When you measure it properly, worker’s compensation is driven by productivity

I wrote last week about how wages are driven by productivity. You might have scoffed at that notion if you’ve seen a chart like this

This chart shows average real hourly wages and productivity growth. This appears to show that, while productivity has doubled since 1973, average real hourly wages have fallen by 7%.  Doesn’t this mean that, in fact, productivity does not drive wages?

Not so fast. The economist James Sherk answered this question in an excellent paper back in 2013.

Compensation is what matters, not wages

Using wages as a variable excludes all kinds of worker compensation such as health insurance, retirement benefits, and paid leave. These have become more important over time. In 1973, non-wage benefits accounted for 13% of employee compensation. By 2012 that figure had risen to 20%.

Furthermore, the wage figures usually come from the Bureau of Labor Statistics (BLS) payroll survey. This covers only the pay of “production and non-supervisory” employees and excludes managers and many salaried employees. These figures also exclude bonuses and other irregular cash payments, thus missing many forms of performance-based cash pay which have become much more common since the 1970s. As a result, the payroll survey misses these pay increases.

There is data on total compensation which, in addition, covers all workers, including managers and salaried employees. If we use the more accurate, comprehensive data for compensation over that for wages, we get the chart below. As Sherk writes,

While hourly cash wages measured by the payroll survey have fallen 7 percent since 1973, total compensation as measured by LPC has risen 30 percent. Part of the apparent gap between pay and productivity stems from not including all elements of employee earning and using different data sources.

More accurate measures of inflation

The purchasing power of money changes over time. How do we account for this?

The BLS adjusts productivity for inflation using the Implicit Price Deflator (IPD). But most analysts adjust wages and compensation for inflation using the Consumer Price Index (CPI). Sherk explains that

These two inflation measures are not directly comparable. They use different methodologies and cover different goods and services. Comparing CPI-adjusted compensation growth to IPD-adjusted productivity growth produces inaccurate conclusions.

For a variety of reasons, the CPI is inferior to both the IPD and the personal consumption expenditures index (PCE). If we use the former to adjust for inflation, we get the following chart. This shows that while CPI-adjusted real compensation grew 30% over the past four decades, IPD-adjusted real compensation grew by 77%.

Sherk notes that “Much of the apparent divergence between pay and productivity stems from using different surveys and formulas to calculate inflation.” Selecting more representative variables, using more accurate statistics, and making use of a better measure of inflation largely closes the supposed gap between earnings and productivity that appears to have opened up since the early 1970s. The argument that productivity drives earnings holds up. If we want higher wages, we must have higher productivity.

John Phelan is an economist at Center of the American Experiment.