Monday, 23 May 2016

Capital shares and income inequality in the long run

Is there any relationship between the distribution of national income between capital and labour – factor shares, functional income distribution – and income inequality in terms of personal income distribution?

Very broadly, there are two types of income distribution. So-called functional income distribution concerns the distribution of national income between classes, according to income types: employees, capital owners, and maybe the self-employed as a group of its own. The more commonly used definition is personal income distribution: the distribution of incomes between individuals, no matter the type of income. This distribution may be measured by Gini coefficients, top income shares or some other measure. Functional income distribution is measured by wage shares and capital shares of national income.

This blog post was written by
Erik Bengtsson, post doctoral
researcher at Lund University
There is certainly no agreement about the relationship between distributional and functional income in the literature. The latest major formulation of the argument that functional income distribution does affect the personal income distribution has been made by Thomas Piketty (2014) in his book Capital in the Twenty-First Century. Piketty argues that inequality of income from capital is higher than inequality of labor income, and thus when capital incomes increase relative to labor incomes, total income inequality increases. On the other hand, critics of the book have argued that the distribution between wage shares and capital shares is an old-fashioned thing (for example Lindert 2014, p. 5) and that the key aspect of inequality is really the distribution of wages.



Daniel Waldenström is
professor in Economics at
Uppsala University
In our EHES paper (No. 92) “Capital Shares and Income Inequality: Evidence from the Long Run”, Daniel Waldenström and I set out to test the two contrasting hypotheses – that an increase in the capital share implies an increase in personal income inequality, or it does not – with historical data. While Piketty and Zucman (2014) present long-run data (further back than 1950) for Britain, France, Germany and the US building on work by themselves as well as other economic historians, we work with the historical national accounts literatures to construct comparable and workable capital shares series going back to at least to the 1930s for 19 countries. We use factor shares adjusted for the incomes of the self-employed and have now got gross and net capital shares, i.e. controlling for capital depreciation for 15 of the 19 countries. (In the published WP we only had both measures for 7 of the countries.)

We use our data to look for common trends, asking questions such as if other countries experienced periods akin to the “Engels’ Pause” found by Allen (2009) for Britain in the early industrialization period or if most countries exhibit wage moderation in the postwar period as argued by for example Eichengreen (2007). But our main focus is not on the movements of capital shares per se, but rather their relationship with personal income inequality, measured especially with top income shares but also, as robustness checks, with Gini coefficients.

Our empirical assessment of the link between capital shares and top income shares is based on panel regressions. Our main focus is the unconditional correlation between the capital share and personal income inequality, so in our main estimations we do not include control variables. (We do include country fixed effects in the panel setting.) In further estimations we include control variables such as GDP per capita, employment share in agriculture, stock market capitalization, and central government spending. We also look at the correlation between capital share and inequality in specific groups of countries as well as broken up by time period (pre-WW1, interwar period, postwar period, post-1980 period).


Capital shares and top 1 % incomes in 15 countries (click to enlarge)

Capital shares and top 1 % incomes in 15 countries (click to enlarge)

Capital shares and top 1 % incomes in 15 countries (click to enlarge)

Among the 15 countries where we have capital share data and top incomes data, in 13 there is the expected positive correlation between capital share and top percentile share. In 11 of the countries the correlation is stronger than 0.55. When we move to the panel regression approach, the results also indicate a strong relationship between capital shares and inequality. In panel regression without control variables, the correlation between capital share and top percentile share with annual data is 0.86 and using five-year averages it is 1.36. The correlation is lower before WW2 and in the early postwar period and stronger after 1980. The correlation is stronger in the Nordic countries than in Anglo-Saxon countries, in accordance with previous literature which has emphasized the role of capital incomes in rising income inequality to a higher degree for the Nordic countries than in for example the US. (See Roine and Waldenström 2012.) The correlation is still strong when including control variables (at its lowest 0.62 in the panel setting). The correlation holds when using the Gini coefficient as inequality measure instead of top income shares.

We conclude in our paper that our results support the argument made by Piketty (2014) and others that the capital-labor split is indeed an important determinant of income inequality. From this follows that it is an important topic for further empirical research how the capital share and inequality co-vary and are jointly determined in various historical settings. We hope that the database that we compile and homogenize, now available in its very first version from Daniel Waldenström’s web site will be helpful in these further research advances. (Milanovic 2016 is a further contribution which has come out since our working paper was published, contributing with a very interesting conceptual and analytical discussion on the relationship between capital shares and income inequality.)

The working paper can be downloaded here: http://www.ehes.org/EHES_92.pdf

References
Eichengreen, Barry (2007) The European Economy Since 1945: Coordinated Capitalism and Beyond, Princeton, NJ: Princeton University Press
Lindert, Peter (2014) “Making the Most of Capital in the 21st Century”, NBER Working Paper No. 20232, June 2014 (Cambridge, MA: NBER).
Milanovic, Branko (2016) “Increasing Capital Income Share and its Effect on Personal Income Inequality”, draft. 31 January 2016. Available at: http://www.gc.cuny.edu/CUNY_GC/media/LISCenter/brankoData/Milanovic_BDS.pdf
Piketty, Thomas (2014) Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press)
Piketty, Thomas and Gabriel Zucman (2014) “Capital Is Back: Wealth-Income Ratios in Rich Countries, 1700–2010”, Quarterly Journal of Economics 129(3): 1255–1310.
Roine, Jesper and Daniel Waldenström (2012) “On the Role of Capital Gains in Swedish Income Inequality”, Review of Income and Wealth 58(3): 569–587.