CEO compensation is at historically high levels, and as a result, is receiving unprecedented levels of attention from multiple stakeholders including the academic, regulatory, business, and political communities. An important by-product of escalating CEO compensation is the disparity in pay with other employees of the firm, and particularly with other executives of the firm who work alongside the CEO. That gap in pay has been steadily rising, with CEOs now earning up to six times the compensation of their closest lieutenants (Pissaris and Golden, 2008), taking up a larger and larger slice of the firm’s resources (Bebchuk et al, 2008).
The rising disparity or gap in pay between the CEO and other executives is commensurate with the number of studies devoted to this subject. There has been a veritable explosion of empirical research aimed towards understanding the relationship between the relative difference in executive pay and their impact on firm performance (Boschen and Smith, 1995; Barkema and Gomez-Mejia, 1998). Recent interest in executive pay has seeped beyond academia and corporate boardrooms. It is now raising eyebrows at the highest levels of government prompting debates aimed at improving corporate governance through additional regulations to better protect shareholders.
Traditionally, corporate governance has relied on both internal and external monitors to align the goals of management with the goals of shareholders. External governance imposed on companies in the United States includes the 2002 Corporate Oversight Bill and the NYSE/Nasdaq/AMEX corporate governance rules. The United States functions under a market based system with various monitors including institutional investors, board of directors, and management compensation. Market-based responses to shareholder dissatisfaction include disposing of shares, lawsuits, changing management, and takeover threats. Pay dispersion is an internal governance mechanism that falls under the broad category of management compensation. Additional internal governance mechanisms include ownership concentration and issues related to the board of directors.
Currently two competing views of executive pay disparity are being debated in the literature. The first, tournament theory, suggests that high pay disparity will encourage competition and thus improve executive efficiency (Lazear and Rosen, 1981). The second, equity fairness (or distributive justice), posits that low pay dispersion will result in higher cooperation among executives leading to stronger performance (Levine, 1991). Empirical literature on the topic of pay dispersion has yet to identify the stronger influence. In support of tournament theory Main et al. (1993) find a positive link with firm performance using a sample of 200 US-based firms. On the other hand, O’Reilly et al. (1988) do not find support for tournament theory using a sample of 105 Fortune 500 firms.
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Empirical Analysis of the Relationship Between Pay Disparity and Performance
