# **7. Role of Firm Heterogeneity**

This section investigates the role of firms in the reduction of wage inequality. Equally skilled workers, even if working in the same occupation and sector, may differ in a key dimension: they may work for different firms. The “firm component” of wage differentials has been shown to be large for developed countries (see Abowd, Kramarz, and Margolis 1999; Goux and Maurin 1999; Abowd, Creecy, and Kramarz 2002; Gruetter and Lalive 2009).<sup>21</sup> Due to data constraints, the evidence is more limited in developing countries, but to the extent that firms differ in attributes such as entrepreneurial skill and management practices, these differences are expected to exist.<sup>22</sup> Although these factors are more structural, demand shifters, such as trade shocks, can affect the productivity (and employment) distribution within a sector and the pass-through from firm characteristics to pay. Thus, the firm component is not static, and changes in this component could affect growth in wage inequality. This section focuses on the role of changes in inter-firm pay differences in generating changes in wage inequality. More specifically, it tackles two questions. First, did inter-firm wage differentials fall over time in those countries where inequality fell? Second, if so, what was the contribution of this fall to the reduction in cross-sectional wage inequality?

The previous sections of this paper rely on individual-level data from household surveys, which are likely representative of the formal and informal workforce. However, these surveys do not identify the employing firm of each worker and do not allow us to follow individual workers over time (except for short periods of time in some countries). This section answers the questions above using longitudinal matched employer-employee data from Brazil, Costa Rica, and Ecuador. These data sets are based on social security administrative records. Thus data coverage is restricted to formal workers. As discussed in the previous section, formal workers accounted for around 55 percent of total employment in Latin America in 2015.

Supplementary online appendix S1.3 describes these administrative data sets. Administrative data cover all workers registered (by their firms or voluntarily) in social security, which provides them access to the benefits and labor protections afforded by the legal employment system. Hence, the definition of formality does not match one to one the one used in the

> 21However, due to limitations in their data, these papers were unable to account fully for selection of workers into firms based on unobservables. Using data for manufacturing in Germany, Card, Heining, and Kline (2013) overcome this limitation and, applying the Abowd, Kramarz, and Margolis (1999) framework, find that the variance of firm fixed effects accounts for around 20 percent of the total variance of wages. The main component is worker effects, which accounts for 45 to 50 percent. The covariance of worker/firm fixed effects accounts for around 15 percent, with the remaining variance being accounted by time trends, age, skills, and the residual.

> 22See Alvarez et al. (2018) for evidence focusing on male workers from Brazil’s manufacturing sector.

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