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August 22, 2016

Does performance-related pay improve productivity?

Opinion image

Do firms that offer their employees a compensation package linking pay to performance have higher productivity?

Many firms around the world have attempted to improve their performance by replacing traditional fixed pay components with more variable pay. They do so in an attempt to motivate workers to be more efficient at work and to increase their attachment to the company, thereby reducing both turnover and absenteeism. Surveys of company pay practices in Europe show that in companies with more than 200 employees nearly one in every two workers is covered by some form of performance-related pay, while comparable figures for the US show a much higher incidence (Boeri et al., 2013). The diffusion of incentive pay is greater in high-skilled jobs, in the private sector, in manufacturing and financial services and less in hotel and restaurant and in other service industries, as well as in countries with a larger proportion of companies listed on a stock exchange. Finally, the diffusion of variable pay schemes, both in Europe and in the US, is also associated with the introduction of “high involvement management” practices, which often encompass performance-related pay, as well as fiscal advantages either in the form of tax exemptions or tax allowances.

One key question for policymaking is whether there is a “causal” effect of performance-related pay on companies’ productivity. While most existing studies support the view that performance-related pay is associated with higher employee productivity and better worker—firm matches, one fundamental problem is that most firms introduce performance-related pay schemes as part of other changes in management practices and usually after a substantial re-organization of work tasks and procedures. This makes it hard to disentangle the effects of pay incentives on labor productivity from those of other work organization practices. Firms that are the first to adopt performance-related pay schemes may do so because they are doing well, or because they have “good management” that might produce good results with any innovation. Also, there is considerable variety in the type and the design of incentive schemes implemented, as well as in the kinds of firms adopting such schemes. The effects of “individual pay incentives” are generally found to be larger than those of other types of incentive schemes, since they combine a direct “incentive effect” (workers put more effort in) and an indirect “selection effect” (more productive workers are attracted when pay is linked to performance, while the least productive leave). Conversely “group pay incentives” and participation in a company’s financial success have smaller effects on performance, due to the low power of collective pay incentives (where the reward is equally shared among all members of a group).

Should governments encourage and subsidize, through tax breaks and other financial incentives, the diffusion of performance-related compensation schemes? The case for government intervention is highly debated due to the diversity of firms and the large social costs involved. In some countries performance-related pay or financial participation in large firms is mandatory; in others governments seem reluctant to intervene in how pay is set in (private sector) companies, and no specific measures nor fiscal incentives to encourage firms are adopted. This variance suggests that the case for government intervention to induce firms to adopt incentive pay schemes should be evaluated with care, as what works in one setting may not work in another.

References
Boeri, T., C. Lucifora, and K. J. Murphy. Executive Remuneration and Employee Performance-Related Pay: A Transatlantic Perspective. Oxford: Oxford University Press, 2013.

Related article:
Performance-related pay and labor productivity, by Claudio Lucifora

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We recognize that IZA World of Labor articles may prompt discussion and possibly controversy. Opinion pieces, such as the one above, capture ideas and debates concisely, and anchor them with real-world examples. Opinions stated here do not necessarily reflect those of the IZA.