Public Capital and the Labor Income Share

The decline of the labor share of income over the last few decades has been documented for many developed economies. A declining labor share is associated with rising income inequality, which raises obvious economic and social concerns. Although several explanations for this fact have been provided in the literature, they usually rely on elastic substitution between private capital and labor, which is generally not supported by the empirical literature. We argue in this paper that the fall in the labor share is potentially associated with the decline in public investment ratios, which have also been observed in most developed economies in the last few decades. We use a calibrated small-scale macroeconomic model to show how a negative public investment shock can have a sizeable negative effect on the labor share. Two assumptions are key in this result: that public capital directly augments private capital in production and that the elasticity of substitution between private capital and labor is smaller than one. We argue that both assumptions are plausible in practice. Our results suggest that, to promote long-run sustainable and inclusive growth, governments should increase the fraction of output devoted to public investment.