This paper identifies and analyzes some of the potential costs and benefits that are likely to be associated with the implementation of wage indexation in an industrial economy. The term “wage indexation” means here an explicit provision, either legislative (mandatory) or voluntary, that automatically links changes in money wages to changes in some general price index (for example, the consumer price index).
Although the idea of indexing wages and/or financial instruments has a long history in economics,1 it has been primarily during periods of high and prolonged inflation that indexation has captured the attention of policymakers as well as economists. Since most countries have experienced rates of inflation in the 1970s well above those of the 1950s and 1960s, it is not surprising that indexation has once again been proposed as a viable policy option.
In brief, the traditional, and perhaps strongest, argument for indexation is that it will make “living with inflation” less costly. More specifically, the proponents of indexation argue that the costs and inequities usually associated with inflation (such as the redistribution of income and wealth and the misallocation of resources) relate almost exclusively to unanticipated inflation,2 and they believe that with proper indexation of labor, product, and financial contracts inflation need not produce any significant social welfare costs.3 More recently, some economists, most notably Milton Friedman (1974), have also tried to dispel the belief that indexation must lead to a higher rate of inflation. In fact, it is Friedman’s position that indexation might even serve to reduce the rate of inflation indirectly by (1) reducing the incentive (from an inflation tax) that governments otherwise might have to pursue inflationary policies, (2) reducing the time lag between aggregate demand reductions and aggregate price changes, and (3) reducing the employment losses associated with aggregate demand reductions (see Section II). Finally, the case for indexation has received a boost (perhaps unjustifiably) from the indexation experiences of a few countries—especially Brazil, where it has been possible to reduce the rate of inflation substantially without any retardation in the rate of economic growth.4
The paper is necessarily limited in scope. First, it deals exclusively with wage indexation, without any attempt to consider the implications of indexing either financial instruments or income taxes.5 Second, while some reference is made to wage indexation policies adopted in the past, no attempt is made to provide a detailed and comprehensive review of such policies.6 Third, while the technical details of wage indexation have obvious practical importance (such as, which wages and salaries are to be indexed, what price index is to be used, how often cost of living compensation is to be made), only limited attention is given to these details, except for their implications for labor market behavior. Finally, the analysis has been restricted to only a few representative wage indexation schemes.
Section I is directed at one of the more controversial questions in the wage indexation debate—namely, is the implementation of wage indexation likely to be inflationary? To provide a framework for analyzing this question, a simple model of wage-price behavior in the absence of indexation is introduced and then the channels by which wage indexation can influence the rate of wage inflation are discussed. In Section II, other potential labor market effects of wage indexation are considered, including its possible effects on the variability of real wage changes over time, on the time duration of labor contracts, on aggregate strike activity, and on the functional distribution of income. Section III deals briefly with the probable effect of wage indexation on the efficacy of exchange rate policy. The principal conclusions are given at the end of Sections I, II, and III, and in Section IV.
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Mr. Goldstein, an economist in the Special Studies Division of the Research Department, is a graduate of Rutgers University and of New York University. He was formerly a Research Fellow in Economics at The Brookings Institution.
Proposals for indexing apparently date back to at least the year 1707; see Friedman (1974) for a good description of the historical development of the “tabular standard.”
For analyses of the redistributional and resource allocation effects of unanticipated inflation, see Bach and Ando (1957), Budd and Seiders (1971), Kessel and Alchian (1972), and Bach and Stephenson (1974).
Economic theory suggests that the only social cost stemming from perfectly anticipated inflation is the wasteful use of resources to economize holdings of currency and other noninterest-bearing means of payment. See Tobin (1972b, p. 15) for an analysis of the likely social cost of perfectly anticipated inflation in the United States.
While there is no doubt that the inflation rate in Brazil fell substantially during the period of indexation (from about 100 per cent in 1964 to about 16 per cent in 1972), there is some controversy as to whether and how wage indexation affected this decline. For analyses of the Brazilian experience, see Fishlow (1974), Guenther (1974), and Kafka (1974).
For treatments of the effects of indexing financial instruments, see Bhatia (1974) and White (1974). An analysis of the effects of indexation of the personal income tax can be found in Dernburg (1975).
One can always argue (as does Friedman, 1974, p. 44) that wage indexation cannot be inflationary (or deflationary) because escalator clauses go into effect only as the result of a previous price increase. This line of reasoning, however, seems to ignore the important fact that the wage response to (past) price changes will in part determine the size of the wage-price spiral. Thus, while wage indexation may not be the original cause of inflation, it can be an important factor in the inflation transmission process.
The fact that it is so difficult to hold other things equal is probably the primary reason why there has been so little empirical work on the effects of indexation. For example, Page and Trollope (1974, p. 51) have written: “To determine the effect that indexation has had in practice, in the limited and incomplete forms in which it has been used, is impossible in any rigorous way because it was rarely introduced as the only change in policy.”
More specifically, in equilibrium, the time path of nominal wages should be determined by the time path of the value of labor’s marginal product (see Kuh, 1967). Note that for expositional convenience γ has been defined in real rather than in nominal terms in equation (1), although economic theory suggests that the latter formulation is the correct one. For the purposes of this study however, the exclusion of output prices from equation (1), given the presence of consumer prices (P) in the equation, should not have any serious consequences for the subsequent analysis.
However, so long as
Since econometric estimates of b1 at least those for the United States, suggest that b1 ≃ 1, the size of the a1 coefficient takes on crucial importance for the stability of the wage-price system (see Tobin, 1972a). It should be noted, however, that past econometric estimates of b1 may well be biased upward because most price equations have omitted capital prices (R) and because it is probable that
This paper deals only with wage indexation schemes that provide for percentage changes in W when there are percentage changes in P. In some cases, however, wage indexation has operated by providing for a lump sum increase in W for every percentage change in P (for example, workers might receive a $50 increase for every 1 per cent increase in the cost of living). For the most part, lump sum indexation has been used as a means of narrowing wage differentials over time between higher-paid and lower-paid workers, since the lump sum payment represents a larger percentage increase in W for lower-paid than for higher-paid workers.
Note that if price changes were the sole determinant of
The above conclusion will hold only for positive price changes. When negative price changes are considered, the necessary condition for wage indexation to be inflationary, ceteris paribus, is that the a1 coefficient with indexation must be less than that in the absence of indexation. While not all wage indexation formulas provide for symmetric indexation, the analysis in this paper (for reasons of length) deals only with positive price changes
Once again, the reader is reminded that one can identify the a1 parameter from the empirical literature only by making some specific a priori assumption about the relationship between actual and expected price changes.
In countries where wage indexation has been present for some periods but not for others, one might try to obtain an estimate of a1 for the years without indexation. However, in many cases there may not be enough observations for these years to obtain a reliable estimate of a1. Further, it is at least possible that in cases where indexation has at times been made mandatory that wage behavior in the period without indexation will be affected by the threat (or expectation) of future indexation. For example, employers may voluntarily and without written agreement provide for an a1 coefficient close to unity to forestall formal indexation. Similarly, in industries without formal indexation, employers may provide for a unitary a1 coefficient on a temporary basis to forestall formal indexation. In both cases, the period without indexation or “policy-off” industries will not make for a good control group because they will be affected by the policy (for a good discussion of this general problem, see Oi, 1974).
At present, about 60 per cent of all employees in manufacturing industries in the United States are covered by escalator clauses (see Giersch, 1974, p. 19, and Perna, 1973). Escalator clauses apparently now cover about 20 per cent of all wage and salary workers in the United Kingdom (see Braun, 1975). No corresponding estimate could be found for Canada.
This presumption is based on the fact that most estimated wage equations (known to the author) that include the 1968–72 period in the sample suggest estimates of a1 not much below unity, and on the assumption that inclusion of the observations for 1973 and 1974 would move the a1 coefficient even closer to unity.
Obviously, even when a1 = 1, there will always be some people who are not receiving “full” cost of living protection because the price index does not accurately reflect their consumption pattern. This problem, however, is ignored in this study.
In the present period in which inflation rates are in excess of 5 per cent a year, threshold indexation will in effect be equivalent to full indexation; thus, unless the threshold rate is set very high, threshold indexation is not likely to offer any anti-inflationary benefits in the current period.
While wage indexation has typically involved indexing money wages on past actual price changes, it should be mentioned that some countries (for example, Brazil and the Netherlands) have experimented with wage indexation schemes that link wages to expected or forecasted inflation rates over the contract period (ex ante indexation). In some cases, money wages are adjusted if the forecast turns out to be incorrect, while no correction is made in other cases. As an example of the latter, it has been argued that the decline in real wages in Brazil during the 1966–67 period was largely attributable to the consistent underestimates of the inflation rate made by the Government during that period (see Guenther, 1974, p. 5).
As Morley (1974, p. 3) has argued, “… the economy with full COL adjustment would operate just like the neoclassical economy of macroeconomic theory, in which employment and output are determined by productivity and willingness to work, and in which the money supply only determines the price level with no feedback into the real workings of the economy.”
Although reference to equation (3) implies that the expected rate of inflation is some function of past actual rates of inflation,
For three notable attempts to use survey data on price expectations in the aggregate wage equation or in the aggregate price equation (for the United States, Canada, and the Federal Republic of Germany, respectively), see Turnovsky and Wachter (1972), Turnovsky (1972), and Knöbl (1974).
It should be noted that both Day and Collier were writing during a period of low or moderate inflation, at least by today’s standards. Also, see Okun (1971, p. 492) for a view of the “announcement effect” of indexation that is supportive of Day and Collier.
For example, Friedman argues that with indexation producers will be more inclined to cut prices in response to a fall in demand because of the assurance that price cuts will reduce their wage costs.
In principle, such an empirical study could be done for any country that has had alternating periods of indexation and nonindexation. In practice, however, it is likely to be very difficult to separate empirically the influence of indexation from that of other factors affecting time lags in the wage-price-employment determination process.
For a real world example of this inflation correction factor at work, see Friedman’s (1974, p. 34) discussion of the 1967 wage contract between General Motors and the United Automobile Workers Union.
There has, however, been some empirical work on the relationship between the mean rate of price inflation and its variability which suggests that the two are positively correlated (see Okun, 1971; and Gordon, 1971b).
The conclusion that an increase in the money wage leads to a decrease in employment (demand) depends on the assumptions that output price, other input prices, and the level of output are all held constant—that is, on the assumptions usually made in drawing a factor demand curve. However, if the government increases demand to prevent employment from falling, then money wages and employment might well rise together. In other words, the analysis in this section traces only the first-round effects of a money wage increase, holding all other factors constant.
For the case where the supply elasticity of capital is infinite, the elasticity of the derived demand for labor (λ) can be written as
For a similar agnostic conclusion on the value of the elasticity of substitution, see Brown (1967).
It should be noted that there exists some controversy in the literature as to how labor’s share should be measured, given the steady growth of government in national income (labor’s share in government output being unity by definition) and the steady decline in self-employment. Nevertheless, even when adjustment is made for these factors, labor’s share still shows an increase over time in most countries (for example, see Kravis, 1968; and Rees, 1973, pp. 215–16).
It should be noted that if money wages are fully indexed on a price index that includes indirect taxes, indexation will, in effect, make wage earners exempt from sales and excise taxes (see Bernstein, 1974), and therefore will reduce the efficacy of tax policy. Here again, however, care must be taken to compare the outcome under indexation with the outcome in the absence of indexation. In this latter regard, there is tentative evidence that money wage changes in the absence of indexation vary positively with increases in direct and indirect taxes (see Gordon, 1971a, and Dernburg, 1974, on this point).
Clearly, if devaluation is instituted when the domestic inflation rate is already high, threshold indexation will not be of much use because the threshold will in all likelihood be exceeded.