The Upside of Performance-Based Compensation

by Reihan Salam

One of the biggest unanswered questions about the increase in the dispersion of income over the past three decades is how much of it can be attributed to changes in the demand for skills vs. the greater variability of short-term earnings, as Matthew C. Klein observes. Rather than try to settle the question, Klein raises some of the methodological challenges involved in answering it, focusing on a new paper by Jason DeBacker, Bradley Helm, Vasia Panousi, Shanthi Ramnath, and Ivan Vidangos which argues that “permanent” changes far outweigh “transitory” shocks. This contrasts with the findings of other scholars, who emphasize the important contribution of transitory shocks.

Though I don’t have much to add to Klein’s basic analysis, which seems sound, his description of the shift in risk from employers to employees reminds me of an intellectual development that is largely overlooked:

Except in the public sector, the promise of lifetime employment is dead. Defined-benefit pension plans have been mostly replaced by defined-contribution plans. Bonuses, stock options and other forms of profit-sharing have become increasingly important forms of compensation compared to traditional fixed salaries, especially for those at the top.

Pushing more risk onto workers has resulted in greater variability in individual incomes, which in turn tends to increase inequality. Imagine an economy with two workers, both making $100 a year, and another with two workers, both making $100 on average, with variations above and below that year by year. The second economy will have greater measured inequality, even though both workers make the same over multiple years. Greater variability has another implication: Inequality looks worse when incomes are measured over a single year than over longer periods of time.

As we have discussed elsewhere, however, stock options and other forms of profit-sharing have another dimension. In The Share Economy, published in 1984, Harvard economist Marvin Weitzman argued that heavier reliance on bonuses (gain-sharing or contingent compensation schemes) might help smooth out the boom-bust cycle. In a downturn, firms could cut bonuses to lower costs rather than shed workers. Performance-based compensation might be more broadly understood to have the effect of allowing firms to retain a wider array of workers than they might under more rigid salary schedules, as differences in productivity across workers are more accurately reflected in differences in compensation. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.