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Performance Pay and Wage Inequality

By Harvard Law School Program on Corporate Governance

(Editor?s note: This post comes from Thomas Lemieux of the University of British Columbia, W. Bentley MacLeod of Columbia University, and Daniel Parent of McGill University.)

In Performance Pay and Wage Inequality, which is forthcoming in the Quarterly Journal of Economics, we evaluate the change in components of pay across different types of jobs, and investigate whether these changes have lead to the increase in wage inequality.

We use data from the Panel Study of Income Dynamics (PSID), and our empirical strategy builds upon two of the most prevalent solutions to how best to set employee pay. The first begins with an evaluation of the needs of a job, and then fixes compensation equal to job value. Under such a system, compensation is effectively fixed before the worker is hired. This implies that compensation is mainly determined by characteristics of the job, with the relationship between worker ability and compensation driven by selection: firms hire the most able person that applies for the job. The second approach is premised on the concept of pay for the person. This system entails rewarding a person’s productivity rather than the job. Under such a regime, the base pay reflects job value, with additional compensation paid after employment to reward the worker for realized performance.

We find that the incidence of performance-pay has increased substantially since the late 1970s. This increase is consistent with the view that the cost of collecting and processing information has declined over time with advances in information and communication technologies. Second, we show that wages are less equally distributed in performance-pay jobs than in other jobs because the return to productive characteristics like education is larger in performance-pay jobs. Putting together these observations, and the fact that the incidence of performance has increased over the same time period, we find that about a quarter of the increase in the variance of wages between the late 1970s and early 1990s is associated with the increased use of performance-pay. Even more striking, we can explain nearly all of the increase in wage inequality above the 80th percentile. This is particularly important because changes in inequality are increasingly concentrated at the top levels of the wage distribution.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on November 17, 2008 (boomark / email).