Where are the gains from productivity?

The U.S. Bureau of Labor Statistics today released updated data on labor productivity, defined as output per hour worked, showing that it decreased by 3.2 percent on an annual basis during the first three months of 2014. On a year to year basis, productivity grew by 1 percent since the first quarter of 2013. The decline is discouraging since growth in labor productivity is the source of prosperity for workers.

According to economic theory, labor productivity is at the root of wages. A worker should be compensated for their marginal value of labor, the amount of value they add to their employer by working one more hour. The value created depends on the price of the good or service being created as well as the worker’s productivity. The higher the worker’s productivity, the higher her wage should be. Of course, this theory doesn’t work out perfectly in the real world and misses important parts of the wage-setting process. But productivity serves as a good baseline of where wages should be.

Even with rising productivity, workers’ wages may not increase as quickly as they could. The past several decades have seen the link between productivity and the returns to workers break. So where have the rewards of productivity gone?

Data show a decoupling between productivity and compensation in the U.S. labor market since 1973. (We use total compensation here since using just wages would miss out other forms from compensation such as retirement benefits and health insurance.) According to an analysis by Larry Mishel of the Economic Policy Institute, labor productivity grew by an average annual rate of 1.6 percent from 1973 to 2011 while median hourly compensation grew at an average annual rate of about 0.3.

Mishel finds that three main factors contributed to the divergence. The first is a technical difference between the different price indices used to deflate the output and wage data. In other words, inflation for goods workers produce has been slower than for goods workers buy. Mishel finds that this divergence explains about one-third of the divergence.

The second source of divergence is a shift from income from labor to capital. Workers aren’t receiving all of the gains of their productivity; some of those gains are going to owners of capital instead. Mishel finds that this shift is responsible for about one-fifth of the gap.

The largest source of divergence is the rise in the inequality of compensation, responsible for just over 45 percent of the gap. The compensation of the typical worker is not growing with productivity since more and more of compensation is going to the top earners. Other research corroborates this point. Ian Dew-Becker of Duke University and Robert Gordon of Northwestern University find that from 1966 to 2001, only the top 10 percent of earners saw wage growth at or above productivity growth.

Increasing productivity is a necessary part of increasing wages for workers. But the last several decades have shown that it’s not a sufficient part.