In many countries, the pay gap between senior management and employees is on the rise, as is the research interest in this topic. A study of Chinese publicly traded companies examined whether a pay gap serves to motivate employees to increase their performance or whether effort is reduced due to aversion to inequity. The results of the study indicate that there is an inverted-U relationship between a company’s pay gap and their productivity, meaning that depending on a company’s proximity to the optimal pay gap level a pay gap can have positive or negative company performance implications.
Key Topics: Executive compensation; Pay gap; Employee performance; China
Title of Reviewed Article: Does Fairness Breed Efficiency? Pay Gap and Firm Productivity in China
Researchers: Yunhao Dai (Huazhong University), Dongmin Kong (Zhongnan University), and Jin Xu (Huazhong University).
Publication: International Review of Economics and Finance, 2017, Vol. 48 No. 1, pp. 406–422.
Setting the Scene
The pay gap (PG) between company executives and their employees has garnered a lot of attention in recent years, with PG often being portrayed in a negative light. In addition, regulators in various countries have increasingly imposed rules requiring companies to disclose pay ratio information, such as the 2010 Dodd–Frank Act in the US, as well as capping of executive compensation, as in the case of China’s State-owned Assets Supervision and Administration Commission (SASAC) imposing a ceiling on executive compensation in government-controlled companies at 12 times the average employee salary.
Despite the trend towards increased PG disclosure and capping of executive pay, there has been limited research relating to how PG impacts on the productivity of companies, and this limited research has primarily been US focused and has proven largely inconclusive (e.g. Faleye et al., 2013).
Two theories often cited in the PG debate are the tournament theory (e.g. Lazear & Rosen, 1981; Clark et al., 2009) and distributive justice theories (e.g., Martin, 1981; Cowherd & Levine, 1992). Tournament theory suggests that a small PG will not motivate employees to strive for promotions and progression in the company, whereas a larger PG gives greater incentive to work harder to progress as the financial rewards on offer are seen to be greater (Banker et al., 2016). On the other hand, distributive justice and inequity aversion theories suggest that the wider the PG is, the more unfair employees will perceive it to be and reduce effort or leave the company if they feel it is too high, as employees will demonstrate inequity aversion (e.g. Chen & Sandino, 2012)
In the current study, the researchers examine the relationship between PG and company productivity through a model which integrates the tournament theory and the inequity aversion theory. They suggest that tournament theory will take effect when the PG is below an optimal level, while the distributive justice theories will dominate employee behaviour when the PG is above an optimal level. As such, the following hypothesis was put forward to examine this further:
Hypothesis 1 – “The effect of PG on firm productivity is nonlinear (inverted-U).”
How the research was conducted
The study included data from all publicly traded non-financial Chinese companies on the Chinese stock markets between 2003-2011.
Information relating to executive and employee compensation, financial statements, and stock returns of companies was collected primarily from the China Stock Market and Accounting Research Database (CSMAR).
The PG was constructed based on the ratio of executive compensation (CEO, and senior management) to average employee compensation.
Total factor productivity (TFP), which measured the improvement in company productivity, was used as a proxy for company productivity growth.
The researchers controlled for various factors such as company size and age, company growth opportunities, company performance, and market employment conditions.
Key Research Findings
The average PG was 5.01, with the average increasing marginally between 2003 and 2011. This trend was primarily attributable to state-owned enterprises (SOE), as the PG for non-SOEs decreased during the period, from 6.28 to 5.27, although the PG is higher in non-SOEs throughout the 2003-2011 period.
The results indicate that there is a non-linear (inverted-U) relationship between a company’s PG and productivity, suggesting that a PG which is too high or too low does not benefit company productivity. This finding supports the research hypothesis.
The results further suggest that an optimal level of PG exists, but that this level can vary significantly across industries due to industry specific factors, such as industry concentration and skill level of workers.
Two primary findings are made in this study. Firstly, that an inverted-U relationship between a company’s PG and productivity exists, and secondly, that there is an optimal level of PG.
The researchers create an integrated framework incorporating both tournament theory and inequity aversion theory to explain the relationship between PG and company productivity, and demonstrate that an optimal level of PG can exist whereby there is a balance between incentive effects and inequity aversion effects, and company productivity is maximized.
The optimal PG appears to be impacted by several factors. Low industry concentration, for example, means there is more competition and more outside jobs, so employees can easily move elsewhere if they are dissatisfied in their job, which in turn has less of a negative productivity effect on their current employer. High concentration industries therefore are more likely to be impacted by fairness concerns of employees impacting morale and in turn productivity. As such, the inverted-U relationship is more pronounced in more competitive (low concentration) industries.
Organizational and Reward Implications
This study highlights the idea that, from a company productivity standpoint, PG is neither wholly positive nor negative, but rather it is a company’s proximity to the optimal PG that is important.
Companies should monitor industry standards on PG but also closely monitor themselves for potential negative behaviours and outcomes that may be related to a PG which is too high, or indeed too low. Furthermore, companies should be mindful of the industry specific factors which are likely to impact on the optimal PG, such as industry concentration. Similarly, regulators and policy makers should consider an industry specific approach to pay gap regulation, given that the optimal PG level is not consistent across industries but rather can differ significantly depending on industry specifics.
The pay gap is often portrayed in a negative light; however, this study indicates that when the pay gap is at optimal levels it can have a positive effect on productivity. This study provides insight into the positive and negative implications of a pay gap, although as the study was China focused, generalization of the results should bear that in mind. Further similar studies in other countries are encouraged and would provide valuable additional insight into the role of PG in company performance.
Source Article: Dai, Y., Kong, D., & Xu, J. (2017). Does Fairness Breed Efficiency? Pay Gap and Firm Productivity in China. International Review of Economics and Finance, 48(1), 406–422.
Published by: Elsevier Inc.
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