On the Role of Learning, Human Capital, and Performance Incentives for Wages

Although performance pay is a key source of wage dispersion, little is known about why it typically accounts for only a small portion of pay or how it shapes wages over the life cycle. As we document, standard models of performance incentives fail to explain its declining importance later in the life cycle. We fill this gap and resolve this puzzle by proposing a new framework that integrates well-known models of dynamic moral hazard, uncertainty about worker productivity, and human capital acquisition, and proving it is identified based on its equilibrium characterization. Once we parameterize the model using well-known firm-level data, we find that performance pay is central to life-cycle wages. Strikingly, its level and life-cycle profile are not driven by the canonical risk-incentive tradeoff of moral-hazard models. Instead, they reflect workers’ desire to insure against the productivity risk arising from uncertainty about their productivity and to acquire human capital.