why are the returns to skill lower for younger than for older workers

Why are the returns to skill lower for younger than for older workers?

By Stijn Broecke.

Older workers earn more than younger workers with the same skills

An empirical regularity observed across all countries that participated in the Survey of Adult Skills (PIAAC, 2012) is that individuals with higher cognitive skills also tend to have higher wages. For policy makers, this carries an important message about the importance of further investing in skills.

That said, two individuals with the same level of skill will not necessarily have the same wages, and sometimes systematic differences arise between groups of individuals in how their skills are rewarded.

One example of this is the difference in pay between older and younger workers. Indeed, in most countries that participated in the Survey of Adult Skills (PIAAC, 2012), the return to skills tends to increase with labour market experience – i.e. individuals with more experience will receive higher wages for a given level of skill than individuals with less experience, all else held constant.

This finding has potentially important implications, not only in terms of fairness, but also in terms of efficiency: if individuals do not see their skills appropriately rewarded in the labour market, then this might act as a disincentive to invest in skills.

So what explains the lower return to skill among younger, less-experienced workers?

Employers may need time to learn about (and reward) the true skills of young workers

One possible explanation is that employers simply do not observe the true level of skills of younger workers. Indeed, assessing the skills of workers who have just left school and have no or little work experience, may be very difficult. As a result, employers may choose to set initial wages by using easily observable proxies of skills, such as educational attainment. Then, as workers gain experience in the labour market, employers learn about (and increasingly reward) their true skills (which were initially unobserved).

This theory of “employer learning” has gained a lot of support in the economics literature, and evidence consistent with it (i.e. an increasing return to skill combined with a decreasing return to education as workers gain experience) has been found in a range of countries, including: Australia, Canada, Chile, Germany, New Zealand, Switzerland, and the United Kingdom.

The Survey of Adult Skills (PIAAC, 2012) provides a unique opportunity to shed additional light on the theory of employer learning. More specifically, it allows the theory to be tested across a large number of countries, using a consistent methodology and comparable data – which is what I do in a recent paper titled “Experience and the returns to education and skill in OECD countries, Evidence of employer learning?” published in the OECD Journal: Economic Studies. The results from this analysis suggest that employer learning may be present in some, though definitely not all, of the countries that participated in the survey.

For example, in countries like Australia and the Netherlands, there is a clear increase in the return to skill, combined with a decrease in the return to education, as individuals gain more experience in the labour market (Figure 1). In other countries, however (e.g. Flanders and the Slovak Republic), the return to education also increases as individuals gain more experience in the labour market, which is contrary to what the theory of employer learning would predict.

Figure 1: How the returns to skill and education evolve with labour market experience in 4 OECD countries

Blog17.1Source: Broecke, S. (2015), “Experience and the returns to skill and education in OECD countries: Evidence of employer learning?”, OECD Journal: Economic Studies, Vol. 2015, pp. 1-25.

Temporary contracts may facilitate employer learning

It is not clear what explains these different patterns across countries in the experience profiles of the return to education and skill. In particular, there appears to be little systematic association between labour market institutions and characteristics of education systems, on the one hand, and the possible presence of employer learning, on the other.

One possible exception is the ease of use of temporary contracts: evidence consistent with employer learning is more likely to be found in countries where employment protection legislation on temporary contracts is less rigid. This may indicate that temporary contracts allow employers to test and learn about young workers, and give them the flexibility to adjust wages in line with observed productivity – which is consistent with previous OECD research which has shown that temporary contracts can be a stepping stone into stable employment for young people. That said, countries need to use such contracts judiciously, since an excessive use of them can have an adverse impact on both equity and efficiency.

As a concluding remark, it is important to stress that employer learning is likely to be only one of many reasons for why the returns to skills rise with experience. Some other reasons may include pay scales that reward seniority rather than productivity, individual worker bargaining power, or even discrimination. Of course, such reasons (and their relative importance) may also vary from country to country. Surprisingly, this is an area we actually know relatively little about, and one which clearly merits much more research.