Reaching for the Stars: Who Pays for Talent in Innovative Industries?, NBER Working Paper 12435

Firms that want to innovate successfully need to hire and motivate highly talented workers. This paper makes a key connection between the potential returns to innovation in terms of new products and the structure of compensation to talented employees. We use linked employer-employee data to show that software firms that operate in product markets with high potential upside gains to innovation (as in video games or Internet firms) have a greater return to hiring ‘stars ’ than do other firms that operate in stable markets (like mainframe software). Firms operating in product domains with highly skewed positive returns are shown to pay employees more in up-front starting salaries and to offer much higher compensation growth. Thus, these firms appear to pay for initial skills and also to pay much more for experience or loyalty: star workers who stay with these firms are paid more than in other firms. The large effects on earnings are robust to the inclusion of a wide range of controls for both worker and firm characteristics. We also show that in firms that have actually developed products with high revenues, or that have hit “home runs”, the rewards for star talent are even greater