Pay Gap and Performance

Abstract

The growing pay gap between executives and employees has been subject to much media publicity and political attention in recent times. We examine how the executive and employee pay components of the pay gap drives firm performance. Economic theories of matching and managerial talent suggest talented executives who can generate relatively better firm performance receive wage premiums, implying a positive relation between the pay gap and performance. Alternatively, wage premiums to skilled employee talent suggest a negative pay gap - performance relation, consistent with efficiency wage theory Sociological theories suggest that the inequity implied by larger pay gaps lowers firm performance through the adverse effects on employee morale and productivity. To test these alternative theories, we utilize pay gap data from China that provides a setting with strong national preferences towards equity but also with a scarcity of experienced managers and abundance of low cost labor. Our results strongly support economic-based theories – firm performance is largely driven by pay premiums for executive talent. Additional tests using a smaller sample of US firms with pay gap data are consistent with our primary findings. Our study is likely to be of interest to politicians, regulators and company executives responsible for understanding and evaluating pay gap and executive pay.