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Interpreting Aggregate Wage Growth: the Role of Labor Market Participation Richard Blundell; Howard Reed; Thomas M. Stoker the American Economic Review, Vol

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Interpreting Aggregate Wage Growth: the Role of Labor Market Participation Richard Blundell; Howard Reed; Thomas M. Stoker the American Economic Review, Vol Interpreting Aggregate Wage Growth: The Role of Labor Market Participation Richard Blundell; Howard Reed; Thomas M. Stoker The American Economic Review, Vol. 93, No. 4. (Nov., 2003), pp. 1114-1131. Stable URL: http://links.jstor.org/sici?sici=0002-8282%28200311%2993%3A4%3C1114%3AIAWGTR%3E2.0.CO%3B2-1 The American Economic Review is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/aea.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR, please contact [email protected]. http://www.jstor.org Tue Jun 26 17:31:35 2007 VOL. 93 NO. 4 BLUNDELL ET AL.: INTERPRETING AGGREGATE WAGE GROWTH 1115 changes within the (selected) sample of workers from which measured wages are recorded. As in the selection bias literature,2 this second factor depends on the covariance between participa- tion and wages. The final term measures the adjustment for composition changes in hours and depends on the size of the covariance be- tween wages and hours. These bias terms are then investigated using data for male wages from the British economy in the 1980's and 1990's. These data analyses point to significant 78 80 82 84 86 88 90 92 94 96 year deviations between aggregate measures and in- dividual measures, that give a substantively dif- ferent picture of actual real wage growth over this period. There are at least three reasons why the Brit- ish labor market experience during the last two decades is particularly attractive for this analy- recession and another sharp decline in partici- sis. First, there have been strong secular and pation. In contrast, log average wages show cyclical movements in male employment over reasonably steady increase from 1978 through this period. Second, there exists a long and the 1990's. growing more than 30 percent in representative time series of individual survey real terms over this period and even displaying data, collected at the household level, that growth during the severe recession of the early records detailed information on individual 1990's. hourly wages as well as many other individual The analysis presented in this paper shows characteristics and income sources. Finally, this picture of the evolution of real wages to be over this period, there has been a systematic highly misleading. Making our three corrections change in the level of real out-of-work income. reveals no evidence of real growth whatsoever The household survey data utilized in this study in the early 1990's, and that over the whole allows an accurate measure of this income vari- period, real wage growth was no more than 20 able which, in turn, acts as an informative in- percent. We show this corrected series is pre- strument in controlling for participation in our cisely estimated and robust to parametric spec- analysis of wages. ification. With our micro-level data, we can Labor market behavior in Britain over the directly measure the large discrepancy in the recent past serves to reinforce the importance level and growth between the aggregate and of these issues. Indeed the relationship between individual wage paths, and we find that it is wage growth and employment in Britain has almost completely captured by the aggregation often been the focus of headline news3 Fig- factors we develop. This validates our model ure 1 displays the time series of aggregate specification and supports our interpretation of hourly wages and aggregate employment for the overall aggregation biases involved. The men in the United Kingdom over two busi- large discrepancy is clearly associated with an ness cycles between 1978 and 1996. In 1978- important upward bias in the aggregate trend of 1979, over 90 percent of men aged between 19 real wages and a reduction in the degree of and 59 were employed. The participation rate procyclicality. fell dramatically in the recession of the The picture of employment fluctuations is early 1980's and then recovered somewhat in even more dramatic between education groups the late 1980's (although not to its initial and date-of-birth cohorts. Given the strong in- level). In the early 1990's there was a further terest in the economics literature on returns to education across education and cohort groups (see Amanda Gosling et al., 2000 and David See Heckman (1979). Card and Thomas Lernieux, 2001, for example), For example, "Rise in Earnings and Jobless Sparks it is important to study how these employment Concern," Financial Times,front page, June 18th, 1998. fluctuations impact estimated returns to education 1116 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 2003 0 left education atlbefore 16 0 left education 17-18 + left education I9or older 78 80 82 84 86 88 90 92 94 96 06 year 76 60 82 84 86 68 90 92 94 96 year FIGURE2. BRITISHMALES: LABORMARKET PARTICIPATION RATE, 1978-1996 FIGURE4. MALE COHORT,BORN 1945-1954: LABORMARKETPARTIC~PATION RATE 0 left educat~onatlbefore 16 0 left education 17-18 + left education 19 or older 1.0- 200 - ? 09- ! 180- $ 41 0.8 ' 8 1604 Y 07- $e 140- -3 0 6 - 120 - 78 80 82 84 66 88 90 92 94 96 78 80 82 84 86 88 90 92 94 96 year year FIGURE3. MALECOHORT,BORN1935-1944: LABORMARKETPARTICIPATION RATE age, and other observed wage determinants. For across these groups. Figures 2-4 present the this we use another feature of recent British picture of employment by education level for experience: the large changes in the real value two central cohorts. For the cohort born be- of benefit (transfer) income which individuals tween 1945-1954, the steep fall in employment receive (or would receive) when out of work.4 experienced by the lower-education group in Figure 5 shows the time-series variation of out- the early 1980's is not matched in the employ- of-work benefit income for a particularly rele- ment patterns of the higher-educated groups. vant group-married low-education men in Indeed, the level and growth in dispersion also rented housing. The housing component of ben- differs substantially across cohort and education efit income5 increased sharply in real terms over groups. Our results show that the selection ef- the period 1978 to 1996, an increase which was fect is often substantial and suggests a large largely dnven by a policy shift from subsidized underestimate in the level and growth in educa- public sector rents and rent controls in the pri- tion returns. However, when aggregated across vate rented sector toward a system where rent groups, this selection effect can be offset by levels more closely reflected the market value of differences in wage dispersion across education and cohort groups. To identify these corrections to the aggregate 4 The out-of-work income measure is constructed for series we need some that affects male each household using a tax and benefit simulation model. employment decisions but does not affect the s This is a means-tested benefit covering a large propor- distribution of wages conditional on education, tion of rental costs. VOL. 93 NO.4 BLUNDELL ET AL.: INTERPREl 'ING AGGREGATE WAGE GROWTH housing. This increase in this housing compo- I. Aggregation and Selection nent is a major contributory factor in the rise in benefit income for the "low-education" families A. A Model for Real Wages depicted in Figure 3. Although it is unlikely that variation in real The approach we use for modeling individual value of benefit income can explain all of wages follows Andrew Roy (1951) in basing the variation in participation rates, we argue wages on human capital or skill levels, assum- that changes in real benefits serve as an im- ing that any two workers with the same human portant instrument in the participation deci- capital level are paid the same wage. Thus we sion, which therefore affect the endogenous assume that there is no comparative advantage, selection in real wages. Moreover, we can and no sectoral differences in wages for workers isolate the selection effects in part because with the same human capital level. We assume the housing benefit varies strongly across that the mapping of skills to human capital is time, location, and cohort group. This varia- time invariant, and that the price or return to tion occurs because individuals with low lev- human capital is not a function of human capital els of education in the older cohorts had a endowments. In particular, we begin with a much higher chance of spending their lives in framework consistent with the proportionality public housing. We take this variation to be hypothesis of Heckman and Sedlacek (1990). exogenous to the individual decision to work The simplest version of the framework as- (conditional on cohort, education, region, sumes that each worker i possesses a human trend, and cycle effects), and find evidence capital (skill) level Hit, which is nondifferenti- of substantial selection effects that vary over ated in that it commands a single price r, in time the economic cycle and across education period t.
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