Earnings Dynamics and Returns to Skills

In this paper, we study the role of returns to unobserved skills in the rising residual earnings inequality for the past few decades in the U.S. We identify and estimate a general model of earnings residuals that incorporates (i) changing returns to unobserved skills, (ii) changing distribution of unobserved skills, and (iii) changing volatility of earnings that is not related to skills. Using data from the PSID, we find that the returns to unobserved skills went down since the mid-1980s despite the steady increase in the residual inequality. Using a simple demand and supply framework, we show that both demand and supply factors contributed to the downward trend in the returns to skills over time.