Do firm effects drift? Evidence from Washington Administrative Data

We investigate the time-series properties of firm effects in the AKM models popularized by
Abowd et al. (1999). We consider two approaches. The first approach — labelled as the rolling
approach — estimates AKM models separately in each T = 2 adjacent time interval. The
second approach is based on an extension of the original AKM — labelled as the Time Varying
AKM Model (TV-AKM) — in which we allow for unrestricted interactions of year and firm
dummies. We correct for biases in the resulting variance decompositions using the leave out
correction of Kline et al. (2019). These approaches allow us to examine how firm effects evolve
stochastically, their relation to the business cycle, and their contribution to changes in the wage
structure at a higher frequency than previously possible. Using data from Washington State, we
find that firm effects in earnings and hourly wages are highly persistent. The autocorrelation
coefficient between firm effects for wage rates in 2002 and 2014 is 0.74, and between firm
effects for earnings in 2002 and 2014 is 0.82. The rolling approach uncovers a significant
degree of cyclicality in firm effects. Variability in firm premiums tended to increase during
the great recession while the degree of worker and firm assortativity decreased. Time-varying
firm effects explains 13% of the variance of log wages and 21% of the variance of log earnings
in the Washington state over 2002–2014. Between 2002-2003 and 2013-2014 the variance of
firm wage premia decreased by 10%, but this decline was offset by increases in the variance in
individual premia and increases in assortative matching that resulted in an overall increase in
the variance of wages. Auxiliary evidence suggests that misspecification in AKM models due
to the drifting of firm effects is a second-order concern.
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