The following section presents results for variables directly affecting the Rate of Return, including, the labor share (sw) in gross product of the business sector, capital productivity (Πk), capacity utilization rate (using as proxy the gap between GDP and potential GDP), relative prices (P/Pk and Pc /P), and fixed capital consumption rate (δ).
The Rise Of The Rate Of Return
Figure 2 illustrates the relatively stable rate of return in the business sector from 2006-2009.[6] As a result of the economic crisis, the rate of return began to fall in 2009, reaching its lowest level during the period of deep structural crisis and harsh adjustment programs imposed by international institutions at the time (2013-2014).
Since 2010, the rate of return has increased from 100 to 125 and has remained at this level until the Covid-19 crisis in 2020 (Fig. 2). In recent years, however, the return rate has begun to rise rapidly again, with return rates approaching 50% higher than they were in 2010.
The Continuing Devaluation Of Labor
We can now understand why the rate of return in Cyprus has increased rapidly in recent years by focusing on the factors that influence profitability. For the examining period 2006–2012, the labor share as a percentage of gross product in Cyprus's business sector fluctuated around 56.1% (Fig. 3). In 2012, it began to decline, and by the end of 2016, it had fallen by 5 percentage points of gross product. As a result of a wage rebound in 2017, the labor share of gross product settled at 52% and remained so until the outbreak of the Covid-19 pandemic period. The restart of the economy in 2021 was accompanied by a precipitous fall in the labor share; it has been reduced to 50% of gross product during 2021 and reached the historical low of 48,5% in the second quarter of 2022.
A labor share represents the value of labor power in the price system. Therefore, the decline in the labor share of the business sector from 2012:1 to 2022:2 represents a significant devaluation of labor in the Cyprus economy.
The extent to which the decline in the labor share is due to unemployment or structural changes remains unclear. For this reason, Fig. 4 plots the labor share in the business sector against the unemployment rate so as to disentangle the two effects.
Due to the increasing unemployment rate, the labor share declined between 2011:3 and 2013:1 (in accordance with the labor share curve BB’) (Fig. 4). During 2013:2, structural changes led to a devaluation of labor due to the adjustment program imposed by international institutions on Cyprus.
Thus, the two structural slumps in the labor share curve that occurred in the last ten years (2012–2022) can be attributed to the decline of 7,6 percentage points in the labor share.
The shift in the primary distribution of income may be further explained by breaking down the labor share into its components (Eq. 2).
Firstly, the labor share rises (falls) in tandem with increases (decreases) in the average real wage (Wreal) that outpace (lag behind) increases in labor productivity (Π). An alternative way to analyze the relation of Wreal versus Π, is to compare the purchasing power of overall gross wages (L Wreal) to the purchasing power of gross operating surplus (Y-L Wreal) which is capital income (profits plus interest plus rents) (all variables before tax and contributions to social security).
It is seen in Fig. 5 that in the business sector the purchasing power of the income of workers increased by approximately 2,5% between 2010–2022 while the corresponding capital income (profits, interest, and rents) during the same period rose by approximately 35% and is still rising.
Secondly, as shown in Eq. 2, the other components of the labor share are (a) the actual rate of employers' contribution to social security (tssf) and (b) relative prices that is consumer prices (Pc) on gross product deflator (P) (or equivalently a function of the real exchange rate ereer-λ).
Figure 6 shows that relative prices and employer's contributions to social security, both contribute to changes in the labor share albeit to a much lesser degree than the real consumption wage (Wreal = W/Pc). To put it another way, Fig. 6 shows that the variability of relative prices and employer's contributions was very low in comparison with the variability of the real consumption wage, which was thus by far the most important determinant of the labor share. Therefore, to simplify the analysis we assume that the combined effect of tssf and ereer was roughly constant. It follows from (5) that approximately
where λs is a constant.
4.3. The Decline Of Capital Productivity
The gross product/fixed capital ratio (Y/K) is analyzed into two components:
(a) capital productivity Πk=Yfc / K, and (b) capacity utilization rate (Q=Y/Yfc).[7] Therefore, the gross product to fixed capital ratio is (Υ/Κ) = QΠk.
Changes in capital productivity and gross product/fixed capital ratio in the business sector (variables Πk and Y/ K) are depicted in Fig. 7.
Figure 7 shows that there was a decline in capital productivity of about 10% between 2006–2015, and then a recovery of barely 5%. It was still 8% lower in 2022 compared to 2006. Our results demonstrate that capital productivity did not contribute to an increase in the rate of return, but rather had the opposite effect.
Meanwhile, capacity utilization (Q) contributed positively to the rise in the rate of return beginning in 2017 and continuing until the outbreak of the pandemic. Since early 2021, it has also contributed positively to profits. This, however, comes at the cost of overheating the economy, resulting in gross output exceeding potential, and persistent large current account deficits. In addition, during the years 2012–2015, a significant under-utilization of productive capacity contributed to a decrease in the rate of return as a result of structural crises.
As a result of these fluctuations, when the time span 2010–2022 is considered, changes in the capacity utilization rate had a rather neutral effect on profits.
In the business sector, capital productivity has decreased as a result of the slow growth of gross product compared with net fixed capital stock, indicating that a higher amount of fixed capital is required now to produce one unit of gross product (Fig. 8). There is a clear indication of negative economies in the use of fixed capital.
In this paper, we also examine the relationship between gross product prices and fixed capital prices (P/Pk), which is another factor affecting the rate of return. Figure 9 illustrates the changes in this ratio during 2006:1-2022:2. As shown in the figure, product prices (P) increased faster during the years 2010–2013 than fixed capital prices (Pk) due to a devaluation of fixed capital, mostly in the housing sector. These differences, however, were relatively small and temporary. Therefore, their importance is generally considered to be of limited significance.
[6] If we examine the history of the rate of return since 1995, we find that it has been oscillating around a constant value.
[7] Full capacity utilization is proxied in this paper by Potential Output available in Ameco database of national accounts. Consequently, capacity utilization rate is proxied by the gap between gross product and potential output.