ISER Working Paper Series 2007-04
Earnings instability and tenure
15 Feb 2007
Estimating the changes in the dispersion of earnings is the topic of the large literature on earnings inequality and mobility. Much of the literature focuses on cross-sectional evidence and assesses competing explanations of increasing inequality such as technical change, trade, institutions. A complementary literature looks at panel data on individual earnings and asks questions such as: What is the extent of intertemporal mobility in the distribution of earnings? Is the change in inequality due to long term earnings components (e.g. ability) or to increasing volatility that make the earnings process more unstable?
This paper models explicitly the role of tenure on-the-job and studies its effect on the long-term and volatile components of earnings. There are reasons why the two can be related. If wages are paid on the basis of worker's marginal product and this is observed with error, then a negative relationship between instability and tenure merges inasmuch as measurement error in productivity decreases with the length of the worker-firm match. Alternatively, firms may be willing to insure workers' incomes against transitory shocks to profitability, and their willingness to do so may increase the more they know about workers' productivity.
These theoretical relationships may have policy implications. In consequence of changes in labour market legislation, fixed-term (temporary) contracts they spread in many European countries in the nineties. These are short tenure contracts which typically last two or three years and can be renewed only once. A large literature has studied the effect of fixed-term contracts on employment, unemployment and job flows but nobody has looked so far at their effects on earnings instability. Yet one of the main concerns about the diffusion of fixed-term contracts is their implications in term of earnings instability and welfare in as much as earnings instability is strictly related to the uncertain component of earnings.
We use Italian matched employer-employee data with an accurate measure of on-the-job tenure. The data also contain information on the type of contract (standard or fixed-term).
Our results indicate that workers with four years of tenure have on average an earnings instability three times lower than workers with zero years of tenure or in other words each year of tenure on the job reduces earnings instability by 15%. Workers on fixed term contract on average have an earnings instability 10% higher than workers on permanent contracts. But workers who spend their entire working life on temporary contract can expect a earnings instability twice as high than somebody on a permanent contract.