Some evidence on the relationship between performance-related pay and the shape of the experience-earnings profile.

• Author: Brown, Sarah

1. Introduction and Background

   In this paper we explore the shape of the experience-earnings profile for individuals employed under different types of contracts: fixed-wage, performance-related pay (PRP), and self-employment contracts. We follow Lazear (1979, 1981) and Lazear and Moore (1984) in hypothesizing that the slope of the experience-earnings profile reflects agency costs, and the reduction thereof, with increased agency costs inducing steeper profiles. If monitoring costs are high, firms may implement compensation schemes designed to encourage employees to self-select behavior in the firms' interests. One such scheme defers a substantial amount of compensation until the later years of tenure. The resulting experience-earnings profile provides a penalty for shirking (Lazear and Moore 1984).

   We, therefore, presume that the profiles of workers employed under fixed-wage contracts are steeper than those of self-employees for whom the issue of agency does not arise because of the duality of principal and owner (Lazear and Moore 1984). The interesting case is that of workers employed under PRP. If such contracts represent a hybrid between fixed-wage and self-employment, then one would expect their experience-earnings profiles to lie somewhere between these two extreme cases. Thus, PRP and a steep experience-earnings profile may be regarded as substitute mechanisms for inducing employee effort.

   The nature of the experience-earnings profile has important implications for labor market behavior. If agency considerations prevail, then issues arise concerning the credibility of long-term employment contracts--firms may have an incentive to replace expensive "older" workers with cheaper "younger" recruits. The shape of the experience-earnings profile may also influence decisions to quit jobs. Experienced "generally" trained workers may face more options in the labor market than their "firm-specifically" trained counterparts. But both types of worker may have more labor market options than those "older" workers whose earnings reflect agency considerations.

   We generalize Lazear and Moore (1984) by allowing for the intermediate category of PRP, which enables us to further explore the agency explanation behind the positive slope of the experience-earnings profile. Our presumption is that all three employment contracts can be nested in the form

   [W.sub.j] = (1 - [[lambda].sub.j]) [bar.w] + [[lambda].sub.j]f(e;[theta]), (1)

   where j = fw, prp, se denotes "fixed-wage," "PRP," and "self-employment," respectively, [w.sub.j] denotes total remuneration, [bar.w] the component of total remuneration that is "fixed" (i.e., independent of worker performance), and f(e; [theta]) some function mapping the relationship between worker performance (i.e., effort), e, "uncertainty," [theta], and pay. (1) [[lambda].sub.j] represents the degree of equity held by a worker in his/her enterprise, that is, the proportion of total remuneration that is dependent on performance. We assume that for fixed-wage employment, [[lambda].sub.fw] = 0; for PRP contracts, [[lambda].sub.prp] [member of] (0, 1); and for self-employment, [[lambda].sub.se] = 1. Our hypothesis is that the shape of the experience-earnings profile depends critically on [[lambda].sub.j]. To be sure, we predict that agency costs decline monotonically with [[lambda].sub.j] such that the slope of the PRP earnings profile falls between the zero-equity, fixed-wage, and 100% equity, self-employed profiles. (2)

2. Data and Methodology

   Our empirical analysis draws on three British data sets: the British Social Attitudes Surveys 1985, 1987, 1993, and 1996, the British Household Panel Surveys 1991-1999, and the British Family Expenditure Surveys 1997/98, 1998/99, and 1999/00.

   The British Social Attitudes Surveys (BSAS) are an annual series of cross-section surveys initiated by Social and Community Planning Research in 1983. The sample comprises individuals, aged 18 and over, living in private households whose addresses were on the electoral registrar; 114 out of 650 Parliamentary constituencies in Great Britain were selected. A polling district was randomly selected from each constituency with addresses being randomly chosen from each district.

   The surveys conducted in 1985, 1987, 1993, and 1996 contained questions relating to the presence of PRP: whether in the year of interview the respondent had received some component of their total remuneration in the form of: (i) a productivity-linked bonus scheme; (ii) an annual bonus (at the employing organization's discretion); (iii) a share ownership or share option scheme; or (iv) a profit-sharing scheme. Individuals who reported that they had participated in any of the four schemes were labeled as PRP employees. (3) Selecting out all male respondents in fixed-wage, PRP, or self-employment with complete records rendered 1467, 783, and 491 individuals, respectively. (4)

   Our second data set is based on the British Household Panel Survey (BHPS). This is a random sample survey conducted by the Institute for Social and Economic Research of each adult member of a nationally representative sample of more than 5000 private households. For wave 1, the interviews took place in 1991. The same individuals are reinterviewed in successive waves.

   We explore data from the 1991-1999 surveys. In the first wave (1991), all individuals were asked whether their pay includes bonuses or profit sharing, thereby enabling us to identify PRP employees. For the period 1992-1995, this question was asked only to individuals who changed their jobs. We, therefore, assume that individuals who did not change job remain in their 1991 employment type. We specify an unbalanced panel of data wherein the minimum number of times an individual is in the sample is one and the maximum is nine. Our sample comprises 4594 fixed-wage employees, 2806 PRP employees, and 1153 self-employees.

   Our third data set is drawn from the Family Expenditure Survey (FES) for Great Britain. This is a nationally representative survey that has been conducted annually since 1957. Approximately 10,000 households are selected each year to take part in the FES, and the average response rate is approximately 70%.

   We use data from the 1997-1998, 1998-1999, and 1999-2000 surveys. (5) Our subsample comprises working males aged between 18 and 65 who are either self-employed or employed under a fixed-wage contract or a contract characterized by PRP. Those individuals classified as being employed under a PRP contract were those in receipt of a productivity-linked bonus, profit-related pay, dividends from employee share ownership, an incentive bonus, or a performance-related bonus. Our sample consists of 8405 male respondents comprising 5965 fixed-wage employees, 1201 PRP employees, and 1239 self-employees.

   It is apparent that there is some tension between our theoretical and empirical definitions of PRP. The former defines PRP as any contract in which current pay is related to current performance broadly defined. Some jobs reward performance with a promotion and/or a salary increment rather than with an explicit bonus. Moreover, some bonus schemes may also be used to identify "fast-track" employees, and for these, a revelatory component may be in operation as the employer learns more about a worker's skills and ability in the early years following an initial hire. (6) The BHPS, but not the BSAS or FES, asks specific questions relating to promotions and salary increments in each year, and we, therefore, augment our BHPS empirical analysis by including dummy variables to control for these factors. (7)

   The empirical definitions of PRP in the three data sets are quite explicit. The BSAS and FES adopt similarly broad definitions that include productivity-linked and discretionary bonuses, share ownership/options, and profit sharing. The BHPS focuses on just bonuses (type not defined) and profit sharing. (8) Which definition is more appropriate is largely a matter of interpretation, but our results are broadly consistent across the three data sets.

   Sample statistics of the key variables for each of the data sets are set out in Table 1. (9) A common finding in all three data sets is the relatively low earnings of self-employed respondents. The problems of accurately measuring pay from self-employment are well documented (see Eardley and Corden 1996; Hamilton 2000). Because our focus is on the slope of the experience-earnings profile, measurement error is not too problematic if the earnings of the self-employed are consistently underreported.

   Our analysis is based on a Mincerian earnings equation of the form:

   1n [w.sub.ijt] = [X.sub.ijt][B.sub.j] + [[alpha].sub.j][E.sub.ijt] + [[beta].sub.j][E.sup.2.sub.ijt] + [[epsilon].sub.ijt], (2)

   where [w.sub.ijt] represents the hourly earnings of an individual i employed in employment type j at time t, with j = s, prp, se representing the three employment categories. (10) [X.sub.ijt] represents a vector of personal and workplace characteristics including education, occupational status, and industrial affiliation, and [E.sub.ijt] denotes labor force experience at time t, proxied by the respondent's age at time t less his/her age when he/she completed full-time education. (11) It is apparent that a first-best estimation of Equation 2 would utilize a panel data source. We adopt such an approach with the BHPS sample, which follows the same individuals across 1991 to 1999. In the case of the BSAS and FES analysis, we are obliged to use pooled cross-section data. This is not too problematic: If we assume that the vector of personal/ workplace characteristics is stable across time then [X.sub.ijt] = [X.sub.ij], [for all] t. (12)

   Estimation is further complicated on account of potential sample selection bias. Our earnings data derive from observing a particular employment contract (i.e., fixed-wage, PRP, or self-employment), and there may be variables that affect both the probability of...