Permanent and Transitory Wage Inequality of British Men, 1975-2001: Year, Age and Cohort Effects

We examine the variance-covariance structure of log-wages over time and over the
lifecycle of British men from 1975 to 2001, hereby controlling for cohort effects.
Wage inequality has risen sharply during the 1980’s and early 1990’s and remained
fairly constant in the second half of the 1990’s. We show that this increase is caused
mainly by a strong increase in the transitory wage inequality and only to a lesser
extent to an increase in the permanent wage inequality. The transitory component
of wages is, however, highly persistent over time: serial correlation decreases from
0.88 over a one-year period to 0.65 over a ten-year period. The constant wage
inequality in the second half of the 1990’s is attributed to a slight decrease in
permanent wages inequality, a stabilization of the variance of the transitory wage
shock, and the strong decrease in the transitory wage inequality for the cohorts
entering employment since the end of the 1980’s. Ignoring age effects in transitory
wage inequality and cohort effects, as is commonly done, leads to severely distorted
inferences concerning the changes in permanent wage inequality.