Government policies should aim to raise wages and incomes for its people. We are in complete agreement with this objective. That is why we were disappointed when the Malaysian government recently announced the target of 45% labour share of total income as the way to address the country’s chronic low-wage environment. The target — one of seven in the Madani Economy policy framework — may make for a good sound bite to the man in the street, but the 45% ratio in and of itself is meaningless. Yes, it may be achievable in the long run — as seen in many developed countries — but certainly not in the way many would envision or what prevailing narratives seem to suggest.

Labour income share measures the portion of total economic output (or gross domestic product [GDP]) that goes to workers, as compensation for their labour. The balance accrues to businesses (capital owners) after netting out the share of GDP that goes to the government as taxes. Thus, in the most simplistic view, a low labour income share conjures an image of “greedy” employers and “suffering” employees. To raise wages and reduce inequality, one would then seek to redistribute income from capital to labour — that is, raise the labour income share, whether through a progressive wage policy or other forms of government intervention. Simple, yet also completely wrong. And one is reminded of the aphorism, “The road to hell is paved with good intentions”. Why do we say this?

The share of labour income-to-GDP is purely a reflection of the underlying structure of the economy. It is a meaningless target.

Imagine two hypothetical countries, A and B. Country A is a knowledge-based economy made up of 10 consultancy businesses — for example, tax, accounting, investments, technology, research and development (R&D), engineering and so on. Its share of labour income-to-GDP will be very high; say, 90%. Why? Because these services require low capital investments. The key inputs are workers who are highly talented and educated.

Country B, on the other hand, has an industrial-driven economy. Its economic output comes from 10 heavy industries — for instance, steel, aluminium, car assembly, oil refineries, liquefied natural gas (LNG) plants, chemical and fertiliser factories, and so on. The majority of workers are blue collar with technical skills, who are easier to replace. In Country B, the ratio of labour income-to-GDP will necessarily be low, maybe 20%, because the required capital investments are very high. A significant portion of gross operating surplus (after paying wages and taxes) goes to depreciation and interest expense on borrowings taken to finance the investments, and yes, a percentage goes to profits for capital owners.

We simplified the above into a chart (Chart 1) to show the entire distribution of GDP — for labour, capital and government. Are the businesses in Country B greedier than Country A simply because the share of labour to GDP in the former is much lower? Of course not. The ratio merely reflects the unique structure of its economy.

See also: <a class='gtm_see_also_1_inread' style='text-decoration: underline;' href='/capital/tongs-portfolio/should-malaysia-force-wages-rise-through-direct-wage-policy-intervention?utm_source=website&utm_medium=article&utm_campaign=ONPAGESEO'>Should Malaysia force wages to rise through direct wage policy intervention?</a>

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The economic structure for each country is different. Therefore, their labour income shares will also be different. Over time, as a country develops, the structure of its economy will change — and so will its labour income share (typically higher but not necessarily so, since it will reflect whatever the structure of the economy will be at that point in time). In any case, the change will unfold over decades, not years.

See also: <a class='gtm_see_also_2_inread' style='text-decoration: underline;' href='/capital/tongs-portfolio/greedflation-stock-prices-and-policy-implications?utm_source=website&utm_medium=article&utm_campaign=ONPAGESEO'>‘Greedflation’, stock prices and the policy implications</a>

What happens when government policy forces wages up in order to raise the labour-to-GDP ratio to its target? It will deprive capital of the appropriate returns. And this may well have the opposite effect of disincentivising investments, which will negatively impact future job creation and future income improvement for the people.

We are not saying that businesses in Country B are definitely not greedy or that wages cannot be higher. We are saying let the market decide. Setting an absolute labour income share target is unhelpful — especially if it merely seeks to redistribute income from capital to labour.

The key to higher wages and incomes is to grow the pie, not slicing the same pie into different sizes. Actionable government policies need to address the “how” — how to grow the pie; that is, transform the economy, to ensure a larger slice for both labour and capital.

Higher wage-income is a journey, not a destination

There is no question that wages in Malaysia are low. The minimum wage is RM1,500 ($437) and median wage is RM2,600, which is barely sufficient for people in bigger cities to maintain an acceptable living standard. This creates a growing problem as the cost of living keeps rising. Left unchecked, it will lead to the increasing perception of inequality and societal unrest. Low incomes also mean low tax collection for the government. Case in point: Only one in every five working Malaysians currently pays income taxes.

We need to raise the people’s wages and income levels. But this is a journey, not a destination. It will take decades to increase real wages, not years. As we said, labour income share reflects the country’s economic structure, that is the composition of GDP, at its current stage of development. It will change with time, mirroring the development path of the economy. What it does not do is tell us the economic well-being of the people. As the table shows, the labour income-to-GDP ratio has no clear correlation to per capita income or economic well-being.

For instance, Saudi Arabia has a lower labour income share (27%) than Malaysia. Yet, its per capita income is well above ours. Saudi’s wealth comes from oil. The oil sector is highly capital intensive for exploration, development, extraction and processing. Saudi Aramco (its national oil company) expects to spend up to US$55 billion for capital expenditure

For more stories about where money flows, <a class='gtm_see_also_3_inread' style='text-decoration: underline;' href='/section/capital?utm_source=website&utm_medium=article&utm_campaign=ONPAGESEO'>click here for Capital Section</a>

in 2023. As such, capital will necessarily have a higher share of economic output — to cover depreciation, interest payments and returns on investments.

Malaysia’s lower labour income share and low wages due to economic structure

Malaysia’s economy has much larger agriculture and mining sectors compared with, say, Singapore and the US. Oil and gas is capital intensive, as is the plantation sector (for land and planting costs). Therefore, both sectors will have comparatively lower labour income shares. This will bring down the average labour income share for the country (see Chart 2).

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Broadly speaking, as an economy develops — typically from agriculture to manufacturing and on to services — services will account for a larger share of GDP. Since services typically have a higher share of labour income, the overall labour income share of the country will rise. This is one reason why most developed countries have comparatively higher labour income shares. Malaysia’s services sector is still smaller than that of Singapore and the US.

The point is, comparing labour income shares across countries tells us very little. A higher labour income share does not necessarily translate into higher wages. Wages in Malaysia are low, not because labour income share is low but because the majority of jobs are low-skilled with low productivity. Case in point: We have a large construction/property sector, which has a high labour income share. Unfortunately, construction employs mostly low-skilled foreign workers. As a result, productivity and the median wage are low. Similarly, the manufacturing and services sectors have higher labour income shares (because the jobs are more labour intensive) but lower median wages. On the other hand, the oil and gas sector has the lowest labour income share but highest median salary (see Chart 3 above).

For ease of understanding, assume company C and company D both generate $100 million in gross profit (revenue less cost of goods sold) — with a net profit of $20 million, total wage bill of $50 million and the balance $30 million for tax, interest and depreciation. Company C has 200 workers and company D has 400. Both have a labour income share of 50% (of gross profit). But workers in company C earn double that of company D because they are more productive.

Malaysia’s manufacturing sector is still mostly engaged in low value-added activities, with slow productivity gains due, in part, to premature deindustrialisation after the Asian financial crisis. Technology adoption and innovation is low and there is a lack of functional upgrading (new value-adding activities). The sector has high import content. As a result, the jobs remain primarily low-skilled, with low wages.

We see the same trend in the services sector, where a high proportion of jobs are concentrated in the low-skilled wholesale-retail, F&B and hospitality subsectors as opposed to knowledge-based subsectors like professional and consultancy services that employ highly educated workers (see Chart 4). Remember, low skill = low wage, regardless of labour income share.

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Secondary effects and consequences

Perhaps even more damaging are the secondary effects of such labour income share targeting actions. Surely increasing the total payroll for workers without a corresponding rise in productivity in the economy will be inflationary. The rise in prices (businesses will be forced to pass on higher wage bills) will increase the cost of living. This is exactly what is termed a “wage-price spiral”. The higher cost of living will, in turn, lead to more demand for higher wages.

The large number of civil servants will demand wage adjustments. This, together with any wage subsidy programme, will give rise to even higher fiscal deficits.

And what about those who currently earn just above this minimum wage? Assume this is now raised to RM2,500 a month. Those making an income from RM2,501 and higher — say, up to RM3,500 a month — will they, too, not demand a pay rise? What consequences would all these compounding effects have on companies? Economics is a social science that examines how people, businesses and others make decisions that affect production and consumption. It is not simple arithmetic or accounting.

If all these consequences were to come to bear, would the stock market and the ringgit not be badly affected?

Therefore, it is crystal clear that to raise wages and incomes, Malaysia needs to transform its economy to a knowledge-based services-driven economy and move up the manufacturing value chain. To do so, we need to reinvigorate investments.

Decades of protectionist policies and a steady supply of cheap low-skilled foreign migrant labour have eroded the global competitiveness of Malaysian companies. Many became overreliant on high volume-low cost production, failing to move up the value chain. Eventually, competitive pressure from newer emerging countries with even larger pools of cheaper labour leads to falling profit margins (note that the uptick in 2020-2022 is due to the Covid-19 pandemic distortions, which are currently normalising lower). (See Chart 5.) The truth of the matter is that companies cannot afford to pay higher wages because their returns on capital are also falling.

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In short, Malaysians may be lowly paid but they are NOT underpaid relative to their productivity (see Chart 6). Businesses cannot pay more and wages cannot rise — at least, not without a negative impact on employment and investments — until they can boost productivity. How?

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As we have explained in depth in our recent three-part series — comparing Malaysia with the economic success of South Korea and failure of South Africa (published in The Edge in the issues dated <a href="https://www.theedgesingapore.com/capital/tongs-portfolio/democracy-ideology-not-solution" target="_blank">July 24</a>, <a href="https://www.theedgesingapore.com/capital/tongs-portfolio/story-two-souths-education-competition-and-corruption" target="_blank">July 31</a> and <a href="https://www.theedgesingapore.com/capital/tongs-portfolio/end-state-capture-enable-economic-transformation-and-improve-livelihoods" target="_blank">Aug 7, 2023</a>.) — the government must undertake bold structural reforms to eliminate “state capture”, to enable economic transformation and improve livelihoods.

Open up the economy to competition, including from domestic enterprises and start-ups, and foreign firms. Do away with rent-seeking activities such as licensing requirements and approved permits for imports. End protectionist policies that only benefit the business elite and privileged few.

Allow competition to drive the market. Force domestic companies to compete by raising productivity through technology adoption and an increase in R&D spending, which will spur innovation and further technological advancements. It will also enable them to be more competitive in the global market.

The small and medium enterprises (SMEs) and micro, small and medium enterprises (MSMEs) are the largest employers in the country. What is holding them back from innovation, increased investments and higher productivity are the lack of financing, over-regulation, excessive corruption and protectionist supply chains. Address these issues to raise productivity, and create jobs and a sustainable increase in wages.

Subsidising wages in the private sector will only worsen Malaysia’s already precarious fiscal position. (Read our article, “<a href="https://www.theedgesingapore.com/capital/tongs-portfolio/tick-tock-tick-tock--time-running-out-malaysia-needs-credible-fiscal" target="_blank">Tick tock tick tock ... time is running out ... Malaysia needs a credible fiscal consolidation plan now</a>”, in the issue dated Aug 14, 2023.) Wage subsidies during the pandemic cost the government some RM21 billion. An even larger subsidy with no end date will most certainly wreck the budget, with very serious repercussions for the country.

Forcing wages “artificially” higher by setting a labour income share target, progressive wage policy and/or subsidising private sector wages — above productivity levels — is unsustainable in the long run and will most likely have the opposite effect of disincentivising investments. Continued and sustainable increase in wages and incomes must be driven by market forces.

And yes, we cannot stress this enough, Malaysia must improve the education system to provide the talent needed to attract high-value investments that will raise productivity and create high paying jobs. Investments will go to countries where talent is available. The competition for talent is increasingly global. Businesses will pay the appropriate wages to retain talent and people will move to where wages are commensurate with their skill sets. Government rarely knows more than the market — that is also why interventions typically do more harm than good.

We conclude this article with a quote from Michael R Strain, director of economic policy studies at the American Enterprise Institute, and author, most recently, of The American Dream Is Not Dead: (But Populism Could Kill It):

“… populist and nationalist solutions won’t work. We owe it to workers to focus on policies that will advance mass flourishing”. — “Why industrial policy fails” (Project Syndicate, Aug 15, 2023)

The Malaysian Portfolio fell 2.2% last week, amid weaker broader market sentiment. All the stocks in our portfolio ended lower, including Star Media Group (-3.8%), Hartalega Holdings (-3.4%) and Insas (-2.9%). Last week’s losses pared total portfolio returns to 149.7% since inception. Nevertheless, this portfolio is outperforming the benchmark FBM KLCI, which is down 21.3%, by a long, long way.

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Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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