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POLICY BRIEF: Firming Up Inequality

August 13, 2017

KEY POLICY INSIGHT: In the past three decades, explanations for income inequality have multiplied almost as fast as the compensation gap in the U.S. and industrialized world. The way private firms have sorted and segregated workers by skill and pay drives disparity in ways that require a closer look from policymakers.

The Changing Shape of Firms

From overpaid corporate executives to job-thieving technology, past research has pointed to a number of different culprits behind the rise in income inequality. But University of Minnesota economist Fatih Guvenen, along with four other researchers, has unveiled a fresh perspective, one they believe deserves a closer look.

Their recent research finds much of U.S. income inequality can be explained in the mundane arena of company organization charts. That is, the way firms shape and reshape the way they do business.

The conclusions are drawn from a staggering amount of government data, assembled and analyzed for the first time across a vast stretch of time.

The study, the first of its kind, required gathering payroll and employment records of an average of 70 million workers at more than five million firms from 1981 through 2013. The job involved matching Social Security records with Employer Identification Numbers in a compilation that would strain, if not break, standards spreadsheets.

“Our data set has several key advantages for studying firms and inequality,” the authors of the study wrote. “It is the only U.S. data set covering 100% of workers and firms for the entire period of the rise in inequality. It has uncapped W-2 earnings capturing a large share of earnings even at the very top, it has no lower earnings limit, and it has information on firms rather than establishments.”

Researchers found what they described as a “strikingly wide” distribution of worker pay in 2013. The range extended from $9,800 for the bottom 10 percent to $36,000 at the median and $104,000 for the top 10 percent to $316,000 for the top 1 percent.

The comprehensive analysis upended many conventional explanations for why income equality has grown and found less-obvious forces that may be hard to counterbalance.

Disparity within firms – with the pay of a handful of workers rocketing away from everyone else on the payroll – is an oft-told tale of income inequality. The story is largely wrong on two fronts.

First, the study found that nearly 70 percent of income inequality can be traced to disparities in pay across firms. That is, some firms are paying far more than others. Less than a third of the rising income gap can be found within the vast majority of firms.

Moreover, only a tiny fraction of companies – concentrated among the biggest firms in the nation – have been showering riches exclusively on the top echelon of management.

At these companies with 10,000 or more on the payroll, CEOs routinely command 300 times or more than what the average worker at the same firm makes. Public discussion of income inequality, not surprisingly, focuses on paydays that add up to millions, tens of millions, or hundreds of millions of dollars a year.

“A lot of the talk about CEO pay, or the very successful within a firm, driving the rise in inequality cannot be right,” Guvenen said.

Why? The ranks of those making these mega-paychecks are small. They’re at the summit of fewer than 1,000 firms. They make headlines. But what about the other 1.2 million firms with 20 employers or more?

In fact, the lopsided compensation that grabs the most attention merits the least. More than ninety-nine percent of firms have fewer than 10,000 employees and 70 percent of people drawing paychecks work at such firms.

“Even if you drop that 1 percent (workers earning more than $300,000), there has been an enormous rise in inequality among the 99 percent,” Guvenen said. “I would rather care about 300 million people than (focus on) 300 CEOs.”

But the inequality at more-typical firms has far less to do with income disparities within companies than between companies.

That was something of a surprise to Guvenen and co- researchers Jae Song, at the Social Security Administration; Till von Wachter, at UCLA; and David J. Price and Nicholas Bloom, at Stanford University.

Instead of a simple story of “winner-take-all” capitalism, they found abundant evidence that companies have reshaped themselves in recent decades. The result is a sorting and segregation of workers.

The Sorting of Jobs and Workers

Not surprisingly, firms that attract the highest-skilled workers pay more than those that don’t. But what was startling was the way companies loaded with high-skilled workers no longer employed people with lesser, more-interchangeable skills. These elite companies balk at hiring all manner of workers who once peppered any successful company’s payroll.

That list includes not only cafeteria workers, now employed by outside food services or janitors provided by custodial firms, it extends to accountants, lawyers, IT specialists, and human resources personnel.

Technology, such as scheduling software that allows contractors to provide janitors where and when they’re needed, doubtlessly makes such services more economical and efficient – but at a price to workers.

Specialized “services” firms provide such labor often for far less than what the companies once themselves paid for “back office” labor. In turn, people at such specialty firms have seen their pay stagnate or fall.

“...the rise in between-firm inequality (in average pay) can be completely explained by changes in the composition of workers between firms,” the study finds.

For people trapped in the cycle of sorting and segregating, the story gets grimmer still. Where once an engineer or accountant might collaborate with people who have more experience and know-how, and learn from them to acquire new skills, they now find themselves “segregated” in jobs that lead nowhere. With no corporate ladder to climb, they stay on the ground floor.

People learn by imitating, watching, and listening to workers who know more than they do. “A lot of the learning of employees happens on the job,” Guvenen said. “If you take a 50-year-old worker, for example, some studies say they have learned 80 percent of what they know on the job.”

But when workers are corralled into companies where others have the same level of education, experience, and skills, career progress that once was inevitable can become all-but-impossible.

That’s a sharp contrast from the 1980s and 1990s when the offices of top executives often were occupied by former engineers, lawyers, or accountants for whom advancement was both possible and expected.

Graph of Change in Percentiles of Annual Earnings Within and Between Firms Relative to 1981
Notes: Only firms and individuals in firms with at least 20 employees are included. Only full-time individuals aged 20 to 60 are included in all statistics, where full-time is defined as earning the equivalent of minimum wage for 40 hours per week in 13 weeks. Individuals and firms in public administration or educational services are not included. Firm statistics are based on the average mean log earnings at the firms for individuals in that percentile of earnings each year. Data on individuals/their firms are based on individual log earnings minus firm mean log earnings for individuals in that percentile of earnings in each year. All values are adjusted for inflation using the PCE price index.

Sorting and segregating has become so powerful a force that the trend may overshadow some compensation differences in education, sex, age, and other commonly studied factors in pay disparity.

“Even when you look at very narrow groups – you look at men, college-educated, age 45 to 50 – even in this group inequality is rising strongly,” Guvenen said.

Put another way, the study’s database was so large that sorting and segregating workers emerged as a clear culprit in income disparity, no matter how finely drawn the description of people being compared.

Testing that hypothesis, researchers examined whether the rise in income inequality was due to some industries becoming less productive while others saw their output surge.

In other words, can most of the variation in pay over the last three decades be explained by industries that prospered and those that didn’t?

To answer that question, the study examined compensation in 49 industries. Result: even in narrow comparisons – say, between different confectioners or different brewers – average pay across employers completely diverged over time. Sorting and segregating prevailed even among companies producing the same goods and services.

Implications of Inequality Between Firms

“Can you perpetuate inequality by putting people in these bins, boxes, where they’re very similar, where there’s no spillover from each other?” Guvenen asked. He fears that answer is yes.

Those stuck in dead end jobs not only have suffered stagnating or falling pay, but fewer benefits – including health insurance.

The sorting and segregation threatens to widen the disparity between “haves” and “have-nots” not only in terms of pay but by measures of long-term health and life expectancy.

“We believe increased worker sorting and worker segregation is potentially worrisome for several reasons,” the authors of the study wrote.

“One concern is of course that low-wage workers appear to have lost access to good jobs at high-wage firms, increasing overall aggregate inequality,” the study concludes. “Another concern is that firms play an important role in providing employee health care and pensions, so rising earnings segregation could very well spill into rising health care and retirement inequality.”

According to the paper, the phenomenon could shorten lives, as well.

“Indeed, over the last 30 years, as noted by the National Academies of Sciences, Engineering, and Medicine (2015), the correlation between income and life expectancy has increased greatly at the same time as a greater fraction of wealth for those at the top comes from benefits, including health insurance.”

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Policy briefs from the Heller-Hurwicz Economics Institute are intended to convey policy relevant research done by researchers associated with the Institute and do not represent the position of the Institute.