When Paying Regulators for Performance Backfires

We have all heard the argument: if you want better results, tie pay to performance. It’s practically gospel in the private sector. But what happens when you try that logic on government regulators – the people tasked with overseeing Wall Street, protecting the environment, and enforcing aviation safety? In our new study, we offer a sobering answer: they leave. 

In our paper, Escaping Pay-for-Performance, we examine the black box of government compensation reform. We study what happened when the U.S. federal government tried to mimic corporate America by linking executive pay to job performance. The idea was simple: reward the best performers and, hopefully, boost the efficiency of federal regulation. Instead, we found that it triggered a wave of resignations, especially among the most capable regulators.

Our analysis centers on a sweeping 2004 reform that changed how federal executives – those high-ranking career officials just below political appointees – were paid. Until then, most of them received steady pay raises tied to tenure, not performance. The reform aimed to fix that by doubling the potential maximum pay but making future raises contingent on performance.

Sounds good in theory. But when we dug into a dataset of 24,000 federal regulators, they found a clear and unintended effect: the best people left. Specifically, voluntary resignations jumped by over 4 percentage points. Among high-ability executives, the exit rate nearly doubled. These weren’t retirements. Most joined the private sector and walked away with a 66% pay bump on average.

Think about that. The reform was meant to retain and motivate top regulators. But in practice, it motivated them to quit.

To make sure this wasn’t a fluke, we looked at two other settings. One was a staggered rollout of performance pay across ten financial regulatory agencies between 1981 and 2006. The other was a 2004 agreement at the FAA that expanded performance-linked pay for air traffic controllers. The result? Same story: performance pay led to more exits.

So why does this keep happening?

We built a structural model – a kind of economic simulation – to understand what’s going on under the hood. In our framework, regulators are mission-driven, but they also have outside options. They value public service, but not infinitely. If you make their job more stressful or uncertain – say, by introducing performance metrics they view as arbitrary or opaque – you reduce the appeal of public service.

Performance pay doesn’t just increase effort. It increases effort and raises the opportunity cost of staying. More effort in government makes regulators more attractive to private employers. And unlike government jobs, private sector pay has no ceiling. Meanwhile, the government still imposes a cap on maximum earnings, even if you’re a superstar. So once a regulator gets close to that cap, extra effort doesn’t pay off. The result is a perverse incentive: the harder you work, the more it makes sense to leave.

This is more than a quirky policy failure. It’s a cautionary tale about importing private sector solutions into public service jobs. Regulation isn’t just another business line; it’s a public good. And those who choose a regulatory career often do so for reasons other than maximizing income. That doesn’t mean they should be underpaid or immune from accountability. But it does mean we should think carefully before throwing market-based solutions at complex public systems.

What makes the study even more compelling is that we quantify the changes. After the reform, we estimate that executives put in about 4.5% more effort, and 24% of their pay was tied to performance. But that modest bump in effort came at a steep cost: a dramatic reshuffling of talent. The people who left weren’t slackers, they were the high-performers with the strongest private-sector prospects.

The policy implications are clear, if uncomfortable. If you want to pay regulators for performance without bleeding talent, you need to raise the government pay cap. Otherwise, you’re just training people to leave. Alternatively, you could find non-monetary ways to motivate effort - like improving job autonomy, clarifying expectations, or investing in performance metrics that employees trust. But the idea that you can turbocharge public sector performance with corporate-style bonuses is, at best, wishful thinking.

Let’s be honest: regulators already work in politically fraught environments. Their decisions affect billions in market value, public safety, and environmental protection. The last thing we want is to create systems that push the best ones out the door.

In the end, Escaping Pay-for-Performance isn’t an argument against accountability. It’s a warning against lazy policymaking. Not all performance incentives are created equal. In the public sector, especially at the top of the regulatory pyramid, compensation structures have ripple effects—on morale, talent retention, and ultimately the quality of governance. Reform, if it’s going to work, has to respect the unique dynamics of public service. Otherwise, we’re just paying regulators to train for their next private sector job. 

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Jason Chen is an Assistant Professor of Finance at the Harbert College of Business, Auburn University.

Jakub Hajda is an Assistant Professor of Finance at HEC Montréal.

Joseph Kalmenovitz is an Assistant Professor of Finance at the Simon Business School, University of Rochester. 

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