Plumper Profits, Skimpier Paychecksby
It seems the best of all worlds. The U.S. economy is hitting on all cylinders: strong growth, low inflation, and a steady flow of new jobs. And U.S. companies, on the ropes in the mid-1980s, are world-class players again.
This prosperity, however, conceals a dramatic shift in who is benefiting from the revival of Corporate America. A new BUSINESS WEEK analysis of national income generated by the corporate sector--labor compensation, profits, and interest payments--shows that workers are getting the short end of the stick. Over the last two years, the share going to labor has dropped sharply. Only 81% of corporate income now goes to wages, salaries, and benefits, the lowest level since 1969. And wages and salaries alone are now less than 67% of income, a post-war low, as downsizing, job cuts, and wage restraint continue to dominate business strategies.
MAJOR IMPACT. These numbers confirm what many Americans feel in their bones: Workers have not yet seen big gains from rising productivity and the strong economy. Instead, the major impact of the good news has shown up in profits. Operating profits, as measured by the government, have risen to over 15% percent of national income in the corporate sector, their highest level in almost 20 years. And with fourth-quarter corporate earnings expected to be strong, that figure could rise even higher.
But while it may be frustrating to workers to see real wages stagnate, even as the economy prospers and profits soar, history and economic theory suggest that they may see benefits a little further down the road. Since the days of Adam Smith, economists have studied how the economic pie is split between payments to labor--wages, salaries, and benefits--and returns to capital--profits and interest on debt. This division influences everything from the distribution of income to the economy's potential rate of growth. Periods with a high profit share have typically also enjoyed rising productivity, high levels of investment, low inflation, and eventually strong wage growth. "What high returns on capital give you is the possibility that you can grow faster," says Richard D. Rippe, chief economist at Prudential Securities Inc. Adds Fred Moseley, an economist at Mount Holyoke College: "Profitability is the most important determinant of the health of the economy."
Certainly that's been true for most of the 20th century in the U.S. In the 1920s, for example, high profitability and a small labor share was accompanied by rising living standards. And the last time labor had as small a share as it does today was the 1960s, which is remembered as a prosperous period for most everyone. Strong profitability helped fund high investment, keeping productivity growth robust and inflation low. And the strong growth of the overall economy meant that real wages could grow fast enough to keep workers happy.
Like an earthquake fault line, the labor-capital split may hardly change for decades. But when the balance does shift, the move is quick and dramatic. The beginning of the 1970s, for example, saw a substantial increase in the share of income going to labor that persisted over the next two decades, as workers--especially ones in strong unions--were able to push up real wages even as productivity growth slowed.
But that increase turned out to be a pyrrhic victory for labor. While workers may have benefited in the short run from a bigger share, the eventual results of lower profits were slower growth and less investment. In addition, as Moseley notes, the double-digit inflation of that decade was in part the result of companies trying to alleviate their profit squeeze by raising prices--a strategy that did not work.
Now the U.S. may be in the midst of another tectonic change in the split between labor and capital. Corporations have been able to boost productivity, using a combination of restructuring, downsizing, and investment in new technology. And while the unemployment rate has fallen, wage growth has been held down by international competition, new technology--which needs a lot less labor--and the impotence of labor unions. In the 1960s, real compensation per hour in nonfinancial corporations rose at an average rate of 2.1%. By contrast, real compensation per hour fell by 0.3% in the first three quarters of 1994 compared with a year earlier.
Indeed, in recent years, some of America's largest companies have dramatically pared down the share of revenues going to workers by boosting productivity, cutting jobs, holding down wages, and outsourcing. For example, General Motors Corp. spent 26% of its revenues on wages, salaries, and benefits in 1989. But by 1993, the percentage of revenues going to labor was only 22%.
With profits' share of corporate income rising again, today's economy is beginning to look a lot more like that of the low-inflation 1960s. Corporate productivity growth is strong, clocking in at 3% in 1994, the highest in two decades. Companies are pouring hundreds of billions into new equipment. And with profits high, they can hold off on price increases, keeping inflation dormant.
Moreover, the rising capital share is good news for the stock market, which, not surprisingly, has historically benefited when profits took a bigger bite of the pie. Indeed, the market is far more responsive to the profit share than it is to the overall growth of the economy.
MARKET MOVER? Certainly, the shift from wages to profits is the major reason the stock market hasn't taken a deep dive in light of the massive interest rate increases by the Federal Reserve. Rippe calculates that the rate of return on capital, adjusted for inflation, has reached about 6.5%, a 25-year high, which may propel the markets even higher. "I don't believe that the conventional wisdom in business has fully recognized" how much corporate profitability has increased in recent years, says Rippe.
The rising profit share also changes the nature of the income-distribution debate. In recent years, both economists and policymakers have concentrated their attention on the widening inequality of wages, looking for ways to narrow the difference. But this leaves out the widening gap between Americans with capital income and those without. Wages are far less important than they used to be as a source of income. Americans now get only 57% of their personal income from wages and salaries, a post-war low. Instead, dividends and self-employment income have become progressively more important. Moreover, notes economist Louis A. Ferleger of the University of Massachusetts at Boston, wage income will shrink even further if the Republicans carry through on their plans to downsize government, since the public sector now accounts for a full 20% of all labor compensation.
With the division of income shifting in favor of capital, when does the payoff for workers come? It took almost a decade for the real wages of workers to adjust to the productivity slowdown of the 1970s. That means it could take some time before wages respond to the improved economic conditions in the 1990s. "The economy is growing, but a large portion of the public are very upset because their real wages aren't going up," says Robert Eisner, an economist at Northwestern University and a former president of the American Economic Assn. Workers will eventually gain if higher profits lead to more investment and more jobs, adds Moseley, "but it hurts a lot."