Financing the rise in income inequality

High salaries and other forms of compensation in the finance sector aren’t a surprise to anyone. Even before the 2008 financial crisis, the high pay of bankers on Wall Street and in “the City” were a source of contention. But the causes behind the large wage premium aren’t as apparent. A new paper documenting trends in pay in finance sheds light onto why pay is so high.

The paper, by Joaane Lindley of King’s College London and Steven McIntosh, of the University of Sheffield, is summarized by the authors in a column for VoxEU. The two economists look at the data for the finance industry for the United Kingdom and especially the City, the hub of financial activity in London.

First, the authors show just how large the wage premium, or the gain for a worker moving into the industry, is for the U.K finance industry. They find that, on average, workers in this sector sees their wages increase by 37 percent when moving to the finance industry from a non-finance industry. The work of the employee didn’t change. The pay premium is based solely on working in the finance industry. Importantly, this premium has been increasing over time, rising by 57 percent from 1997 to 2011.

The authors then test to see whether the wage premium is the result of the industry hiring employees from more highly paid occupations. They find that the premium exists up and down the occupational distribution. Finance executives make more than non-finance executives and customer service representatives for financial firms make more than representatives for non-financial firms.

Lindley and McIntosh offer three possible explanations for the high and rising finance pay premium. The first is skill intensity. Finance firms might just employ workers with more skills. The authors find that the industry employs more skilled workers and that this may contribute to the size of the premium. Yet the skill intensity doesn’t appear to have changed over time even though the premium has. So this explanation is incomplete.

The same goes for so called skill-biased technological change, the idea that increasing wage inequality is due to increased demand for skilled labor. The finance sector might employ more workers with non-routine skills that can’t be replaced with technology. But that also hasn’t changed much over time, according to data analyzed by the authors.

The authors’ preferred explanation is the firm sharing “rents” with its workers—rents in this case meaning excessive profits made above what the industry would have made in a more competitive marketplace. Financial deregulation beginning in the late 1970s through the mid-2000s created opportunities to extract these rents from other industries in need of the finance industry’s services. And then those rents were shared with workers up and down the financial industry’s pay ladder, resulting in the large premium for finance-industry workers.

Lindley and McIntosh’s data are only for the United Kingdom, but the premium exists in the United States as well. A 2012 paper by economists Thomas Philippon of New York University, and Ariell Reshef of the University of Virginia find a large and rising finance sector pay premium. The average premium is 50 percent over non-finance sectors, but 250 percent for executives in the finance industry over their counterparts in other sectors.

The large premium for finance workers, particularly executives, results in the industry’s overrepresentation at the very top of the income ladder. In 2005, about 14 percent of taxpayers in the top 1 percent and 18 percent of those in the top 0.1 percent were employed in the finance industry, compared to just under 8 percent of the top 1 percent and 11 percent of the top 0.1 percent in 1979.

In light of the 2008 financial crisis, the economic value of the U.S. finance industry as currently constituted has been called into question. The fact that new research shows the high pay in the financial services sector doesn’t come from economic efficiency but rather from excessive rents is another point in the case for policies that might redress the imbalances in pay. Policymakers should consider reining in pay packages in the finance sector because this step could well increase economic stability and efficiency and help reduce inequality, too