Size-dependent policies, talent misallocation, and the return to skill

We study the allocation of talent in knowledge-based hierarchies subject to a payroll tax that increases with establishment size. The tax distorts the allocation of talent across occupations, as well as the sorting of all infra-marginal agents, thus attenuating the strength of the positive sorting throughout the entire economy. This talent misallocation results in lower output, smaller plants, higher self-employment, less wage employment, and lower returns to skill. To quantify these effects, we first estimate a tax policy to match the establishment-level evidence on the size-dependent compliance of social security contributions in Mexico, and conduct two sets of numerical exercises. Introducing this size-dependent policy into an undistorted economy calibrated to the U.S. generates a reduction in average plant size and output losses of 10 percent. The returns to skill for wage workers decrease by 75 percent. When we isolate the margins of misallocation in our model, we find that slightly over half of the output losses are due to talent mismatch, whereas the rest is accounted for by the best wage workers turning into self-employment. Similarly, eliminating the labor distortion in Mexico increases average plant size by 12 percent, and output by 9 percent, while the average return to skill for workers increases by 14 percent. Perfect enforcement of the average effective tax accounts for one fifth of the output gains from removing the tax. Size-dependent policies in our model generate a reduction in average plant size that is only a fifth of that obtained using a standard span-of-control model, yet output losses are three times as large. The main losers from this type of policies are high-skill wage workers. (Copyright: Elsevier)