The Evolution of Unobserved Skill Returns in the U.S.: A New Approach Using Panel Data

Economists disagree about the factors driving the substantial increase in residual wage inequality in the United States over the past few decades. To identify changes in the returns to unobserved skills, we make a novel assumption about the dynamics of skills (especially among older workers) rather than about the stability of skill distributions across cohorts, as is standard. We show that this assumption is supported by data on test score dynamics for older workers in the Health and Retirement Study. Using survey data from the Panel Study of Income Dynamics and administrative data from the Internal Revenue Service and the Social Security Administration, we estimate that the returns to unobserved skills declined substantially since the mid-1980s despite a sizable increase in residual inequality. Instead, the variance of skills rose over this period due to increasing variability in idiosyncratic lifecycle skill growth. We extend our framework to consider occupational differences in returns to skill and multiple unobserved skills and show that returns to skill display similar patterns for workers employed in cognitive, routine and social occupations.