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The first estimates of economic growth in the September quarter indicate that India’s ongoing recovery has been better than expected. This is a good time to resurrect a question this column had raised in August: Will the economic recovery be led by profits or wages? The answer matters because it has implications for aggregate demand in the coming quarters.

A good place to begin is the corporate results for the three months ended September. Indian companies reported a decline in sales. However, operating profits growth was in the double digits. Net profits grew even faster. Large firms achieved this by slashing costs.

Listed companies are only a small part of the overall Indian economy, but they have an outsized influence on the initial gross domestic product (GDP) estimates that the government releases. The increase in the operating profits of large companies, despite lower sales, is also a reason why industrial gross value added (GVA) was positive in the second quarter, despite a decline in the index of industrial production (IIP).

J.P. Morgan chief India economist Sajjid Chinoy has pointed out that one of the many ways to calculate the GDP of a country is by adding incomes—the operating profits of companies, wages of households, and the net indirect taxes collected by the government. Higher operating profits in a shrinking economy suggest that the share of wages in the economy has come down. In other words, the ongoing recovery seems to be led by profits, rather than wages.

The macroeconomic impact of higher or lower wages is an old debate in economics. The battle-lines are drawn on an ideological basis. The Left usually argues that higher wages expand the domestic market by increasing the purchasing power of those with the highest propensity to consume. The Right usually argues that higher wages are the first step in an inflationary spiral as companies respond to an increase in employee costs by increasing the prices of their products.

In two classic papers published in 1990, economists Amit Bhaduri and Stephen Marglin showed that the reality is more nuanced. A lot depends on the context. Growth can be stimulated by higher wages in some situations and by higher profits in others. Higher wages will not improve aggregate outcomes in an economy with low unemployment as well as minimal excess capacity. This was the situation in the rich countries during the 1970s. Higher wages will stimulate the economy when there is slack, as has been the case after the 2008 North Atlantic financial crisis.

The Bhaduri-Marglin argument is more focused on the situation in advanced economies than emerging ones. And it is about wage rates rather than the share of wages in the economy. However, their insight can be adapted to the case of a recovery in an emerging market such as India. A recovery led by profits will not lead to higher investment demand as long as there is significant excess capacity in many parts of the Indian economy. On the other hand, a recovery led by wages can stimulate the economy even if one assumes that there will be a rise in precautionary household savings, as this column has been arguing.

Much depends on the state of the labour market as well as the trend in business investment over the coming months. The latter situation is well known. New business investment has been weak in India through most of the past decade because of excess capacity. As far as the labour market goes, unemployment has dropped below pre-covid levels, but that is partly because of a decrease in the labour participation rate. Rural wage growth has been strong while it was been sluggish in the cities. It is also likely that informal enterprises are struggling. These straws in the wind suggest that wage growth is not as strong as profit growth right now.

Bhaduri and Marglin had pointed out the complex role of wages in a modern economy: “Higher wages mean higher costs on manufacturing, but by providing more purchasing power to the workers they also stimulate demand. In its contradictory role as the main element of variable production cost and as a major source of demand, movement in the wage rate has a complex, even ambiguous, effect on the level of employment and output."

In a survey of chief executive officers (CEOs) conducted by Mint and Bain in September, more than half the companies surveyed had reduced employee costs through either salary cuts or lay-offs. Sixty-six percent of these CEOs were worried about reduced consumer purchasing power. This is the classic fallacy of composition in economics, where what is rational for one company may not be rational for all of them.

Recent data suggests that wage payments have recovered in large companies, but the situation in the rest of the urban economy is less clear. A recovery led by profits will be stress tested in an economy with excess capacity. Business spending on new capital equipment is likely to remain weak till capacity utilization improves. Companies are likely to focus on building reserves or paying off debt. In such a situation, much depends on household spending to support aggregate demand from the private sector. And that is why wages matter.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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