Elasticity of substitution between labor and capital: robust evidence from developed economies

The main aim of the current study is to provide robust evidence on the magnitude of the elasticity of substitution between labor and capital in developed economies. Empirical strategy consists in estimating two- and three-equation supply-side systems which combine a normalized CES production function and first order conditions for factors of production. The baseline econometric analysis base on (nonlinear) panel estimation. As a robustness check, the system estimation at the country level is provided. Moreover, various assumptions on time-varying factor-augmenting technical change are additionally considered, i.e. (i) an abrupt break in the growth rates of factor augmentation, (ii) the Box-Cox transformation, (iii) time dummies, and (iv) a trigonometric representation approximating smooth structural breaks. It is found that capital and labor are gross complements and the elasticity of substation between labor and capital is on average around 0.7. Moreover, net labor-augmenting technical progress is documented. Above findings remain robust to various assumptions on time-varying factor-augmenting technical change. Furthermore, the benchmark results are replaciated with two alternative datasets. To strengthen these findings a systematic evidence of capital-labor substitution is provided at the country level. Although substantial cross-country variation in the elasticity of substitution between labor and capital can be found, a wide range of estimates confirms that labor and capital are gross complements and technical change is net labor-augmenting.