The interrelation between firm compensation system structure, equitable pay, and firm performance

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The Dodd-Frank Wall Street Reform and Consumer Protection Act Section 953 mandates the disclosure of the relationship between executive compensation and firm performance and the ratio of CEO compensation to median employee compensation. Prior research inspired by the Dodd-Frank Act provides mixed evidence on the relationship between the ratio of CEO compensation to median employee compensation and future economic performance. I propose employee perceptions of pay equability are a function of how employees’ compensation fits in the firm’s compensation system, so Dodd-Frank Act inspired ratios may be incapable of detecting the underlying firm compensation 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. 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.

Dodd-Frank Act, Compensation system structure, Income inequality, Non-executive compensation, Promotional pay ladder, CEO pay ratio