Declining Labor and Capital Shares

• DOI: http://doi.org/10.1111/jofi.12909
• Author: SIMCHA BARKAI
• Date: 01 October 2020
• Published date: 01 October 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 5 •OCTOBER 2020

Declining Labor and Capital Shares

SIMCHA BARKAI∗

ABSTRACT

This paper presents direct measures of capital costs, equal to the product of the re-

quired rate of return on capital and the value of the capital stock. The capital share,

equal to the ratio of capital costs and gross value added, does not offset the decline

in the labor share. Instead, a large increase in the share of pure profits offsets de-

clines in the shares of both labor and capital. Industry data show that increases in

concentration are associated with declines in the labor share.

SINCE THE EARLY 1980SWEHAVEwitnessed a large decline in the labor

share of gross value added (Elsby, Hobijn, and ¸Sahin (2013), Karabarbounis

and Neiman (2014)). Many existing explanations for the decline in the labor

share, such as technological change, mechanization, capital accumulation,

and a change in the relative price of capital, focus on tradeoffs between labor

and physical capital. These explanations argue that firms have substituted

expenditures on labor inputs into production with expenditures on physical

capital inputs into production and each of these explanations offers a different

rationale for this substitution. In this paper, I show that the shares of both

labor and capital are declining and are jointly offset by a large increase in the

share of pure profits.

In this paper, I draw a distinction between capital costs and pure profits and

show that this distinction is critical for understanding the decline in the labor

∗Simcha Barkai is with London Business School. I thank my advisers Amir Sufi, Stavros

Panageas,H ugoSonnenschein, and Luigi Zingales for all their support. I also wish to thank Olivier

Blanchard, Tony Fan, Austan Goolsbee,Evgenii Gorbatikov, Lars Hansen, Joram Mayshar, Larry

Schmidt, Amit Seru, John Shea, Robert Solow,Willem van Vliet, Tony Zhang, Eric Zwick, and sem-

inar participants at the American Economic Association Meeting, Columbia University (INET),

Federal Reserve Bank of Cleveland, Growth, Stagnation and Inequality Conference (Bank of Eng-

land), Haifa University,Hebrew University, Kent University,London Business School, MFM Sum-

mer Session for Young Scholars, Norges Bank, Northwestern University Kellogg, Stanford GSB,

Tel Aviv University, UCLA Anderson, University of Chicago, University of Maryland, University

of Pennsylvania Wharton, and the World Bank for their comments and feedback. I acknowledge

financial support from the Stigler Center for the Study of the Economy and the State. I have read

The Journal of Finance’s disclosure policy and have no conflicts of interest to disclose.

Correspondence: Simcha Barkai, Department of Finance, London Business School, Regent’s

Park, London NW1 4SA, United Kingdom; e-mail: sbarkai@london.edu.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial

License, which permits use, distribution and reproduction in any medium, provided the original

work is properly cited and is not used for commercial purposes.

DOI: 10.1111/jofi.12909

© 2020 The Authors. The Journal of Finance published by Wiley Periodicals LLC on behalf of

American Finance Association

2421

2422 The Journal of Finance®

share. Capital costs are the annual costs of using all capital inputs in produc-

tion. In a world in which firms lease all of their capital inputs, constructing

capital costs would be simple: we would sum all annual leasing expenses. Pure

profits are what a firm earns in excess of all production costs (material inputs,

labor costs, and capital costs). Firms that use a lot of expensive equipment

have high capital costs. Firms that charge consumers high prices relative to

the cost of production have high pure profits. An increase in the capital share,

equal to the ratio of capital costs to gross value added, at the expense of the

labor share is indicative of a substitution from labor to capital inputs into

production. By contrast, an increase in the pure profit share, equal to the ratio

of pure profits to gross value added, is indicative of an increase in market

power and a decline in competition.

Measuring capital costs presents an empirical challenge. Most of the phys-

ical capital stock is owned by firms rather than leased. When firms own

physical capital, they do not report an annual line item that approximates

annual leasing costs and these costs cannot be backed out from accounting

measures of profits. Moreover, there are forms of productive capital that

are not physical, such as software, research and development (R&D), and

product designs. These forms of intangible capital are at times firm-specific

and therefore cannot easily be leased. To overcome these challenges, for each

type of capital, I compute a required rate of return, which approximates the

annual leasing cost of one dollar’s worth of this type of capital. This approach

is grounded in economic theory, supported by past research, and is similar to

approximating a wage bill for an unincorporated business. Given a required

rate of return, it is straightforward to aggregate across the various types of

capital to come up with an aggregate measure of capital costs.

Following Hall and Jorgenson (1967), I compute a series of capital costs

for the U.S. nonfinancial corporate sector over the period 1984 to 2014, equal

to the product of the required rate of return on capital and the value of the

capital stock. The required rate of return is a function of the cost of borrowing

in financial markets (henceforth, cost of capital), depreciation rates, expected

price inflation of capital, and the tax treatment of both capital and debt. In

simplified models, this required rate of return is the familiar r+δ. Over this

time period, the cost of capital shows a large decline and tracks the decline

in the risk-free rate. At the same time, measures of expected and realized

inflation show no trend. The required rate of return on capital declines sharply,

due to the large decline in the cost of capital.

The large decline in the required rate of return does not necessarily imply

a decline in the capital share. In a typical model of firm production, firms

respond to the decline in the required rate of return by increasing their use

of capital inputs. If firms respond strongly enough, the increase in capital

inputs is larger than the decline in the required rate of return, and as a result,

the capital share increases. Indeed, this is the common prediction of all the

explanations for the decline in the labor share that focus on trade-offs between

labor and physical capital.

Declining Labor and Capital Shares 2423

However, the U.S. nonfinancial corporate sector does not sufficiently increase

its use of capital inputs to offset the decline in the required rate of return, and

as a result, the capital share declines. The decline in the risk-free rate and the

lack of capital accumulation have been noted by Furman and Orszag (2015).

Measured in percentage terms, the decline in the capital share (22%) is much

more dramatic than the decline in the labor share (11%). Back in 1984, every

dollar of labor costs was accompanied by approximately 49¢ of capital costs.

By 2014, a dollar of labor costs was accompanied by only 42¢ of capital costs.

Thus, despite the decline in the labor share, labor costs have increased faster

than capital costs.

As a share of gross value added, since the early 1980s, firms have reduced

both labor and capital costs and increased pure profits. Consistent with earlier

research, I find that pure profits were very small in the early 1980s. However,

pure profits have increased dramatically since the early 1980s. In the main

specification, the pure profit share (equal to the ratio of pure profits to gross

value added) increases by 13.5 percentage points (pp). To offer a sense of the

magnitude, the value of this increase in pure profits amounts to over $1.2

trillion in 2014, or $14.6 thousand for each of the approximately 81 million

employees of the nonfinancial corporate sector.

One concern with the measurement of capital costs and pure profits is the

possibility of omitted or unobserved capital. Past research has considered

several forms of intangible capital that are not currently capitalized by the

Bureau of Economic Analysis (BEA) and has argued that these are important

for explaining asset valuations and cash flows. The inclusion of additional

capital likely increases the capital share and decreases the pure profit share.

At the same time, the effects of including additional capital on the time trends

of the capital and pure profit shares are less clear. The large decline in the cost

of capital equally affects the required rate of return on any additional form of

capital. As a result, if this additional capital grows only at the rate of output,

then the additional capital costs will grow far slower than output. Thus, in

order for this additional capital to have a mitigating effect on the measured

trends of the shares of capital and pure profits, the stock of additional capital

would need to grow significantly faster than output.

I take two approaches to assessing the contribution of omitted intangible

capital to the measured increase in pure profits. First, I incorporate the most

comprehensive existing measures of omitted intangible capital into the anal-

ysis. Second, I construct a large number of scenarios for omitted intangible

capital. Each scenario is a parameterization of investment, depreciation, and

capital inflation of intangible capital. For each scenario, I compute capital

costs and pure profits that fully incorporate the unobserved investment. I

find that existing measures of intangible capital are unable to explain the

increase in pure profits. Of the large number of scenarios that I consider, none

can fully account for the increase in pure profits. There are scenarios that

can account for most of the increase in pure profits, but in all such scenarios,

the value of missing intangible capital in 2014 would need to be much larger