The Evolution of Unobserved Skill Returns in the U.S.: A New Approach Using Panel Data

Abstract: Economists disagree about the factors driving the substantial increase in residual wage inequality in the US over the past few decades. To identify changes in the returns to unobserved skills, we make a novel assumption about the dynamics of skills rather than about the stability of skill distributions across cohorts, as is standard. We show that our assumption is supported by data on test score dynamics for older workers in the HRS. Using survey data from the PSID and administrative data from the IRS and SSA, we estimate that the returns to unobserved skills $declined$ substantially in the late-1980s and 1990s despite an increase in residual inequality. Accounting for firm-specific pay differences yields similar results. Extending our framework to consider occupational differences in returns to skill and multiple unobserved skills, we further show that skill returns display similar patterns for workers employed in each of cognitive, routine, and social occupations. Finally, our results suggest that increasing skill dispersion, driven by rising skill volatility, explains most of the growth in residual wage inequality since the 1980s.