Climbing the Wage Ladders: Determining the Sources of Idiosyncratic Wage Dynamics and Implications for Policy
(UNIVERSITY of BRISTOL)
OCTOBER 16, 2019
Abstract: The workhorse macroeconomic model that studies the efficiency, insurance and redistributive properties of different tax and transfer policies with realistic earnings and wealth distributions is assuming an exogenous process of earnings (or hourly wages). Endogenizing the wage process may have significant impact on the results of such policy analysis. Recent empirical papers using large administrative data show that earnings changes have fait tails and asymmetric dynamics at the extremes. There is also evidence that wage changes both within and across employment spells are significant determinants of earnings variations. The first paper in this project introduces a dynamic labor contracting model that is able to reproduce these facts and other important features regarding job flows and the earnings distribution. The framework includes search frictions out and on the job that are mostly responsible for infrequent but large wage changes across job spells, but also some infrequent sizeable wage rises within a job spell. These frictions give rise to an external wage ladder. The novel feature of the model is the moral hazard friction that requires (long-term) incentive contracts. This friction gives rise to and internal wage ladder that is responsible for smaller but frequent wage changes within a job spell. The paper also documents the rich interaction of the two ladders to determine the shape of the wage distribution. The second paper of the project shows that it is critical to consider the endogeneity of the earnings process in this framework when the effect of different policies is studied. In particular, we show that increasing tax progressivity is improving welfare when wages are considered to be exogenous. However, when we take into account endogeneity of the wage ladders, both the equilibrium external and internal wage ladder becomes flatter and this effect more than offsets the insurance gains of more progressivity.