Friday, September 3, 2010

Performance Pay and Wage Inequality

. Friday, September 3, 2010

I don't recall reading much discussion of "Performance Pay and Wage Inequality", a paper by Thomas Lemieux, W. Bentley MacLeod, and Daniel Parent, either when it was released as an NBER working paper in 2007 or when it was published in the Quarterly Journal of Economics in 2009 (ungated pdf here). That's too bad, because it is an important paper and does more than any other to answer the perennial question "What has caused the increase in income inequality in the U.S. since the 1970s?" Almost all of the shift in income distribution over that period has accrued to the top 10% of workers, but it hasn't been clear why. Some have argued that the increase in inequality was caused by increased trade openness, changing cultural norms rewarding greed, the decline of labor unions, skill-biased technological change, shifting tax policy that rewarded the rich, and/or increasing returns to economic "superstars" like entertainers and athletes.

The authors make a pretty strong case that it has been because employers have become better able to find and reward more-productive workers for their work, while less-productive workers are left behind. (This is largely consistent with the "skill-biased technological change" explanation, though more specific in theory and causal mechanism.) The abstract:

An increasing fraction of jobs in the U.S. labor market explicitly pay workers for their performance using bonus pay, commissions, or piece-rate contracts. Using data from the Panel Study of Income Dynamics, we show that compensation in performance-pay jobs is more closely tied to both observed and unobserved productive characteristics of workers than compensation in non-performance-pay jobs. We also find that the return to these productive characteristics increased faster over time in performance-pay than in non-performance-pay jobs. We show that this finding is consistent with the view that underlying changes in returns to skill due, for instance, to technological change induce more firms to offer performance-pay contracts and result in more wage inequality among workers who are paid for performance. Thus, performance pay provides a channel through which underlying changes in returns to skill get translated into higher wage inequality. We conclude that this channel accounts for 21% of the growth in the variance of male wages between the late 1970s and the early 1990s and for most of the increase in wage inequality above the eightieth percentile over the same period.

In other words, workers that have earned more have largely deserved to earn more, by objective criteria. Employers have become better at discovering top performers and compensating them accordingly. Top employees have become better at finding ways to demonstrate to employers what their true value is. Over time, more jobs have included performance pay as some or all of their compensation, so inequality has increased. The striking thing is that this explains almost all of the inequality increase in the 80th percentile and above, which is where almost all of the increase in inequality has occurred. It's a powerful paper.

This isn't as sexy or sinister as other narratives of increasing inequality, but it makes sense. Technology has made it easier to demonstrate and assess productivity, especially in information-intensive professions. The information technology sector has increased relative to traditional salaried sectors like manufacturing. Hence, inequality has increased.

I'm amazed that this wasn't covered more in blogosphere. Is it because it contradicts some sacred cows?

Anyway the news that the American political economy is not unjustly controlled by the rich using their power to extract rents should be welcomed by everyone. In other words, we should be very pleased that we do not live in a "New Gilded Age", at least if that's defined by robber-barons seizing wealth that they were not entitled to. This paper is evidence that the wages are distributed more fairly than most of us had thought.


sarah bd said...

This issue of technology vs education and their effects on inequality and structural unemployment in at least the US was touched upon by Raghu Rajan at an APSA panel this morning. I am planning to make one of my spotty appearances on this blog by writing a panel wrap-up later tonight. Raghu made some interesting points about the implications of this type of inequality for the international economic and political system.

Kindred Winecoff said...

Please write that. I'd be interested to hear what he said, and what you think.

To me, the most obvious implication is that we need to make more and better investments toward making more people more productive.

Brad, Boston said...

are you for real? you claim to be a political scientist? you are so naive. where are the politics in your analysis? The wealthy in the finance industry have been productive because they were selling lots of expensive, crappy, and risky products, which led to huge profits for them. they were able to efficiently sell such products because they got the government to rig the system in their favor. The government carries much of the responsibility for these rigged rules, but those in the finance industry saw a spike in their income because they were able to sell risky, crappy products and make lots of money doing it while others were not doing the same. in other words, the rigged rules were the main cause of those in the finance industry to increase their income at the same time that others were playing a different game, one that didn't allow them to make huge sums of money, even those with similar education levels and productivity levels (i.e. educators). i can't believe you think this is all a benign process, even though political economists know that domestic groups influence policy so that they can maximize their income, even if this has large costs on others (think of trade politics).

Kindred Winecoff said...

Brad -

I didn't say it was benign, although I could see how I might've left that impression. All I'm doing is reporting an empirical finding that I had missed previously, and that matches with a plausible theoretical narrative.

I think you're (partially) on to something when you talk about finance. That industry has become a much larger part of the overall U.S. economy, and obviously some of that "productivity" was totally ephemeral (to put it mildly). The study ends before the crash, so revisiting it in a few years might change the story. The article, however, looks across income classes, education levels, industries, and occupations. In other words, this is an economy-wide effect, not limited to one particular sector. If you'd bother to even glance at the article you would've noticed that.

What you're alleging needs some substantiation. How exactly was the system rigged? The analysis I linked uses pre-tax income, so it's not that. The U.S. has some of the highest capital gains and corporate income tax rates in the industrialized world, so it's not that either. The U.S. has (and had) stricter financial regulations than most other developed economies as well. (The sample period includes the Glass-Steagall years, for example.) So what is your claim, exactly?

Again, we're talking about private sector movements here. Obviously government policy can and does play a role in shaping market behaviors, but there isn't an obvious causal rent-seeking mechanism that I see here. If you do, propose it.

That's not to say that this doesn't have political ramifications, of course, which is why I linked to it. You're right that I should write more about those. I'll try to get to it over the weekend.

Performance Pay and Wage Inequality
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