Capital Structure and Employee Pay: An Empirical Analysis

Abstract

Tradeoff theory points to direct bankruptcy costs as the main reason for the observed low leverage in corporate capital structure. However, the empirical evidence does not justify direct bankruptcy costs as a sufficient disincentive to issue debt. Recent theoretical models suggest that indirect bankruptcy costs arising from human capital can be one disincentive to the use of debt. We empirically test the impact of leverage on labor costs, and explore whether human capital costs are large enough to limit the use of debt. We conduct our analysis using two measures of labor costs: the magnitude of CEO compensation and the average employee pay. In both simple OLS and instrumental variable regressions, we find that leverage has a significantly positive impact on CEOs’ cash, equity-based, and total compensation. To identify causality, we study the compensation of new CEOs who are hired from outside. We show that the pay of a newly hired CEO is positively affected by leverage. We also find that the leverage ratio has a significant and positive impact on average employee pay, in OLS, instrument variable regression, and Heckman two-step analysis. We show that the incremental total labor expenses associated with an increase in leverage is large enough to offset the incremental tax benefits of debt. In addition, the impact of leverage on average employee pay is positive and significant for old economy firms, but not for new economy firms; leverage has a significant and positive influence on CEOs’ cash, equity-based, and total compensation in old economy firms, although it does not have a significant influence on CEOs’ total or equity-based compensation in new economy firms. Overall, our analysis provides empirical support for the notion that labor costs limit the use of debt.