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Pay for performance and wage inequality
Lemieux, MacLeod, and Parent get to the point:
We document that an increasing fraction of jobs in the U.S. labor market explicitly pay workers for their performance using bonuses, commissions, or piece-rates. We find that compensation in performance-pay jobs is more closely tied to both observed (by the econometrician) and unobserved productive characteristics of workers. Moreover, the growing incidence of performance-pay can explain 24 percent of the growth in the variance of male wages between the late 1970s and the early 1990s, and accounts for nearly all of the top-end growth in wage dispersion (above the 80th percentile).
Here is the link, here is a non-gated version. It is perhaps simplistic to say the people at the top now earn more because they can, but simplistic is not the same as wrong. For me the puzzle is why the world held back so much on bonus pay for so long.
Posted by Tyler Cowen on May 29, 2007 at 01:33 PM in Economics | Permalink
Comments
"For me the puzzle is why the world held back so much on bonus pay for so long. "
Well, from my personal experiences, I'd tell you to look at something marginal, the marginal tax rates. Bonuses were great, until you realized you have to pay income and payroll taxes. A good chunk of your bonus goes to the government. Maybe you jump up a tax bracket thanks to the bonus, so more of it goes away.
Most companies don't handle the taxes on the bonus properly, so you wind up owing federal or state taxing money at the end of the year. Or, your tax planning for the year gets all screwed up because you planned on earning $X and instead earned 1.1 * $X (10% bonus, as an example).
Maybe improved accounting software is the cause for increases in bonuses.
Posted by: Xmas at May 29, 2007 2:31:15 PM
I note this is only a working paper and I don't have time to go over the methodology, but performance related pay has been studied by others, although it's mostly been published in organisation studies journals, because HR types are the ones who have been most concerned to work out if performance-related pay "does what it says on the tin."
And, this single paper doesn't really change the balance much, which is that overall, the studies are split. Sometimes it seems that PRP is well correlated with productivity, sometimes it isn't and sometimes it seems only to be inversely correlated.
And that is probably why the concept hasn't had such a large take up in the past.
Maybe if someone has more time they can analyse the time series to see if PRP has improved over the years? That might explain (and/or be explained by) increasing take up also.
Posted by: Meh at May 29, 2007 2:41:14 PM
"the puzzle is why the world held back so much on bonus pay for so long"
Reduction of unionization?
"MIAMI -- A teachers union went to court Friday to challenge the state's pioneering bonus-pay program..."
http://www.washingtonpost.com/wp-dyn/content/article/2007/01/12/AR2007011201562.html
Posted by: Mr. Econotarian at May 29, 2007 3:02:03 PM
Performance equals what? To the extent performance means holding down little people, getting special boosts from the fed, monopolizing, wasting resources (oil), polluting with CO2, etc., it is not something to be crowing about.
Also relevant from a macro perspective is the large waste involved in accumulating vast fortunes just to turn around and give them away (e.g., Buffett and Gates).
The US and its ilk need an ethic and goal that is more happiness-focused and world-community focused as opposed to focused on piling up billions for particular individuals. How to do that - not sure. But whooping about how great it is that we are producing huge income inequality through contingent fees and the like seems a bit short-sighted and narrow-minded. Even if the pie is getting bigger, if there is no equitable distribution, the econ system is not working at anything like an ideal level.
Posted by: cfw at May 29, 2007 4:19:20 PM
I'm a libertarian. I commend incentive based salaries. Incentive based salaries not only help the stars of our economy, but those at the bottom of the pyramid by reducing prices.
Still, most people in this country are not libertarians. I'm afraid some sort of backlash might emerge. obama worries me.
Posted by: thehova at May 29, 2007 4:34:46 PM
It seems to me that performance-based pay works best where performance is easily measured and there is large variation among individual employees. Obviously, it has been used for a very long time in paying salespeople, where these characteristics are present. Where measurement is difficult this method can be counterproductive.
Posted by: Bernard Yomtov at May 29, 2007 4:56:18 PM
"For me the puzzle is why the world held back so much on bonus pay for so long."
In most cases the performance and therefore of the bonus depends on things that are not completely under the control of the employee, so it makes the pay risky. A company will have higher average employment cost if they they offer compensation that is risky because most employees are risk adverse about their income.Only if a job shows a substantial effect of pay incentives would the company to offer a high bonus.
The effect of two earner families would decrease the extra average employee cost to the company. A 50% probability of earning either $10,000 or $90,000 is seen as much less valuable than a sure $50,000 or even $40,000. If however your spouse is earning a steady income of $50,000 the choice is then a 50% chance of $60,000 or $140,000 and you might take it in preference to a sure $90,000.
Posted by: joan at May 29, 2007 6:24:03 PM
"For me the puzzle is why the world held back so much on bonus pay for so long."
It's a heck of a lot easier to track, store, and analyze all kinds of data, including performance data, now. I can imagine that sales, commissions, etc. were more difficult and time consuming to track before the widespread use of computers.
Posted by: Jacqueline at May 29, 2007 6:45:00 PM
So that's what Hall-of-Fame hockey players do after they retire. They become economists! (Although I don't know who that MacLeod guy played for.)
Sorry, couldn't resist! ;)
Posted by: Doug at May 29, 2007 7:01:04 PM
I'm with Econotarian and Yomtov -- in my field (teaching) people are extraordinarily averse to performance pay, and I think there are two main reasons:
1) A culture of solidarity, springing from though not entirely linked to unionization (it's present in private schools too), where teachers are seen as equals/all in this together and things that would compare and separate teachers are seen as pitting them against one another and developing workplace distrust;
2) A belief that teaching is uniquely subjective and thus its efficacy cannot be assessed (built in part on 2a), a belief that assessment methods would be extremely stupid (eg just test scores, with no other components and no corrections for student demographics), and leading to corollary 2b), the fear that such instruments would be used arbitrarily by bosses who play favorites).
Oh, wait, and
3) The fact that most of my colleagues are bizarre, incomprehensible aliens.
Posted by: Andromeda at May 29, 2007 8:13:23 PM
Have performance bonuses really gone up? Or did they used to take other, non-cash forms?
Did the high performing executive of yesteryear get a vice-president ship or a cute secretary to take on all-expenses business trips?
If so, the VP position is much less secure now, as corporate restructuring and takeovers mean that a VP is only secure for a year or two. Hence it isn't really that great a reward anymore, cold hard cash is preferrable.
And obviously the cute "secretary" is right out these days.
So maybe the extra pay is appearing in the figures because previous methods have been rendered worthless.
Posted by: doctorpat at May 29, 2007 10:45:25 PM
Why do I have a feeling that nobody will touch "performance-based" CEO pay with a 100-foot pole?
The main problem with performance-based pay for us plebes is that it's not transparent.
Posted by: fustercluck at May 29, 2007 10:54:29 PM
The good ole boy fascist bloc of the Supreme Court doing what it does best:
http://www.nytimes.com/2007/05/30/washington/30scotus.html?hp
Again, major lack of transparency.
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Posted by: viccol at May 30, 2007 2:39:27 AM
TC: "For me the puzzle is why the world held back so much on bonus pay for so long."
Joan: "In most cases the performance and therefore of the bonus depends on things that are not completely under the control of the employee, so it makes the pay risky."
It also makes it potentially unfair, and it will often have the same problem that I claim tipping has: that it poisons the relationship between the benefactor and the recipient. The more arbitrary the performance bonuses are (for instance, if they are given on a principal's "qualitative evaluation"), the more demeaning they are for the recipient. It's payment for a service after the service is already given - closer to begging for scraps at the table than an exchange between equals.
However, if bonuses are tied to some external indicator of quality, they have their own troubles, because these indicator are rarely completely dependent on what they are supposed to measure. Teachers may pursue cramming rather than promoting understanding, CEOs may make short-term decisions or even use illegal means to inflate their share prices.
There was one "armchair economist" here who stated that the basic fact of economics is that people respond to incentives. Well, it seems to me that is either trivially true (if you by incentives mean anything people respond to) or dangerous oversimplification (if you only think of performance bonuses and such).
Posted by: Harald Korneliussen at May 30, 2007 3:01:04 AM
If your abilities are only average, then unionization and union support is probably the better strategy for you. Hide among the mediocrities.
However, if you are more than one SD above the average, then you can probably do better for your self by standing out ...
Posted by: Loki on the run at May 30, 2007 4:53:03 PM
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Posted by: thuserep at Jun 14, 2007 6:44:50 AM
Shoot you all think that's bad my husband has worked for gm for twenty-two years through a temp service do you think thats fair no benefits,no retirement. Not a thing has this company done for this man. but let me tell you he has done every job in the place even does supervisor job when the other is on vacation or does not want to work the week end he works so many hours at very little pay no holiday pay works over just to make up the pay he lost. but it takes care of what bills we have but I'll be honest we drive ford and so do my older two kids and so will my next three coming up to their driving years. This company has been treating my husband wrong for years and I don't praise gm to anyone. My man has nothing but a promis from gm years ago that he would be hired that was in 1985. thats a bounes from me to you.
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