Chapter 01 – The future of personal income

In this article, we discuss the future of personal income. Personal income is, in many ways, the lifeblood of the financial advice profession. After all, it is our main point of professional interest. Our future as advisers depends on our ability to assist people to attract, maximise, preserve and diversify their personal income.

In this article, we take a look at the state of play for personal income in Australia. Personal income is changing in developed countries such as Australia, and the rate of change can be expected to continue into the future. While no one can predict the future with any certainty, we can examine current trends and apply intelligent analysis to position ourselves and our clients as well as possible for the unknown future.

What is income?

Classic economics tells us that there are four factors of production involved in economic activity. These are:

  1. land
  2. labour
  3. capital; and
  4. enterprise (which may at times also be a form of capital).

Income is the return to the owner of one or more of these factors of production. For example, landowners receive their income as rent. Labourers receive their income as wages or salary. Capitalists receive their income as some form of payment from the enterprise in which they invest, such as loan interest. And entrepreneurs receive profits from their businesses.

Historically, all economic activity tended to use two or more of these factors of production. That meant that the income generated by that economic activity needed to be distributed between the owners of the relevant factors of production. For example, an entrepreneur needed to pay a landlord, workers and any financial backers of the enterprise from the revenue of the business before he or she could take what remained as profit.

Obviously, the share of business revenue went to each of these factors of production depended on the extent to which these factors contributed to the business’s activity. A business with many labourers would pay a larger share of its revenue to those labourers. A business that was land intensive would pay a larger share of its revenue to the landowner. A business that relied more heavily on debt finance would pay a larger share of its revenue to its financiers. That rare business that used relatively little land, labour or investment capital returned most of its revenue to the entrepreneur.

In addition to the contribution each factor made to production, that factor’s share of revenue also depended on its relative scarcity. A factor is relatively scarce if demand for it is high relative to its supply. Such a situation will drive up the price of any such factor. So, a business that was labour-intensive and which operated in a market where labour was relatively scarce paid an even higher proportion of its revenue to that labour. Similarly, if land was scarce then it’s owners could command a higher share of total income. Finally, if capital was tight, interest rates tended to be higher, increasing the share of business income that went to the owners of capital.

Labour’s Share of Income

in the post Second World War period, Australia operated at or near full employment. Virtually everyone who wanted a job could find one. This meant that labour was relatively scarce, which raised its price. In addition, manufacturing (in particular) was relatively labour-intensive. This meant that labour could command a greater share of business revenue.

Technology is now changing this. Technology is allowing a greater amount of economic activity to take place with a lower contribution from labour. The diminishing contribution of labour is happening across the entire economy. As a result, it can be seen in macroeconomic statistics such as the share of ‘national income’ going to labour. National income is the total amount of income going to owners of each of the four factors of production. The proportion of national income going to labour has been falling across all developed economies over the last four decades. This is shown in the following graph, published in February 2015 by the Organisation for Economic Co-Operation and Development (OECD):

This rate of reduction is gathering pace. Across the OECD, between 1990 and 2009, labour’s share of national income fell from 66.1% to 61.7%. This means that the longer-term rate of reduction between 1980 and late 2000’s is 0.3% of total income per year.

Remember, total income must equal 100%. So, for labour to be taking a declining share of national income, an increasing share of that same income must be going to owners of other factors of production. While it is true that the cost of land in Australia is increasing, the nature of the economy is such that, increasingly, economic activity does not require increased land input. (We will discuss land at the end of this article).

In November 2017, the Reserve Bank provided the following info graphic as a snapshot of the composition of the Australian economy:

As can be seen, finance is approaching 10% of the total economy. Increasingly, finance takes place in a digital realm. As it expands its share of the economy, it does not expand the amount of land devoted to this activity.

And when it comes to labour, banking is actually reducing its labour force. In the same month (November 2017) the National Australia Bank announced that it would reduce its workforce by 6000 workers – 18% of its total full-time employees. The work being completed by these employees would henceforth be done by technology.

As a factor of production, technology is typically owned by the enterprise owner (in the case of the National Australia Bank, its shareholders). As technology’s contribution to total business output increases, so too does the share of business revenue going to the owners of technology. So, the reduction in national income going to labour is being replaced by an increase in the share of national income going to enterprise. (If the enterprise is debt-financed, then an increasing share will also go to capital).

In general, people who own enterprises are taking an increasing share of total national income. People who own only their labour are taking a shrinking share.

We can see this in manufacturing as well. As the RBA’s info graphic makes clear, in 2017 manufacturing comprised just 6% of total economic activity. In the 1960s, the share was 25%. Of course, people are still buying things and these things need to be manufactured. But they are being manufactured overseas and imported to Australia. This means that, in terms of Australian income, a greater share of retail spending is going to importers (once again, the owners of enterprises) rather than manufacturers.

To see an extreme example of the movement away from labour and towards capital and business owners, consider the case of Instagram. Founded in 2011, it was sold in 2012 to Facebook for $US1 billion. At the time, it had just 13 employees. It took just 13 employees to run a business that the market valued at US $1 billion. Various venture capitalists did very well, as did the enterprise owner. Interestingly, a number of the employees also had ownership shares in the business.

The drivers of change

This last point indicates the first driver of change. Increasing globalisation means that countries can now compete to provide factors into the production process. In terms of labour, those countries with lower labour costs than Australia have an obvious competitive advantage. And so we see the labour component of much economic production being sent off shore. As outlined above, this is happening in manufacturing. But it is also happening across all other sectors of the economy, from call centres to tele medicine. Consider this recent headline from the Wall Street Journal:

With our high rate of GDP per person, Australia has a structural disadvantage in terms of providing labour into the economic process. There are certain jobs that cannot be sent off shore (for example, care work). But work that can be performed elsewhere often will. And as the headline above suggests, it is not just unskilled work that is vulnerable to off shoring.

Of course, the movement of service businesses such as medicine to an international setting is made possible by technology. The future impact of technology is very hard to predict. Many readers will be familiar with the concept of Moore’s Law. Moore’s law suggests that computing capacity will double every 18 to 24 months. The law was first suggested in the 1960s (by a chap named Moore) and has since been proven to be completely accurate.

To get an idea of how the law operates, consider the following graph developed by Chris Witeck of Citrix. It shows the number of transistors in various pieces of technology over the last 40 years:

For our purposes, compare the number of transistors in the original iPhone (released in 2007) with the original iPad released just three years later. While the iPad was bigger, it nevertheless had triple the number of transistors that its predecessor had contained just three years previously. Raspberry Pi is a device that measures just 10 cm x 5 cm, and in 2012 it contained almost twice as many transistors again.

The doubling of technological power is now coming off a large base. This means that future growth will be huge. Indeed, if this law is to continue, within 10 years computing capacity could be as much as 30 times more powerful than it is today. This is an absolute explosion of technological potential. As a result, we need to be very sceptical about people who make specific predictions about the future economy. All we can say is that technology will play an even greater role than it does today. Economics would suggest that this means an even further reduction in the share of income going to labour.

Credible commentators are suggesting that it will not just be unskilled or low skilled labour that is replaced by technology. Indeed, in their work The Future of the Professions, father and son academics Richard and Daniel Susskind suggest that previously esteemed professions such as the law will also be placed at great risk by technology.

While the long-term effect of technology might be to displace workers, the shorter-term effect is generally to make workers more productive. That is, for a given number of workers, a business can produce more output and therefore create more revenue. Once again, this shifts the share of business income away from labour and towards the owners of capital and the enterprise.

What this means for financial advisers

As the above analysis makes clear, in a developed economy such as Australia the share of national income going to labour is falling and can be expected to continue to fall. This means that people whose only source of income is their labour are likely to receive a diminishing share of future economic output. That share is being and will continue to be taken by the owners of capital and enterprises.

Historically, much of what a financial adviser does centres around the management of labour income. Most life insurances, for example, aim to compensate a client or their loved ones if they become unable to generate labour income. So, at first glance, any threat to labour income might be seen as ‘bad news’ for advisers. But, when we look more deeply, we can see that the opposite is the case. In actual fact, financial advisers have always tried to help clients generate income unrelated to their labour. In responding to changes in the economy, financial advisers are just applying the same concepts in a different way. In addition to assisting clients to insure their labour income, advisers now need to take an extra step in the same direction, and assist clients to establish streams of income unrelated to their labour. That is, advisers need to assist clients to become owners of capital and/or enterprises.

Very happily, financial advisers are well-placed to do this. The ‘capitalist system’ in Australia is an extremely open one. According to the ASX, in 2014 36% of the adult Australian population directly owned investments listed on the ASX. This does not include investments made through managed superannuation funds (although it does include investments made through self-managed superannuation funds). This is the rate of Australians who deliberately (rather than automatically through super) invest in shares.

This is one of the highest rates of direct share investment in the world. A share holder is an owner of an enterprise. Shareholders receive enterprise income in the form of dividends, which are a share of company profits.

Interestingly, this rate of direct ownership represents a reduction from previous years. Direct share ownership peaked around 2004 at a level above 40%. Of course, when we add in those Australians who invest into the sharemarket indirectly, especially through a managed superannuation fund, the rate at which Australians own capital and enterprises is extremely high by world standards. You can read more about the demographics of Australian shareholders here. The point is that the Australian sharemarket is relatively easy for Australians to enter.

The opportunity for financial advisers is to understand the changing way in which national income is being shared and to assist their clients become the owners of factors of production other than their labour. Put simply, this means assisting their clients to become investors.

In Dover’s experience, approximately 50% of all statements of advice written within the group are for risk insurance only. We think advisers who limit their client service to risk insurance miss a wonderful opportunity to assist their clients to gain alternative sources of personal income other than labour. This is simply an extension of the work done to get risk insurances in place. Having prepared for physical challenges to a person’s ability to earn labour income, the adviser can take the next step and help their clients prepare for economic challenges to their ability to earn labour income.

What about land?

In the above analysis we have not discussed land in any great detail. In mainstream economics, the land referred to as a factor of production is typically land used in economic activity such as business. Land used for private purposes, such as residential property, tends not to be included.

This is a mistake, really. After all, the business of housing population is one of the most important economic tasks for any community. Private housing actually accounts for 43% of total private wealth in Australia. So, land tends to be where wealth ‘ends up.’

The above analysis about the share of national income going to labour describes only the way in which the ‘economic pie’ is divided. As it happens, the size of the economic pie in developed countries such as Australia is growing strongly. Over the very long term, total national income in countries like Australia is growing at a rate of at least 2% per person per year, inflation-adjusted.

So, while an increasing share of income is being redistributed away from labour, total income is also rising. This means that the owners of capital and enterprises are not just receiving a bigger share of the pie: they are receiving a bigger share of a bigger pie.

What isn’t rising, simply because it cannot, is the amount of residential land available in close proximity to desirable features such as the centre of Australia’s capital cities. That is why, over the last 20 years, we have seen an enormous increase in the value of residential property in sought-after parts of Australia. In addition, Australia’s population continues to grow. Most of this growth is fuelled by immigration, with immigrants generally preferring to live in established areas of established cities where possible.

So, the share of national income that goes to the owners of land, and in particular residential that is currently in high demand, can be expected to either retain its current level even to increase.

Once again, this creates an opportunity for financial advisers who can assist their clients to own either their own homes and/or investment properties. Becoming a property owner means acquiring another factor of economic production. That factor is land. And when people acquire land, they reduce their reliance on labour income. That is why Dover has always looked very favourably upon property as a desirable investment asset for clients of our advisers. Advisers who can assist clients to own more and/or better land will help those clients to prosper in the ‘new economy.’

Summary

In summary, it is clear that an increasing share of the economic pie is going to the owners of factors of production other than labour. Economy is changing. These changes mean that landlords, financiers and business owners (including shareholders) are taking an increasing share of national income. What’s more, national income is growing, meaning that landlords financiers and business owners are achieving a double positive effect.

This creates a wonderful opportunity for financial advisers. Advisors who understand the changes to the economy and can communicate them to clients can then assist those clients to diversify their income away from labour and towards the ownership of other economic resources.

The Dover Group