Earnings Dynamics: the Role of Learning, Human Capital, and Performance Incentives

Using both public individual survey data and proprietary firm personnel records, we document that the importance of performance pay declines at the end of a career. This evidence is at odds with the implication of models of implicit and explicit performance incentives that have attempted to explain the life-cycle profile of the variable component of wages. We provide a novel model that integrates uncertainty and learning about ability, human capital acquisition, and performance incentives to account for the life-cycle profile of individual wages and provide a rationale for the declining importance of the pay-for-performance component of wages with experience. We analytically characterize the equilibrium wage contract in this environment, derive its qualitative properties, and decompose the pay-for-performance component of the equilibrium wage into different terms. These terms capture the standard trade-off between risk and incentives arising in contexts of moral hazard, the desire to hedge against the risk inherent in learning about ability, and the changing strength of reputational and human capital investment motives over time. We prove the model is identified based on a panel of wages. We derive estimators of the model's primitive parameters, estimate the model, and use the estimated parameters to measure the relative contribution of the three sources of wage dynamics we nest---learning, human capital acquisition, and performance incentives---to the life-cycle profile of total wages and their variable component. According to our preliminary estimates, performance incentives seem to be qualitatively and quantitatively key to explaining the life-cycle profile of wages and variable pay, despite the declining importance of variable pay relative to fixed pay over time.