Vertical Pay Disparity and Firm Performance

Kentaro Koga
Professor, NUCB Business School

Vertical pay disparity may either lift or suppress firm performance.  Our empirical research finds that the pay ratio explained by the economic factors raises firm performance, especially in the upper layer tournament between executives and middle managers. Furthermore, the promotion probability plays a critical role in this relationship.

The compensation schemes between Japanese and US firms stand in stark contrast. A 2020 Nikkei newspaper article reports that, in Japan, an executive earns 4.2 times as much as a regular employee on average whereas, in the US, an executive does so 15 times. Japanese doubt the US compensation scheme could sustain firms’ competitiveness since a steep vertical pay disparity would not motivate the regular employees. Americans perceive the Japanese compensation scheme likewise but because a shallow vertical pay disparity would discourage the executives.

This modern US perspective on compensation, however, is not rooted in history. Old Americans thought like contemporary Japanese. For example, JP Morgan, a US banker 100 years ago, said “CEO pay should not exceed 20 times the average worker pay.” Peter Drucker asserted that “A 20-to-1 salary ratio is the limit beyond which they cannot go if they don’t want resentment and falling morale to hit their companies.”

Furthermore, some modern Americans also believe that the steep vertical pay disparity is detrimental to businesses and the society. In order to monitor the compensation divergence, the 2010 Dodd Frank Act mandates US listed firms to disclose the CEO to median employee pay ratio.

Although the contrasting perspectives could stem from the cultural, historical and political differences, one wonders which compensation scheme contributes to a stronger competitive advantage. For example, when Japanese and US firms compete head to head in the global market, which perform better? Academically, organizational behavior’s equity theory favors the Japanese compensation scheme as a shallow vertical pay disparity would engender a feeling of fairness. On the other hand, economics’ tournament theory supports the US compensation scheme because a steep vertical pay disparity should draw greater effort.

Professors Jeong-Hoon Hyun and Jae Yong Shin of Chung-Ang and Seoul National Universities, respectively, and Sang Ahn, a PhD student of the University of San Francisco and I have explored this research question (Ahn, Hyun, Koga and Shin 2024). We analyze a unique dataset from Korea where firms must disclose not only the average executive and employee compensations, but also the workforce characteristics such as the headcounts, the average tenure and the part-time worker proportion.

Firm Performance Improves as the Economic Pay Ratio between Executives and
Middle Managers Becomes Greater

We separate the average executive to employee pay ratio into that explained by economic factors and that unexplained. For example, economics asserts that executives managing larger firms should earn greater compensation because of more complex tasks. An average employee working for a more R&D intense firm should receive greater compensation because researchers make up a higher proportion of the workforce. Contrarily, an average employee working for a more capital intense firm should receive a smaller compensation.

Regression analysis shows that one year ahead return on assets (ROA) is positively associated with the economic pay ratio between executives and employees confirming Rouen (2020) upon US data. The association stems from the upper layer tournament between executives and middle managers rather than the lower layer tournament between middle managers and employees. In addition, the promotion probability plays a role in the association between one year ahead ROA and the economic pay ratio i.e., the higher the promotion probability, the stronger the association between one year ahead ROA and the economic pay ratio.

Our research has valuable implications to business practice, especially, the compensation design. First, only the economic pay ratio contributes to the firm performance as the tournament theory hypothesizes but not the unexplained pay ratio. Although we do not find the association between the unexplained pay ratio and firm performance, Rouen (2020) documents a negative relationship i.e., unexplained pay ratio suppresses firm performance as the equity theory predicts. Second, the upper layer tournament’s compensation impacts firm performance more significantly than that of the lower layer tournament. Third, it is instrumental to design the promotion probability together with the pay ratio for the latter to impact firm performance.

References

• Ahn, S., J. Hyun, K. Koga, and J. Y. Shin. 2024. Dissecting corporate tournaments: Multi-layered structures and firm performance. Working paper. University of San Francisco, Chung-Ang University, NUCB, and Seoul National University
• Rouen, E. 2020. Rethinking measurement of pay disparity and its relation to firm performance. Accounting Review 95 (1): 343-378