Journal Issue
Finance & Development, December 1976

Incomes policy and development planning: An analysis of their relationship, and the role of incomes policy in the fight against unemployment

International Monetary Fund. External Relations Dept.
Published Date:
December 1976
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V. V. Bhatt

A number of industrially advanced countries have become increasingly aware of the need for a conscious incomes policy if they are to attain full employment, growth with relative price stability, and a viable balance of payments. Such an incomes policy would have to bring within its purview not only wage and salary incomes but also all other types of income, and it has become obvious that this sort of policy cannot be evolved and enforced without popular consensus on objectives and instruments.

In view of this move toward incomes policies in the industrial world, it is somewhat surprising that there is hardly any discussion on their relevance for the less developed countries (LDCs), where the need for them is much more urgent than in the industrial world.

With their labor forces growing at more than 2.5 per cent a year on top of a considerable backlog of underemployment and unemployment, developing countries are faced with an acute employment problem. Because of trade union activity and government legislation, money wage rates are nearly three times labor productivity and wage rates in the traditional sector. This has two effects: it induces migration from rural to urban areas; and at the same time it makes it difficult to increase employment in the modern sector at the rate required. Open unemployment in urban areas and worsening living conditions among small farmers and the landless labor in the rural areas are the inevitable consequences of this situation. If this socially explosive situation is to be avoided, it is essential to regulate the level and pace of increase of money wages in the modern sector, and at the same time to increase the growth rate of employment and capital formation.

Incomes policy, and its appropriate instruments, should form an integral part of the development policy framework in the developing countries.

Role of incomes policy

Underdeveloped countries have been planning for a structural transformation of their economies so as to attain certain social objectives. These generally aim at a progressive improvement in living standards through a self-sustaining process of economic development. This requires not only an accelerating increase in national income but also its equitable distribution. The objective of raising per capita income levels is normally specified in plan documents, while the objective of equitable distribution is often just mentioned but not translated in terms of any precise measurable index. This lack of clarity makes it difficult to formulate rational economic policies.

The pertinent question that arises in connection with income distribution is whether this objective should be expressed in terms of consumption or in terms of income. What seems to be important from the point of view of equity is to reduce the disparity in consumption levels, rather than in income distribution, where a certain disparity may be necessary to maintain incentives to save and to work. In fact, an attempt to reduce income disparities beyond a certain point may result in lower consumption levels for the low income groups in absolute terms over time than the levels they could reach if such income disparities were maintained.

Thus, assuming that ex ante investment does not exceed ex ante saving and capital inflow, and given the objectives of planned economic development, the purpose of an incomes policy should be: (1) to prevent the emergence of inflationary pressures; and (2) to ensure that the consumption pattern that emerges is consistent with the objective of even income distribution. What, then, should be the guidelines for the developing world in formulating an incomes policy?

Not labor productivity

In the industrial countries, the major guideline that is generally accepted relates to the increase in overall labor productivity in the private sector (excluding government services). If all incomes increase at this rate, it is likely that no inflationary pressures will arise in a closed economy. This is true, however, only under the following assumptions: provided there is no overall excess demand; and provided the present income distribution is more or less acceptable. Under these assumptions, if all incomes are permitted to rise at the same rate as overall labor productivity, inflationary pressures can be avoided.

However, in the developing countries it is the essence of development policy to bring about structural change that requires saving and investment to grow at a rate higher than income. Further, the ratio of government revenue to gross domestic product (GDP) needs to be raised to satisfy the demands for public goods and particularly the collective consumption of the poor. Both these conditions can be satisfied only if private consumption increases at a rate lower than the increase in overall labor productivity. This can be ensured if the incomes of the saving and investing classes (including government enterprises) increase at a rate higher than overall labor productivity. As a corollary to this, the incomes of the classes with low saving propensity (which include landless laborers, domestic servants, and industrial labor) should increase correspondingly slower than overall labor productivity.

Increase in consumption

What is then the criterion to follow in projecting an increase in the incomes of the nonsaving classes? In simple terms, the total income for all these classes should not grow at a rate higher than the planned rate of increase of private consumption.

This does not mean that all wage rates can rise at this rate. For even when the wage rates do not rise, any shift of labor from low-wage to high-wage occupations causes total wage incomes to go up. In the urban-industrial areas, the proportion of labor in the high productivity sectors would increase with economic development, and thus the average wage rate would increase even if productivity in different sectors remained the same. However, this shift would probably be more than offset initially by a relative increase in the labor force in the lower wage scales as a result of rural-urban migration. Thus, the effect of these different shifts may cancel each other out, and the average wage rate may remain constant in the urban industrial areas. However, the average wage rate of both the rural and the urban sectors together would tend to increase. Thus, per capita consumption of the wage-earning classes would increase. Hence, the wage rates in the different occupations can be raised only at a rate that is lower than the rate of increase in per capita private consumption.

There is, however, one further consideration to be taken into account. Urban wage earners do save a part of their incomes in the form of their contribution to the various social security schemes like provident fund schemes, while the rural workers have no such schemes. Hence, though a relative shift of labor from the rural to the urban areas would tend to raise the average wage rate, the average rate of consumption per worker might not increase in the same proportion. Further, if the provident fund contribution is raised so as to increase the savings/income ratio of the urban wage earners, the wage rates can be allowed to rise at the same rate as in per capita private consumption.

In any case, an increase in wage rates above this limit could be viable in terms of the development objectives only if the rate of growth in per capita consumption of the other classes—self-employed farmers, high-income salary earners, self-employed businessmen, professional people, and other high-income nonsalary earners—is lower than the rate of growth of per capita saving. This can be done by inducing, in a variety of ways, these classes to save a larger proportion of their incomes.

One way in which the growth rate in the per capita consumption of these classes can be reduced is to tax heavily all functionless incomes. In this category would come all households receiving incomes/capital gains on the basis of ownership of urban land and such households that receive large fortunes not through their own work or saving but entirely through gift or inheritance.

Thus, the rate of increase in average wage rates can be raised above the projected growth rate in per capita consumption only to the extent to which the other classes can be induced to save or pay out in tax a larger proportion of their income. However, there is a limit to the extent to which this can be done. As a guideline, therefore, it is desirable to increase wage rates only to the extent of the increase in per capita consumption.

Agricultural wages, productivity

Such a guideline, of course, assumes that labor productivity in agriculture will increase at an appropriate rate. In the present context, this is a crucial assumption. Given the labor force in agriculture, and assuming that all increases in this labor force have to be absorbed in non-agricultural occupations, the real wage rate in the nonagricultural sector can increase only if the marketable surplus of food increases at a rate higher than the increase in the total labor force. For this, labor productivity in agriculture should increase at a rate significantly higher than the rate of increase in the total labor force. For example, if the labor force increases at 2.5 per cent a year, if per capita consumption is projected to grow at 2 per cent a year, and if the expenditure elasticity of the demand for food is 0.6 per cent, labor productivity in agriculture should rise at 3.7 per cent a year. Unless such an increase can be brought about, the real wage rate in the nonagricultural sector cannot rise; an increase in money wages would be offset by an increase in the price of foodgrains.

There is another consideration to be taken into account. If, in the example given, labor productivity in the agricultural sector was growing at an annual rate of less than 3.7 per cent, an increase in real wage rates would be possible only with considerable unemployment. Such unemployment would then depress the wage rates, particularly in the rural areas, and it would be the weaker sections of the community like the landless laborers whose conditions would deteriorate. Thus, there is a vital relationship among the rate of growth of labor productivity in agriculture, the rate of growth of employment, and the real wage rate. In order to improve the living conditions of landless labor, the productivity of labor in agriculture should increase at a rate high enough to raise their real wages and to support productive employment of the rising labor force. This is so unless the requirement of wage-goods can be met through imports against the exports of nonagricultural goods and services—a condition that is relevant only for city states like Singapore and Hong Kong or mineral producing countries like those of the Middle East.

The structure of wages and salaries in nonagricultural occupations is governed by the basic wage rate of unskilled labor and the relative scarcity of the personnel required. This structure may need to be rationalized so that for the same occupation the real income does not differ among industries or regions, unless there are other compensating factors operating.

Since the government sector is supposed to play a vital role in the planned process of development, it has to attract and retain an increasing corps of employees with an immensely wide range of occupational skills and abilities. The wage and salary scales of government employees are, therefore, important and some definite guidelines in this matter need to be thought out.

The foremost consideration here should be the ability of the government to attract the right type of skill and talent, and therefore government wage and salary scales should be comparable to the private sector for similar types of work and skill requirements. This is the principle of “fair comparison” as enunciated by the Royal Commission on the Civil Service (1955) in the United Kingdom, and which forms the basis of the Federal Salary Reform Act (1962) in the United States.

One of the essential points of this principle is that if the public services are to be efficiently manned, incomes policy must include a policy of competitive equality between public services and private employment within which they compete for recruits. If the public services are to remain efficient, they must follow an inflationary spiral if others set one going, but they should never set one off.

Nonwage and salary incomes

Since the saving-income ratio has to be raised progressively, the classes that are able to save will experience a more rapid rise in income than the wage and low-income salary earners. What has to be ensured, however, is that these classes save such a proportion of income and in such forms as are required to attain the plan objectives.

The forms of saving that do not serve any development function are: excessive investment in residential construction used for conspicuous consumption; speculative holding of commodities; holding of gold; and speculative investment in urban land. Of course, if inflationary pressures are generally avoided, speculative holding of commodities will not take place.

The other functionless incomes arise from gift/inheritance of property. Such gifts and inheritance should attract a fairly high progressive tax. It may be argued that such a tax may prove to be a disincentive to save, because to be able to bequeath property to one’s children is one of the most significant motives to save. However, to the extent to which this is a dominant motive, saving in fact could be larger because of the tax than it otherwise would be.

Incomes policy and prices

The success of the development effort depends on the extent to which incomes from the other productive forms of saving rise faster than national income, as long as the consumption of these classes grows, either at a rate lower than or similar to that at which per capita consumption is projected to rise. If these incomes are restrained by means of taxes or otherwise, the incentive to work as well as to save may be affected. What is necessary is not a restraint on the growth of these incomes but a restraint on consumption out of these incomes.

The rate of profit of a business enterprise, whether corporate or noncorporate, can be an index of its efficiency. However, if the enterprise is the sole producer of a particular good or service, and if it earns a high rate of profit simply because of its monopolistic position in the market—especially in the field of essential raw materials and consumption goods—its monopolistic pricing may set off a price-wage or wage-price spiral. Such monopolies should be controlled in one way or the other.

There is another case where the market may need regulation. In a situation of increasing overall demand the rate of profit may be maintained or raised if business enterprises raise product prices and thus set in motion a price-wage and a wage-price spiral feeding on each other. If the wages are regulated, there is no reason why the enterprises should raise prices unless there is an unavoidable increase in some other costs. Therefore, attention should be paid to prevent business enterprises from raising prices merely to increase profits, particularly in the field of certain strategic commodities.

There should also be some regulation of prices of essential commodities and services produced by the factory type of business enterprises, in order to restrain those price increases that may be resorted to mainly for raising the rate of profit. With such regulation of price increases, and increases in wages and salaries, overall prices are likely to remain stable. Any increase in the rate of profit of business enterprises under such circumstances could arise only as a result of technical change and improvement in productive efficiency and would generally be accompanied by some reduction in the prices of their products. Such price reductions should be encouraged as they would be necessary to offset unavoidable price increases in some sectors and further to pass on a part of the benefit of improved efficiency to the consumer. The tax instrument can be used for this purpose.

However, the prices of industrial products will not remain stable if food prices increase relative to the prices of industrial products. If agricultural productivity increases at an appropriate rate continuously, food prices may not rise. But agricultural output fluctuates and will continue to fluctuate because of the vagaries of the weather. Hence, in a bad year, food prices will tend to rise and this rise will be aggravated because of the precautionary and speculative demand for food. An energetic buffer stock policy, therefore, is necessary if food prices are to be kept stable.

The relative prices of agricultural products have to be determined from the point of view of providing adequate incentives to the farmers to increase agricultural productivity at the required rate. The target for increases in the real wage rate of agricultural labor should also be one of the governing factors in determining relative food prices. The real wage rate of landless labor—as the weakest section of the community—should be raised faster than the real wage rate in the industrial sector. The industrial wage rate is almost three times that of the landless labor; this disparity is much too great and if continued it will tend to promote migration from the rural sector to the urban industrial sector at a rate which cannot be absorbed in productive employment and will create grave social and economic problems.

Once these relative prices are determined, policy measures should be effective enough to keep food prices stable. If the policy measures fail, and food prices do rise, there will be a demand for an increase in money wages. This demand will be legitimate to keep real wages stable and can be successfully resisted by a consensus only if the rise in food prices is expected to be temporary. However, if the rise is expected to be permanent, the choice will be between allowing money wages to rise and creating a wage-price spiral, and establishing some machinery for equitable distribution of food at stable prices. A continuous rise in food prices reflects imbalances in the development program; the attempt, therefore, should be such as to have a program that can be supported without a rise in food prices. If they are allowed to rise as a permanent feature of the development process, a wage-price spiral and the resulting socio-economic tensions cannot be avoided.

Collective consumption

It has been seen that the average real wage rate should be allowed to rise only according to the projected rise in per capita consumption. The wage rate can rise faster only to the extent to which functionless incomes can be taxed and the consumption of such classes can be prevented from increasing. However, these measures would have only a once-and-for-all impact. From a long-term point of view, the guideline should be as suggested.

However, with the rising proportion of government taxes to national income, the government would be able to increase the collective consumption of the community, particularly the consumption of the weaker sections of the community. Thus, the rate of increase in total consumption of the weaker sections would be higher than that of the better-off sections.

Collective consumption to improve the living standards of the poorer sections should take principally the following forms: free educational opportunities to improve their productive efficiency and thus to enable them to raise their living standards; free health services also to improve their productive efficiency; and, finally, to enable them to build their own houses, land should be made available to them at nominal cost and such savings institutions and instruments should be created as would induce them to save for building these houses. In addition, unemployment insurance and/or provision of employment opportunities would stabilize their incomes. All these, of course, can be accomplished only by stages, but a rational perspective plan should be formulated indicating clearly how and in what stages collective consumption would increase and how it would be directed principally toward improving the living conditions of the weak and vulnerable sections of the community. There should be a clear plan of action in this sphere if an incomes policy is to gain support from the wage-earning classes.

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