Escaping Pay-for-Performance

Abstract:

Should we pay regulators for performance? We address the question using a unique dataset that tracks the careers of 26,000 senior federal regulators. They are the highest-ranking bureaucrats in the federal government who collectively oversee all its regulatory activities. We exploit a major reform that switched most senior regulators to a pay-for-performance system. Using a difference-in-differences framework, we find that the reform accelerated the revolving door of affected regulators, who voluntarily left for the private sector. To understand this unexpected response, we build a structural model which highlights two crucial features: government pay is capped, and regulators can accept a private sector job with uncapped pay. Performance pay may induce more effort, but since regulators risk hitting the pay cap, they prefer to move to the private sector where effort is rewarded even more. Estimating our model, we find that 21% of executive pay in the federal government is performance-based. Moreover, performance pay has a large quantitative impact: a 1% increase in pay-for-performance will increase effort by 0.04% and exits by 7.2%. We design alternative executive pay packages, combining a stronger pay-for-performance component with a higher pay cap, to increase regulatory effort without accelerating the revolving door. Overall, our results shed light on the benefits and drawbacks of performance-based pay for regulators.