Research Highlights Article
August 16, 2024
Explaining differences in the college wage premium across countries
Do employment protection policies help buoy the wages of less educated workers relative to their more educated counterparts?
Source: Hannamariah
Since the 1980s, the wages of better educated workers in the United States have outpaced the wages of their less educated peers. By 2017, college graduates were earning 65 percent more than non-college-educated workers on average, a nearly 30 percentage point increase compared to 40 years prior. Similar trends have occurred in Canada and the United Kingdom.
But some advanced economies, such as Germany, have largely avoided this source of growing inequality.
In a paper in the American Economic Journal: Macroeconomics, authors Matthias Doepke and Ruben Gaetani show that differences in employment protection are key to understanding the divergence in the college wage premium across developed countries. The authors built a quantitative model of the labor market in which on-the-job skill accumulation is a major source of income disparity among workers, and calibrated it to the United States and Germany.
Previous work on the college wage premium put a strong emphasis on the role of technological advancements that favored more educated workers. Doepke and Gaetani take these institutional factors into consideration, but point out that modern high-income countries like Germany face the same pressures and yet don’t see a rising college wage premium.
Something else must account for the divergence between the United States and Germany, and OECD measures of employment protection across countries provided a clue. In Germany, the law gives special protections to older workers and those with longer tenures.
“When we correlate these measures with the change in the skill premium, we find a negative correlation between the two,” Gaetani told the AEA in an interview. “So economies with much stricter laws that protect employment experience a significantly lower increase in the college premium. This basic correlation is what got us motivated in the first place.”
Labor protection and the education premium
The chart below shows the percentage change in the college premium between 1980 and 2006 among some OECD countries against their OECD labor protection index in the 1990s.
The authors sought to explain this negative relationship between employment protection and the college wage premium. In their model, firms have a choice between creating either high-quality jobs that allow workers to accumulate skills or less costly, low-quality jobs in which workers’ productivity remains stagnant. At the same time, workers can also decide how much effort to put into accumulating the skills that will earn them higher wages.
Under such conditions, when firms and workers come together, they will be more likely to invest in their relationship when they expect it to last longer. Companies have little incentive to invest in workers when there is high turnover, and workers have little incentive to invest in skills that can’t be taken to other firms. But according to the authors, there’s a differential impact of employment duration on college-educated and less educated workers.
Since the skills of college-educated workers are not as firm-specific as less educated workers, their investment in new skills depends less on the expected duration of a given employment spell. Hence, employment protection, which helps make job matches more durable, does more to buoy the skills and wages of less educated workers compared to their better educated counterparts.
“Stricter employment protection creates better incentives for firms and for workers to invest in skills on the job,” Gaetani said. “It improves the incentives that firms have to create good jobs that require training specific to the employment relationship itself.”
This means that when the economy overall is more volatile, stronger employment protections help keep workers and firms matched for longer and keep the wages of less educated workers from stagnating. As a result, the college wage premium doesn’t increase as quickly compared to countries with weaker employment protections.
Stricter employment protection creates better incentives for firms and for workers to invest in skills on the job. It improves the incentives that firms have to create good jobs that require training specific to the employment relationship itself.
Ruben Gaetani
When the authors applied their model to data between 1980 and 2010, they found that employment protection policies could explain close to half of the divergent trend in the college wage premium between the United States and Germany. In particular, roughly 40 percent of the college wage premium in the United States would disappear if it had employment protections as strict as Germany’s.
Overall, the findings suggest that when weighing the costs and benefits of employment protections, policymakers should take into consideration the long-run impact on less educated workers.
“Most of the literature in macro labor that has focused on employment protection tends to find negative welfare effects from employment protection overall,” Gaetani said. “But once you account for employment protection fixing some inefficiencies in the economy, a moderate amount of employment protection can actually be beneficial to welfare.”
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“Why Didn't the College Premium Rise Everywhere? Employment Protection and On-the-Job Investment in Skills” appears in the July 2024 issue of the American Economic Journal: Macroeconomics.