Measuring Compensation System Structure: The Interrelation Between Equitable Pay and Firm Performance

Abstract

Recent political and popular discourse focusing on income inequality between ordinary workers and top executives concentrates on the ratio of chief executive officer (CEO) compensation to “average” or median employee compensation (CEO pay ratio). Largely ignored in the income inequality debate is the importance of the underlying firm’s compensation system that determines the CEO’s and the average employee’s compensations. I propose employee perceptions of pay equitability are a function of how employees’ compensation fits in the firm’s compensation system, so CEO pay ratios may be incapable of detecting the underlying firm compensation system structure. Because the structure of the compensation system dictates the relative differences between superior and subordinate pay, I measure the compensation system structure using the promotional pay ladder (PPL), which measures how percentage increases in compensation correspond to increases in employee responsibility. I find that firms with “unequal” PPL (those which deviate from a theorized effective threshold) are associated with lower future economic performance. Deviations above and below the theorized effective level affect different groups of employees in the firm and have different impacts on firm performance. This study contributes to the growing literature on income inequality by providing evidence that employee compensation amounts need to be examined within the context of the firm’s compensation system.