Worker-Firm Heterogeneity and Matching: An Analysis Using Worker and Firm Fixed Effects Estimated From LEED

This was commissioned as a LEED Research Report by Statistics New Zealand

This paper uses Statistics New Zealand's Linked Employer-Employee Data (LEED) over the six year period April 1999-March 2005 to derive and analyse estimates of two-way worker and firm fixed effects components of job earnings rates. The fixed effects estimates reflect the portable earnings premium that each worker receives in whichever firm they work for, and the time-invariant premium that each firm pays to all the workers it employs. Our main estimates use full-time equivalent annual earnings for each job-year observation weighted by its effective employment, which involves about 18.7 million job-year observations for 2.8 million employees and 320,000 firms.

Our analysis focuses on three issues. First, how much of the variation in job earnings rates is attributable to observable worker demographic factors (age and sex), unobserved worker effects and unobserved firm effects? We find that worker effects account for about one half, worker demographics one quarter, and firm effects 10-25 percent of the variance in job earnings.

Second, how much compositional change occurred during this period of substantial employment growth? As measured by changes in the annual averages, worker and firm effects declined by about 5 and 1 percent, respectively, over the period.

Third, what is the aggregate pattern of sorting of workers and firms across jobs? The correlation between worker and firm effects is 0.12, which is higher than international estimates and implies a tendency for high-earning workers to work for high-paying firms. A primary dimension along which sorting occurs is the full-time / part-time employment dimension.

The results are qualitatively robust to various sensitivity tests, including unweighted estimation across all jobs, using only workers' main jobs held in each year, jobs of workers estimated to be employed full-time during the year, and excluding jobs in firms that have a low degree of connectivity to other firms. The estimated correlation between worker and firm effects is higher based on unweighted jobs (0.18) and more-connected firms (0.17), but lower based on main job (0.06) and full-time workers (-0.01).