The nexus between labor share and income inequality: theory and evidence from the U.S

Abstract This paper develops a theoretical framework to explain observed trends in the labor share, income inequality, and their nexus. Our model, incorporating capital-skill complementarity and capital-biased technological progress, accounts for the evolution of factor and personal income distributions in the U.S. along two dimensions of decomposition: by skill level (high-skilled and low-skilled) and income source (labor and capital income). Our findings reveal that between-skill inequality is the primary channel linking labor share dynamics to income inequality. Beyond the overall decline in labor share, rising between-skill inequality contributes to the divergence in labor income shares between high-skilled and low-skilled workers, while also driving labor income inequality to increase in parallel with aggregate inequality. The share of labor is therefore negatively correlated with income inequality. The model shows empirical consistency, indicating that our theory captures key structural forces driving the dynamics of the factor and personal income distributions.