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Within-firm income distribution and firm performance
Roya Taherifar a, Mark J. Holmes a, Gazi Hassan a
a School of Accounting, Finance and Economics, University of Waikato, Hamilton, New Zealand
Keywords: labour share, pay inequality, firm performance, income distribution
Corresponding Author:
Roya Taherifar Tel: +64273532426
Email: [email protected]
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The worldwide fall in labour share and the rise in pay inequality have been the subject of a significant body of research. Some studies (e.g., Elsby et al., 2013; Karabarbounis & Neiman, 2014;
Piketty, 2017) show that the labour share (as a fraction of GDP) has declined in many countries over recent decades. The fall in the labour share implies that the fraction of the population profiting from economic development is decreasing and, therefore, is associated with an increase in pay inequality (Atkinson, 2009). While labour share and pay inequality are the results of production and compensation decisions that take place within firms, most empirical studies rely on industry or aggregate macro data, downplaying the importance of heterogeneity among firms (e.g., Bentolila & Saint-Paul, 2003).
Furthermore, it is argued that income distribution within a firm impacts firm performance (Donangelo et al., 2019; Faleye et al., 2013; Rouen, 2020). The impact of pay inequality, measured by CEO- employee pay gap, has been extensively studied. However, there has been less empirical work on the impact of labour share, employee compensation to value-added ratio, and its link with pay inequality.
Therefore, what is lacking is a systematic analysis of the factors determining within-firm labour share, its relation with pay inequality, and its effects on firm performance. This study addresses these issues by examining three related questions: (i) What factors explain the labour share within firms? (ii) Is there a relation between labour share and pay inequality within a firm? (iii) What effects does income distribution, measured by labour share and pay inequality, have on operating performance and firm value?
Using data from a sample of Australian public firms over the period 2004-2019, first, we investigate the determinants of labour share. There is an ongoing debate about the underlying causes of the changes in labour share. Among them, we examine the dynamic contribution of technological changes, product market power and labour market concentration on labour share. The result shows that labour share is driven by the complex interplay among these factors. We find that capital deepening and technology progress has a significant negative impact on labour share. In addition, under imperfect competition, firms with higher mark-up have significantly lower labour shares. Moreover, the discrepancy between the marginal product of labour and the real wage due to labour adjustment costs is negatively related to labour share. Our findings cast doubt on the hypothesis that labour market concentration and union impact labour share. Then we investigate the nexus between labour share and pay inequality. The empirical analysis entailed two-stage least squares (2SLS), three-stage least square (3SLS) and multiple equation GMM approaches for the robustness. Our key findings suggest significant causality between labour share and pay inequality within the firm. Notably, an increase in pay inequality causes lower labour share. In return, a decrease in labour share appears to increase pay inequality.
In the last step, we extend the relation between two dimensions of the income distribution, labour share and pay inequality, to their impact on firm operating performance and value. Our result suggests that firm operating performance, measured by Return on Asset (ROA) and Return on Equity (ROE), significantly decreases when labour share and pay inequality increases. However, the negative impact of labour share on operating performance is more significant and robust. We also find that firms have lower value when labour share is higher. For robustness check, we also estimate a system of labour share, pay inequality, and firm performance equations using 3SLS and 2SLS, which allows dealing with potential endogeneity issues and potential cross-equation error correlation. The result remains similar.
Our findings extend the previous empirical research on the determinants of the labour share at the level of individual firms and provide novel insights about the effect of income distribution on firm performance.
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References
Atkinson, A. B. (2009). Factor shares: the principal problem of political economy? Oxford Review of Economic Policy, 25(1), 3–16.
Bentolila, S., & Saint-Paul, G. (2003). Explaining movements in the labor share. Contributions to Macroeconomics, 3(1).
Donangelo, A., Gourio, F., Kehrig, M., & Palacios, M. (2019). The cross-section of labor leverage and equity returns. Journal of Financial Economics, 132(2), 497–518.
Elsby, M. W. L., Hobijn, B., & Şahin, A. (2013). The decline of the U.S. Labor Share. Brookings Papers on Economic Activity, 2013(2), 1–63.
Faleye, O., Reis, E., & Venkateswaran, A. (2013). The determinants and effects of CEO-employee pay ratios. Journal of Banking and Finance, 37(8), 3258–3272.
Karabarbounis, L., & Neiman, B. (2014). The Global Decline of the Labor Share. The Quarterly Journal of Economics, 129(1), 61–103.
Piketty, T. (2017). Capital in the Twenty-First Century. In Capital in the Twenty-First Century. Harvard University Press.
Rouen, E. (2020). Rethinking measurement of pay disparity and its relation to firm performance.
Accounting Review, 95(1), 343–378.
