Labor Shares and Income Inequality

The share of aggregate income paid as compensation to labor is frequently used as a proxy for income inequality. If capital holdings are very concentrated among high income individuals, increasing their share of GDP, all else equal, widens the gap with poorer workers. Indeed, two striking features over the last three decades of many advanced and developing economies are the declining labor shares in income and the rise in income inequality. The relationship between factor shares and inequality, however, is not so simple in a richer world with realistic features such as endogenous portfolio decisions and capital-skill complementarity. In such a world, total inequality will change with (i) the labor share, (ii) the amount of within-labor and within-capital income inequality, and (iii) the degree to which the highest wage earners are also those earning the highest capital incomes. Macroeconomic trends and shocks that impact any one of these three moments are likely to impact simultaneously all of them. We develop a framework where all these terms are jointly determined and estimate the model to clarify the roles of changing technology, policies, and factor proportions on labor shares and total income inequality around the globe.