Lambert here with a spoiler alert: Rents.
Steven McIntosh, Reader in Economics, University of Sheffield. Originally published at VoxEU.
Individuals who work in the finance sector enjoy a significant wage advantage. This wage premium has received increasing attention from researchers following the financial crisis, with focus being put onto wages at the top of the distribution in general, and finance sector wages in particular (see Bell and Van Reenen 2010, 2013 for discussion in the UK context). Policymakers have also targeted this wage premium, with the recent implementation of the Capital Requirements Directive capping bankers’ bonuses at a maximum of one year of salary from 2014. In this article, we document the finance sector pay premium, and then investigate possible reasons for its existence (see Lindley and McIntosh 2014 for a fuller discussion of our analysis).
Our focus is the UK, and we define the finance sector as any firms involved in financial transactions. We are therefore considering banks and insurance companies, as well as the ‘City’ firms of fund managers, stockbrokers etc., who come to mind when mention is made of the ‘finance’ sector.
The New Earnings Survey is the best source of wage information in the UK, covering as it does 1% of all workers in the country. The measure of wages used from the New Earnings Survey is annual earnings, which therefore includes annual bonus payments – an important consideration when analysing the finance sector. Holding constant gender, age, and region of residence, finance sector workers are found to earn 48% more on average than non-finance sector workers. Part of this difference will be due to the characteristics of workers who tend to work in finance, be they more motivated, driven etc. Because the New Earnings Survey is a longitudinal dataset that observes the same individuals over time, we can control for any such characteristics even when they are not measured – as long as they remain constant over time – by looking at the change in wages for individuals who move into, or out of, the finance sector, and whose fixed unobserved characteristics will not have changed. The results suggest a 37% change in wages, on average, when individuals move between the non-finance and finance sectors. Thus, much of the finance sector premium remains even after controlling for such unobserved differences across workers.
The Robustness of the Finance-Sector Wage Premium
Another potential reason for the finance sector wage premium is that finance contains occupations that are typically better paid on average, whichever sector they are in. We again looked at those individuals moving into and out of the finance sector, but this time restricted the sample only to those doing a job with the same title in both the finance and non-finance sectors, focusing on generic job titles such as ‘function manager’, ‘ICT professional’, ‘secretarial’, ‘customer service’ etc. The results reveal that the same people doing the same job earn around 20% more when doing that job in the finance sector rather than the non-finance sector. This premium is observed to be remarkably similar whatever job title is considered – whether it is a typically high-paid or low-paid job. This suggests that the pay premium is ubiquitous across all individuals working in the finance sector. This idea is further supported by looking at the wage premium at various points of the wage distribution. Although the finance sector pay premium is observed to be the largest between high earners in the finance and non-finance sectors – at the top end of the wage distribution – it is certainly the case that it is also observed throughout the full distribution.
We can consider the different sub-sectors of finance. As perhaps expected, the premium is highest in the sub-sectors most associated with the ‘City’, such as fund management (55% estimated premium in the specification observing the same individuals moving across sectors), security dealing (49%), pension funding (47%), and security broking (45%). However, a significant premium is observed in all sub-sectors, again hinting at its ubiquity.
Explaining the Finance-Sector Wage Premium
How can we explain the high and rising wage premium available to all finance sector workers? Using a selection of data sets, we considered various hypotheses.
Rent sharing – the idea here is that the finance sector produces larger rents (surplus profits) than most sectors, which are then shared with the workforce.
The fact that the finance sector pay premium is received by all workers – regardless of their position in the wage distribution or the job they do – is consistent with a common factor such as profits being important, but is more difficult to explain with individual-level characteristics, which would need to be common to all workers in the sector. We provide further evidence for rent sharing by using EU KLEMS data to regress real gross value added (value of output minus value of input materials, as a measure of rents) against a set of sector indicators and other control variables. Observed rents in the finance sector are amongst the highest of all sectors (together with sectors involved in petroleum, energy, tobacco, and real estate, which all also produce excess profits of their own for various reasons). Furthermore, when we estimate individual-level wage equations, including a measure of sectoral rents, we observe such rents to be more strongly associated with wages in some of the sub-sectors of finance than in most other sectors. For example, on average in the non-finance sector, a 1% increase in rents is associated with a 0.15% increase in annual wages. In the fund management and security broking sub-sectors of finance, however, this figure is 0.9% and 0.63% respectively. There is therefore a strong association between rents and earnings, particularly in the investment-related jobs associated with the ‘City’.
Is the finance sector more skill intensive? The reason for the high finance sector wage premium could simply be that finance hires, on average, more highly skilled workers who would earn a higher wage wherever they worked.
We investigated this, considering both formal qualifications and childhood literacy and numeracy tests as different indicators of workers’ skills. As expected, the finance sector hires a larger proportion of graduates than the economy as a whole, and in particular, graduates from numerate subject areas such as economics and maths/computing, as well as management, are over-represented in finance. Furthermore, the data suggest a rise in the extent to which graduates are over-represented over time, though the increase is relatively small. This therefore cannot be the full story behind the rising pay premium. In addition, controlling for qualifications still leaves a significant finance pay premium when looking at wage differences across sectors within qualification groups.
We measured cognitive skills by looking at the childhood tests scores of individuals who go on to work in the finance sector when they are adults, compared to the non-finance sector. We consider two cohorts of individuals: one born in 1958 (the National Child Development Study) and the other born in 1970 (the British Cohort Study). Again as expected, finance sector workers have higher average scores on childhood numeracy tests than non-finance workers. However, there is no evidence that this gap is widening, it being around 0.4 standard deviations for both cohorts. For literacy scores, the 1970 cohort do see a higher finance–non-finance gap than the 1958 cohort, though most of this improvement in the literacy scores of future finance workers is amongst the least well qualified. Finally, controlling for cognitive test scores has little effect on reducing the estimated finance premium. Thus, while it is true that individuals working in the finance sector are more skilled than average workers, there is little evidence that this is responsible for much of the finance wage premium, and no evidence it can explain the rising premium.
Rather than the characteristics of the individuals working in the finance sector, it might be the nature of the jobs that they do that explains the high and rising wage premium.
In particular, the theory of task-biased technological change argues that new ICT technology has replaced workers doing routine, easily programmed tasks, but is complementary to non-routine analytical tasks (see Autor et al. 2003). We used data from the GB Skills Survey, which asks about the tasks involved in workers’ jobs. Jobs in the finance sector are more likely than non-finance jobs to involve non-routine tasks, such as numeracy, literacy, problem-solving, influencing people, and complex computing tasks, and thus the high demand for labour to carry out such tasks may help to explain the finance sector premium. However, there is no evidence that the non-routine task component of finance sector jobs increased over time between 1997 and 2012, while there is such a trend in the non-finance sector, so that the finance–non-finance gap in non-routine task use has actually fallen over time. Again, therefore, the theory cannot explain the rising finance pay premium over time. In addition, the premium remains statistically significant for skilled workers even after controlling for task content of jobs.
In summary, the available evidence is most consistent with the rent sharing explanation for the finance sector pay premium. For this explanation to work, however, we also need it to explain why the premium is rising. This could be due to a rising opportunity to engage in rent sharing, due to financial deregulation, implicit insurance against risk through bank bailouts, and increasing complexity of financial products creating more asymmetric information, as well as increased incentives to aim for a larger share of rents due to falling top-end marginal tax rates. Whether governments want to enact policies to try to reduce the premium depends on whether they view it as a private sector matter with benign effects on the economy as a whole, or as having a distorting effect on the labour market, attracting the best workers away from potentially more socially useful jobs.
Autor, D, F Levy, and R Murnane (2003), “The Skill Content of Recent Technological Change: An Empirical Exploration”, Quarterly Journal of Economics, 118(4): 1279–1334.
Bell, B and J Van Reenen (2010), “Bankers’ Pay and Extreme Wage Inequality in the UK”, LSE Centre for Economic Performance Special Paper 21.
Bell, B and J Van Reenen (2013), “Bankers and Their Bonuses”, LSE Centre for Economic Performance Occasional Paper 35.
Lindley, J and S McIntosh (2014), “Finance Sector Wage Growth and the Role of Human Capital”, Sheffield Economics Research Paper 2014002.