Innovation demands top talent – and top talent demands top compensation. That is the central finding of a new research report, published in the June 2009 Economic Journal, which analyses the links between the potential returns to innovation and the structure of compensation for the most talented employees in one high-technology industry.

The study – by Professors Fredrik Andersson, Matthew Freedman, John Haltiwanger, Julia Lane and Kathryn Shaw – demonstrates that software firms in the United States that operate in product markets with high potential upside gains to innovation but also significant downside risks – video games, for example – pay more to ''star'' workers than do software firms that operate in more stable markets – such as database and distribution software.

For a worker at the upper end of the skill distribution, the difference in the starting salary at a firm in a riskier product market compared with at a firm in a stable one is on the order of $30,000. Not only do star workers receive higher starting salaries at firms in riskier product markets, but they also enjoy stronger earnings growth as firms endeavour to motivate valuable workers and to reward loyalty.

Over time, therefore, gaps in earnings among workers grow, leading to differences in average annual compensation between the most talented, experienced workers in risky markets and their counterparts in less risky markets amounting to several million dollars.

Altogether, the authors' results highlight the importance of both attracting and retaining talent in firms with a greater reliance on innovations and demonstrate the striking implications for the structure of pay.

The strong link between the compensation of star workers and the potential returns to innovations cannot be accounted for by differences in the observed characteristics of firms, including size, age, workforce composition, location or even their actual performances.

Hefty bonuses and stock option grants are more prevalent at firms in riskier product markets. But even stripping out these components of pay, the structure of compensation is clearly skewed towards higher returns to star workers in these firms.

These findings add to our understanding of how changes in the industrial structure of the United States and other developed countries over the past few decades – and the associated changes in the demand for different skills – are related not only to the compensation strategies of individual firms, but also to shifts in the income distribution.

With the rapid growth of high-technology industries in which firm survival hinges on innovation, the returns to skill have increased and performance-based pay that rewards top talent has become more pervasive. This, in turn, has helped to fuel overall increases in earnings inequality, which have been driven largely by rising pay in the upper reaches of the income distribution.

These findings also have important implications for education and workforce development policy. Human capital has consistently been identified as a driver of innovation by both governments and businesses. See, for example, the UK''s Innovation Nation white paper (http://www.dius.gov.uk/innovation/innovation_nation), the OECD''s Innovation Strategy (www.oecd.org/innovation/strategy) or a recent Conference Board conference (http://www.conference- board.org/conferences/conference.cfm?id=1558).

With little evidence about how to stimulate innovation, governments have typically focused on supply-side strategies such as training scientists and engineers. The results of this research suggest that, independent of any such initiatives, firms'' compensation policies are also closely linked to innovative activities.

''Reaching for the Stars: Who Pays for Talent in Innovative Industries?'' by Fredrik Andersson, Matthew Freedman, John Haltiwanger, Julia Lane and Kathryn Shaw is published in the June 2009 issue of the Economic Journal.