Inequality and Production Elasticity

We address a contention regarding capital deepening when the labor share of income declines and the elasticity of substitution is above unity between Karabarbounis and Neiman (2013) and Elsby et. al (2013). We demonstrate the incentive for technical change, which increases inequality and how investments in new technology create temporal misalignment between a decrease in the labor share of income and capital deepening. We show how the decline in the saving rate that occurred during the 80's and 90's may resolve the contention regarding capital deepening. We find that elasticity of substitution below unity is less consistent with the decline in the labor share of income. A second contention is whether the elasticity of substitution is above or below unity. We perform a time-varying state-space estimation of the evolution of elasticity using the unadjusted marginal product of labor and the Kalman Filter. We find that the elasticity between capital and labor has been fluctuating slightly above unity since 1980, which is consistent with our theoretical findings. We note that an elasticity of substitution above unity has important implications for balanced growth under capital augmentation.