Bengt Holmstrom, this years' Nobel Prize winner for Economics, has some interesting things to say about merit pay, specifically as it pertains to teachers and education.
"Payments for teachers linked to student test results, for example, risk generating good grades at the expense of any teacher effort in developing harder-to-measure skills in students, such a creativity."
And then there is this:
A teacher rewarded only on the basis of student test scores might spend more time than is optimal on test preparation and too little time teaching equally important (but harder to measure) skills such as creativity and independent thinking. A fixed salary, independent of any performance measures, would lead to a more balanced allocation of effort across tasks"
