovery ‘remains modest compared to past recoveries’, with per capita economic growth well short of pre-crisis norms.

In our book, Fair Share: Competing Claims and Australia’s Economic Future, which is to be released next week, Stephen Bell and I argue that the fundamental problem has been the continuing stagnation of aggregate demand across the developed economies. This stands in stark contrast to the previous ruling orthodoxy, that over the medium term the growth of economic output (i.e. potential output) would be determined almost exclusively by the supply side of the economy. That is to say, economic growth was thought to be determined solely by the rates of growth of population, productivity and employment participation. Accordingly, stabilisation policies to manage fluctuations in aggregate demand were considered to play no role in determining the rate of economic growth over the medium term.

However, the learning experience for policymakers over this last decade has instead been that in present circumstances intervention by governments is necessary to support aggregate demand. Government budget deficits have generally increased, with public debt now running at unprecedented levels, but in many cases, this fiscal stimulus was little more than an automatic response to lower levels of economic activity which reduced tax receipts and increased welfare payments. Instead, the principal policy response in many countries was first to lower interest rates and when interest rates fell to zero, and could not be lowered further, some extraordinary monetary policies, known as quantitative easing, were tried.

The underlying presumption was that very low-interest rates and an increase in the money supply would lead to an increase in asset values and in investment, which would then underpin economic recovery. But firms don’t invest if they cannot see a demand for their products. Instead, the main response to lower borrowing costs was an increase in the value of financial assets, but little increase in real investment and economic capacity. Furthermore, it is highly probable that there would be exactly the same response to a company tax cut, and for the same reasons.

Indeed, as Bell and I show in Fair Share, corporate profit rates have never been higher in most of the advanced economies, but whereas corporates used to be net borrowers they are now net lenders.  For example, in the US there has been a distinct reduction in the share of profits allocated to investment since 2000 and a concurrent increase in the allocation of profits going to dividends and share buybacks and investment in financial assets. In fact, since 2013 S&P companies (in the US) have spent more of their operating cash flow on share buybacks than real capital expenditures, while the reverse was true in the pre GFC period; the difference averaging 10 percentage points. And most recently, in the first six weeks of this year in response to the Trump tax cuts, US companies have announced a record $171 billion of share buybacks; more than double the $76 billion announced by the same time last year. The general consensus of expert opinion is that this switch to share buy-backs is largely (although not entirely) indicative of a lack of worthwhile investment projects, and this is likely to continue while aggregate demand remains depressed.

It is true that after a decade the US is at last now approaching full-employment again (albeit with lower participation), but this largely reflects the extent to which inadequate demand has slowed the underlying rate of productivity growth.  First, investment has been held back, slowing the rate of increase in capital per worker, as well as reducing the scope for introducing new technologies and realizing further economies of scale. Second, workforce skills have atrophied as many workers have experienced long-term unemployment. Thus the return to full employment in the US mainly reflects a decline in productivity and relatively low participation rates, rather than a return to normal rates of economic growth.

In short, an investment-led economic recovery is highly unlikely while the growth of aggregate demand remains sluggish. Instead, most governments are now looking for other ways to stimulate aggregate demand, and increasingly it is being recognised that rising inequality is the prime cause of the continuing economic stagnation. The fundamental problem is that higher income earners have a lower propensity to consume, than low-income earners, and this is the main reason why increasing inequality has led to a shortfall in aggregate demand. This, in turn, is why there have been calls for a faster rate of increase in wages, especially for low-income households which are most dependent on their wage incomes. For example, the Governor of the Reserve Bank, Philip Lowe, is on record as saying: ‘The crisis is really in real wage growth’.

Many of those now calling for a faster rate of wage growth have (understandably) sought to link this with a decline in the power of trade unions. On this basis, they have argued for changes in the industrial relations system to strengthen the capacity of trade unions to deliver wage increases, and for workers to push harder for a decent pay rise (see for example, Ross Gittins, Canberra Times, 19 February, 2108).

However, the reasons for increasing inequality are much more complex and varied than this simple explanation of a decline in trade union power. We need to understand these reasons better and only then design the policy response. In Fair Share Bell and I explore in detail, the changes in income distribution, their drivers, and their impact on economic growth, and the following summary of that analysis is provided here.

In brief, increased income inequality for the working population can arise from either a shift in the capital/labour income split in favour of profits, or a shift in the distribution of wage earnings. And a shift in the distribution of wage earnings can reflect either a shift in the job structure or a shift in relative pay rates, or a combination of the two. Thus, there are three main drivers of changes in the distribution of private incomes, and each of these will be considered below. But it is important to note at the outset, that the appropriate policy response depends upon which element of incomes has changed and why.

The capital/labour income split

In many countries over the last three decades or so, there has been a shift in the distribution of national income in favour of capital and a concomitant downward shift in the share of wages. It is this decline in the wage-share that Keynesian political economists have focussed on and is the basis for their demands for government intervention to support ‘wage-led’ economic growth.

Such a shift in the distribution in favour of capital is, however, less apparent for Australia. The Treasury (2017: 38) finds that ‘The labour share of income has been broadly unchanged since the early 1990s’. However, this analysis is complicated by shifts in the terms of trade, which can be quite large for a commodity exporter like Australia.

In Fair Share, Bell and I also find that ‘over the long term the rate of real wage growth has broadly matched the rate of increase in labour productivity’, and that the wage and capital shares were in equilibrium around 1993. During the next decade, however, the wage share declined, and this probably contributed to the increase in inequality in those years. On the other hand, this position was reversed during the resources boom, when real wages increased faster than labour productivity, although not as fast as the increase in real national disposable income which was buoyed up by the improvement in the terms of trade.  Since the peak of the resources boom in 2011-12 the terms of trade have declined and accordingly real national disposable income has also declined, and it was therefore appropriate that wages rose less fast than labour productivity. However, our judgement in Fair Share is that by the end of 2016 equilibrium had been restored to the wage and capital shares in Australia, and from there on it would be a concern if wages did not keep pace with the increase in labour productivity.

Inequality in the distribution of earnings

In all countries the decline in the wage share is not, however, the principal cause of increasing inequality. Most of the rise in inequality is due to an increase in the inequality of the earnings distribution, and this is not affected by the share of capital.

The US is probably the stand-out exemplar of inequality and its increase over the last few decades. Most of the US wage growth has been concentrated in the top of the wage distribution and the real wages of the lower six deciles in the wages distribution actually declined. Indeed, Stiglitz reported in 2015 that ‘the typical American man makes less than he did 45 years ago (after adjusting for inflation)’ – so much for the American dream that if you work hard you will get ahead.

On the other hand, the evidence reported in Fair Share shows that relative wage rates have largely remained stable in Australia over the years. The increased dispersion in the distribution of earnings in Australia mainly reflects a changing job structure. Most importantly technological change has reduced the number of middle-level routine jobs, while creating more skilled jobs and leaving unskilled jobs relatively unaffected.  This hollowing out of middle level jobs inevitably shows up as an increase in earnings inequality, even if there is no change in relative wage rates.

This stability in Australian relative wage rates over the last 3-4 decades is in stark contrast to the US. The reason seems to be that Australia has increased investment in its education system and successfully increased the supply of skills in line with demand.  Consequently, the wage premium for an Australian university degree has not changed much over time. By contrast, in the US, where the supply of skills has not risen much, the wage premium for a university degree has roughly doubled, and this shift in relative wage rates has further exacerbated US inequality.

Although technological change explains most of the increase in dispersion of earnings, the earnings of the top 1 or 2 percent of the workforce represent a partial exception. It is these incomes that have increased most, not only in Australia, but also in many other countries, and particularly the English-speaking countries. This increase in earnings at the top probably reflects the impact of financialisation, where senior managers’ remuneration is increasingly tied to asset values, which in turn are driven up by the very high rates of share buy-backs that these same senior managers pursue.

Reducing inequality: the policy response

Australia has been fortunate in that inequality appears to have increased less here than in most of the other advanced economies of the OECD.  This is probably why Australia has done well in sustaining aggregate demand in the past and would help explain why Australia avoided recession over the last 26 years. Nevertheless, Australia faces an immediate policy challenge to maintain sufficient growth in aggregate demand in the future by ensuring that real wages continue to increase in line with productivity. Although Australia’s track record in this regard has so far been satisfactory, given the experience of many other advanced economies, this correspondence between productivity and wage growth cannot be taken for granted.

The trade union movement can play a useful role in achieving this necessary increase in wage incomes in line with productivity growth. However, it is doubtful whether strengthening the power of trade unions would really help much in reversing the increase in inequality and preventing any further such increase.  The remuneration arrangements that have underpinned the huge increases in pay for senior executives are unlikely to be affected by trade unions. Even more importantly, it is difficult to envisage how increased trade union power could influence future technological progress, except to slow it, and that would only damage Australia’s competitiveness and future growth prospects.

Instead, the principal challenge for governments is to ensure that technological change is compatible with maintaining full employment. Fundamentally the most important reform will be to develop the capabilities of the workforce so that employees are better able to adopt and adjust to future technological change. The focus of future economic reform should therefore be on increasing and improving skills and training. A more skilled workforce, which can then earn higher wages, will help resist the tendency to stagnating demand. It will also increase Australia’s potential supply and raise productivity which must provide the basis for sustained economic growth.

In addition, for those whose jobs are most at risk in the future, Australia needs to increase the number and quality of places funded under active labour market programs and VET programs to improve their skills and help them retrain for the new jobs that will become available. In short, in responding to future structural change, Australia would be well served by moving towards something like the Danish ‘Flexisecurity System’, which combines a highly flexible labour market with expenditure on active labour market programs equivalent to as much as 1.9 per cent of GDP; a rate of expenditure which compares with around 0.3 per cent of GDP in Australia. Finally, to assist those, who, for whatever reason, cannot take advantage of the reforms just suggested, some increase in the social wage or in direct income support may be needed to achieve a distribution of income consistent with sustained economic growth.


Bell, S. & Keating, M. 2018, Fair Share: Competing Claims and Australia’s Economic Future, Melbourne University Press, Melbourne. Available in book stores from 1 March.

The Treasury, 2017, Analysis of Wage Growth, Commonwealth of Australia.

Michael Keating, AC is a former Head of the Departments of Prime Minister & Cabinet, Finance and Employment and Industrial Relations. He is presently a Visiting Fellow at the Australian National University.

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