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Seven ways to raise wages.
A wage rate is a market price. The hourly wage is what it costs to purchase one hour of labor services of a certain type, in a certain place. Economists generally disbelieve in tampering with market prices unless there are good reasons. Are there good reasons to tamper with wages—specifically, to try to push them up? Maybe so.
First, unlike the prices of gasoline, shoes, or movie tickets, people’s wage rates are the bases of their living standards. Impersonal markets may assign wages to particular “low productivity” people that are so meager that they can’t support themselves, let alone their families. More generally, even when abject poverty is not the issue, market wages may lead to levels of inequality that many in society find intolerable. In such cases, governments may wish to intervene with measures such as minimum wages that are “above market” or so-called tax-and-transfer programs that raise after-tax net wages relative to pretax gross wages, such as the Earned Income Tax Credit.
Second, real wage growth (after accounting for inflation) has been abominable for most American workers for decades. Worse yet, what little wage growth there has been was concentrated at the very top. Wages at the median of the earning distribution and below have fallen or barely risen in thirty-five years. Figure 1 shows the dismaying “staircase” pattern of real wage growth by decile that has characterized the U.S. labor market since 1979—the approximate start of the Age of Inequality. At the 10 percent point of the wage ladder (counting from the bottom), real wages actually declined about 6 percent over thirty-three years. At the 50 percent point (the median), real wages rose a scant 5 percent. Even at the 90 percent point, the real wage increase was less than 1 percent per year. In stark contrast, real wage growth at the top 1 percent point—not shown here because it would be, literally, off the chart—was up 154 percent in thirty-three years.
Third, economists’ standard explanation of how wages are determined—the idea that each worker’s wage equals the value he or she adds to the production process—does not take us far in explaining what has happened to wages. Output per hour in the non-farm business sector (“labor productivity”) rose 93 percent over the thirty-three years covered by Figure 1, for a compound annual growth rate of 2 percent, but real compensation per hour (which includes fringe benefits) rose just 38 percent, a mere 1 percent per year. So even ignoring rising wage inequality, average American workers lost about 1 percent per year in wages relative to their productivity.
Markets are not supposed to work that way. Productivity is supposed to be rewarded in the pay packet. Indeed, markets did just that during the “golden age” of shared prosperity, 1947 to 1973. Doing the same calculation for those twenty-six years shows that labor productivity rose 2.8 percent per year while real hourly compensation rose 2.6 percent.
The entire postwar history of labor’s productivity and compensation is summarized in Figure 2, which shows a widening gap between compensation and productivity since the early 1970s. The divergence is actually pretty minor through 1979, but grows large thereafter. Furthermore, research by U.S. Bureau of Labor Statistics economists Susan Fleck, John Glaser, and Shawn Sprague shows that until the turn of the twenty-first century much of the growing gap between real compensation and productivity was accounted for by differences in “deflation,” that is, in how economists adjust wage and production data for inflation. Thereafter, labor’s share started to erode. But the story is, in some sense, even worse than Figure 2 indicates because part of the rising compensation was merely to cover the increasing costs of health insurance, not to improve living standards.
This analysis of America’s wage problem suggests several questions for policy: How can we raise the productivity of labor, especially that of relatively low-skilled labor? How can we close the gap between labor’s productivity and the compensation workers receive? How can we raise wages after taxes and transfers (net wages) relative to wages before taxes and transfers (gross wages)?
Let’s try to answer each of these questions in turn.
Raising the productivity of labor
There aren’t many mysteries here. A nation raises the productivity of labor by equipping its workers with more and better capital, by improving the technology of production, and by giving them more skills and training—starting, the evidence clearly shows, with pre-kindergarten.
The first method, boosting capital formation, has been the bedrock of U.S. economic growth policy (to the extent we have had any) for decades, leading to the creation of all sorts of tax incentives for saving and investment. The ratio of gross private domestic investment, which includes business investment and home building, to overall gross domestic product is highly cyclical, but it shows some modest upward trend since 1979 (marred by a huge collapse during the Great Recession of 2007-09), thus making a small contribution to productivity growth. (See Figure 3.)
Yet wages do not seem to have benefited much from the “success” in boosting capital formation. As we saw in the two earlier figures, real wage growth was anemic to negative except at the very top.
The second method, improving technology, has traditionally been the biggest source of growth in labor productivity and wages. But some observers, most prominently the coauthors of The Second Machine Age, Massachusetts Institute of Technology economists Erik Brynjolfsson and Andrew McAfee, have claimed that, in contrast to history since the Industrial Revolution, recent technological developments may be hostile to labor’s best interests. Only time will tell if forthcoming innovations in information technology will lead to faster or slower wage growth, but few economists expect technology to be a big game changer in labor’s favor in the short term.
The most direct approach to helping labor is, of course, to increase education, training, and workplace skills—especially for the lower 90 percent of wage earners. We have known for years that the financial returns to formal education, as measured by increased earnings, are high—perhaps even higher than the returns to capital. Economists usually view that fact as suggesting underinvestment in education because enough such investment would have beaten down the financial returns. A few pertinent facts are well known:
- We are miles away from offering all American children high-quality pre-K education, even though research speaks with one voice on how important this is to their future development. The rich make sure their children get what they need; poor children often need what they don’t get.
- The quality of our K-12 education system lags behind those of many other advanced (and some not so advanced) countries. It is also highly unequal, offering much-higher-quality education in higher-income areas.
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