The Real Cost of CEO Compensation: The Effect of Behindness Aversion of Employees
Rising executive compensation has been subject of fierce public debates over the last decades. One group that voices strong opposition against high and increasing executive pay is rank and file employees (and their union representatives). Just recently, the US introduced regulation which forces listed firms to report the ratio of CEO to median employee wages every year. Many people seem to be worried that “too much” wage inequality within a firm might be bad for society overall. Such behavior is difficult to explain with standard rational preferences, because formally CEOs are employees and paid by shareholders, so regular employees should, in principle, not object to them being overpaid.
In our paper, we link the economic (theoretical and experimental) literature on inequality aversion with executive compensation. We show first theoretically that employee wages increase with CEO wages if employees are envious of the pay their CEO receives. The reason for this is that the employees who feel envious have to be compensated for the disutility they perceive from a larger pay gap between themselves and the CEO. There can be direct and indirect channels through which CEO compensation affects employee wages. Through the direct channel, workers observe the compensation of CEOs from published reports. They derive disutility directly from comparison. Another channel is indirect: Top managers compare their wages to the CEO, and their disutility is compensated. Regular managers compare their wages to top managers, lower managers to regular managers, and regular employees compare their wages to lower managers. The effect of high CEO compensation gradually passes down to regular employees. In a second step, we test and confirm this prediction using German data.
We analyze data of the largest listed firms in Germany between 2000 and 2011. We match data on CEO compensation (and other firm-level variables) with detailed employee data from the Research Institute of the German Federal Employment Agency (IAB). In total, we are able to match 100 firms to 34,000 establishments (i.e., branches). In our empirical analysis, we find that an increase of the CEO’s compensation by 10% increases median worker compensation by 0.4%. It is instructive to make an example for an average firm where the CEO makes €2.6 million p.a., the average employee makes €35,167 p.a., and the average number of employees (in Germany) is about 50,000. If an average firm wants to increase CEO pay by 10%, it will raise the total wage bill by more than €7 million instead of only €260,000 when just taking into account the CEO’s compensation. These numbers show that “real” costs of CEO compensation might be substantially higher than generally thought. To the best of our knowledge we are the first to establish this economically important relationship.
In further analyses, we try to establish causality running from CEO compensation to rank-and-file employees’ wages by exploiting a regulation change in Germany in 2006. Since that year firms are required to publish individual salaries of all management board members. We observe a strong increase of employee wages in firms where employees were able to observe CEO wages for the first time, compared to firms that published individual compensation already before 2003.
We also look at employee turnover. We find that turnover is lower in a firm where CEO pay is high. This suggest that the firm overcompensates the envious behaviour of employees.
Overall we believe, we can present compelling evidence that employees are envious of the pay their CEO receives and that this behavior has important economic implications.