One of the key dynamics of our economy for more than 30 years has been the divergence between productivity growth and compensation (or wage) increases for the typical worker. This divergence between pay and productivity has been increasingly recognized as being at the heart of the growth of income inequality. I am proud that Jared Bernstein (yo, Jared!) and I were the first ones to call attention to this, which we did in the introduction to The State of Working America 1994/1995, which was published on Labor Day in 1994. At that time, we were responding to the oft-repeated claim that wage stagnation experienced by most workers was caused by the post-1973 productivity slowdown. Get productivity up and all would be OK, we were told. Bob Rubin told us reducing the deficit would help accomplish that. By plotting productivity and median wage growth together, we were able to demonstrate that even though productivity growth was indeed historically slow in the preceding two decades, the growth of the median wage had substantially lagged even this anemic productivity growth. As it turns out, productivity growth accelerated in 1996 and has remained higher than in the 1973-1995 period since. Interestingly, the gap between productivity and median hourly compensation growth has grown at its greatest rate over the 2000-11 period despite productivity growth that continued to outpace the 1973-95 rates.

Understanding the driving forces behind the productivity-median hourly compensation gap is the subject of a new paper, The wedges between productivity and median compensation growth, that previews a portion of the analysis in the forthcoming State of Working America. This research reflects the results in a more technical paper, Why Aren’t Workers Benefiting from Labour Productivity Growth in the United States, that I co-authored with Kar-Fai Gee, an economist at the Canadian Centre for the Study of Living Standards (CSLS). The paper is in the spring 2012 issue of the International Productivity Monitor(edited by Andrew Sharpe and published by CSLS, on whose board I am proud to serve).

During the 1973 to 2011 period, labor productivity rose 80.4 percent but real median hourly wage increased 4.0 percent, and the real median hourly compensation (including all wages and benefits) increased just 10.7 percent. These trends are shown in the table below. If the real median hourly compensation had grown at the same rate as labor productivity over the period, it would have been $32.61 in 2011 (2011 dollars), considerably more than the actual $20.01 (2011 dollars). Consequently, the conventional notion that increased productivity is the mechanism by which living standards increases are produced must be revised to this: Productivity growth establishes the potential for living standards improvements and economic policy must work to reconnect pay and productivity.

The objective of our new paper is to provide a comprehensive and consistent decomposition of the factors explaining the divergence between growth in real median compensation (note the paper focuses on median wages while I have simplified the analysis here to focus on median compensation) and labor productivity since 1973 in the United States, with particular attention to the post-2000 period. In particular, the paper identifies the relative importance of three wedges driving the median compensation-productivity gap: 1) rising compensation inequality, 2) declining share of labor compensation in the economy (the shift from labor to capital income), and 3) divergence of consumer and output prices.

The following table is based on this paper and will be in the new edition of State of Working America that will be released on Labor Day. This decomposition is of economy-wide productivity growth, real average hourly compensation growth of all workers (including the self-employed), and the median real hourly compensation of workers age 18-64. See the paper for technical details.

Panel A presents the basic trends in wages, compensation (median and average), and productivity, and reveals that the productivity-median compensation gap grew an average of 1.3 percent each year from 1973 to 2011 but grew the fastest since 2000. The most important factor in the 2000-11 era was the decline in labor’s share of income and the corresponding increase in capital’s income share. In contrast, the period of sharply rising productivity and falling unemployment in the late 1990s saw a rise in labor’s share of income. Growing inequality of compensation was very important throughout the 1979 to 2011 period. Growing inequality of compensation and the erosion of labor’s income share are the key overall drivers of the wedge between productivity and median compensation, accounting for two-thirds of the wedge since 1973 and about 85 percent of the wedge since 2000. These factors, in turn, reflect the various ways that the typical worker has lost bargaining power in the economy over the last three decades: excessive unemployment, eroded labor market institutions such as the minimum wage and unions, globalization, deregulation of industries, privatization, and the rising power of finance. The third factor, the fact that output prices (covering investment, exports, imports, government as well as consumption)  grew more slowly than the prices of consumer purchases—sometimes labeled a deterioration in “labor’s terms of trade”—was evident throughout most of the last three decades and was most important in the 1970s and least important in the 2000s.

Maintaining rapid overall productivity growth—through innovation, restoring manufacturing, improved education and skills—is obviously an important policy goal. But if we want to improve the living standards of the vast majority—and we definitely can do so given the expected productivity growth—then we must also place the challenge of reconnecting growth in overall productivity and median compensation at the center of economic policy.