Pay for performance and merit pay have become popular in the manufacturing world to incentivize increased output, and if done correctly, quality and innovation. In the lean manufacturing arena we believe that pay must also be tied to team and organizational performance.
More traditional organizations continue to provide annual cost of living adjustment increases, however those are like a drug. Employees become effectively addicted, performance often decreases, and as the Detroit Three have found out, you end up paying more than your competitors for an equal labor quantity. COLA is also like a self-fulfilling prophecy in that as you increase pay, you increase buying power, which increases demand, which increases inflation… which increases the cost of living.
Tyler Cowen at the Marginal Revolution blog had an interesting post this morning telling us of a study that links pay for performance with wage inequality. The income gap and reduction of the middle class have become a political hot button lately, although some of the facts about income inequality and the resulting tax contribution run counter to prevailing wisdom.
In effect the study from the National Bureau of Economic Research concludes that pay for performance has significantly contributed to wage inequality by boosting the income of the most productive while incomes of less productive workers, and those not in a pay for performance program, remain stagnant.
An increasing fraction of jobs in the U.S. labor market explicitly pay workers for their performance using bonuses, commissions, or piece-rates. We find that compensation in performance-pay jobs is more closely tied to both observed and unobserved productive characteristics of workers. Moreover, the growing incidence of performance-pay can explain 24 percent of the growth in the variance of wages, and accounts for nearly all of the top-end (above the 80th percentile) growth in wage dispersion.
I had never thought of pay for performance being a contributor to this widening gap, and 24 percent is pretty significant. Many on a certain end of the political spectrum want to reduce the gap by reigning in income growth on the high side. Perhaps this study shows that that policy is misguided and would hurt productivity and performance, and instead we should reduce the gap by increasing income growth on the low side through wider use of pay for performance.
As Tyler concludes, "For me the puzzle is why the world held back so much on bonus pay for so long." Well, partially because bonus pay without true ties to performance is counterproductive and has been abused. But with true performance goals it can be very powerful, and a win-win that increases productivity and quality as well as personal income.