Cross-country Variation in Factor Shares and its Implications for Development Accounting

The stability of factor shares has long been considered one of the “stylized facts” of macroeconomics. However, the relationship between cross-country factor shares and economic development is dependent on how factor shares are measured. Most factor share studies acknowledge only two factors of production: total capital and total labor. The failure to acknowledge more than two factors yields misleading results. In the first part of the paper, I distinguish between reproducible and non-reproducible factors of production. I disentangle physical capital’s share from natural capital’s share and human capital’s share from unskilled labor’s share. Results reveal that non-reproducible factor shares decrease with the stage of economic development, and reproducible factor shares increase with the stage of economic development. This suggests that studies relying on the macroeconomic paradigm of constant factor shares should be revisited. Development accounting nearly always assumes the constancy of factor shares. In the second part of the paper, I perform the development accounting exercise but allow factor shares to vary and distinguish between reproducible and non-reproducible factors. My approach yields results that stand in stark contrast to those previously attained. The general consensus is that at least half of the cross-country variation in output per worker accrues to the Total Factor Productivity (TFP) residual. With my approach, the majority of variation in output per worker accrues to factor shares, specifically physical capital’s share and natural capital’s share. The explanatory power of the TFP residual decreases by more than 30 percentage points. This evidence does not, however, diminish the role of technical change. Rather, the evidence indicates the importance of acknowledging a new type of technical change, one that impacts factor shares.