Earnings Dynamics, Inequality, and Firm Heterogeneity

ABSTRACT Studies of individual earnings dynamics typically overlook firm heterogeneity, while worker and firm decompositions of earnings inequality often neglect the life cycle. We study firm effects in individual earnings dynamics for the Italian private sector population, using the covariance structure of co‐worker earnings for identification. We allow for dynamics of both worker and firm effects, as well as worker‐firm sorting and worker segregation. When workers are young, firm and worker heterogeneity explain similar shares of earnings inequality; however, over the life cycle, workers account for most of the inequality. Sorting is substantial, especially among younger workers. Segregation accounts for most of the earnings inequality between firms.