The rising disparity between CEO and worker pay over the past few decades has been attracting considerable attention from academics. Over the last two decades, the CEO to median employee pay ratio has been increasing for small (S&P SmallCap 600), medium (S&P MidCap 400), and large (S&P 500) firms. The literature names the managerial rent extraction, the rare talent of CEOs, and CEO strategic choice of peer group firms among the plausible explanations of the widening CEO-employee pay gap. This issue is widely discussed in the media, and politicians refer to it as “a national disgrace” and attempt to address it by curbing CEO pay through tax policies and promoting binding say-on-pay votes.
At the same time, the literature has not addressed the question of whether CEO pay responds to changes in worker pay. Understanding the connection between CEO pay and worker pay is important because it allows for evaluating the efficacy of measures aimed at reducing the CEO-employee pay gap. In my recent paper, I aim to shed light on one such measure: a mandated increase in worker pay. For example, if the elasticity of CEO pay with respect to employee pay is less than one, then increasing employee pay will result in a drop in the CEO-employee pay ratio, which may be desirable; otherwise, this policy will only exacerbate the pay disparity. I attempt to fill the gap and investigate how shocks to employee pay affect CEO pay and why.
CEO pay could potentially change in three directions following an employee pay raise. An increase in CEO pay will be consistent with several hypotheses, including the fairness hypothesis of executive compensation and the efficiency wage hypothesis. The fairness hypothesis states that CEOs assess whether their pay is “fair” with respect to a set of reference points, including employee pay, and request a pay increase when employees receive an unexpected pay raise. According to the hypothesis, if the board does not grant this request, CEOs will lose motivation, which will adversely affect firm value. Alternatively, the efficiency wage hypothesis posits that a pay raise will incentivize employees to be more productive. It follows that CEOs will receive larger pay due to enhanced firm performance.
Conversely, a decrease in CEO pay will be consistent with the idea that the firm treats a worker’s pay raise as an extra unplanned wage expense mandated by the government. This expense reduces firm profits, leaving a smaller “piece of the pie” for the CEO. Finally, no change in CEO pay will be consistent with CEO pay being unrelated to employee pay (e.g., because CEOs and employees operate in different labor markets). However, it is empirically challenging to test these hypotheses and establish the direction of causality because employee and CEO pay are endogenously determined (e.g., affected by common factors).
Natural Experiment: The Fair Minimum Wage Act of 2007
I provide novel evidence on the causal effect of changes in employee pay on CEO pay using an increase in the federal minimum wage (“MW”) in the U.S. as a natural experiment. The analysis exploits the Fair Minimum Wage Act of 2007, which raised the federal MW from $5.15 to $5.85, $6.55, and $7.25 per hour each year from July 2007. Notably, the law triggered a significant overall increase in the federal MW of about 40%, and it is the only federal MW law that took place post the early 2000s. An increase in MW leads to an increase in pay for rank-and-file employees who are paid at or below MW without any effect on CEO pay. Importantly, a federal MW hike does not depend on the performance of a particular firm, which alleviates the endogeneity concern. Thus, the introduction of a MW law signed on May 25, 2007, provides an ideal opportunity to estimate the effect of employee pay on CEO pay.
To identify the link between employee pay and CEO pay, I employ a triple-differences (“DDD”) empirical strategy that exploits the distribution of workers across states. Since an employee has the legal right to receive the larger of state and federal MWs, the law impacts only employees in states where the initial state MW was lower than the federal MW (referred to as “bound states”). Therefore, I compare changes in CEO pay across firms with different proportions of employees working at establishments located in bound states (first difference). The second difference compares CEO pay before and after the MW hike. Importantly, the law only affects firms that rely largely on MW labor, referred to as “affected firms” and defined as those in the leisure and hospitality and retail trade industries (e.g., grocery stores, hotels, and restaurants). Hence, the third difference compares changes in CEO pay across affected versus unaffected firms. To summarize, the DDD strategy estimates changes in CEO pay after the MW hike between firms with different employment shares in bound states and with different exposure to MW labor.
I start by verifying important presumptions for my analysis. I show that the MW law indeed raises employee pay: a 10-percentage point increase in the share of employees in bound states leads to a 42% increase in the average employee wage for affected compared to unaffected firms after the MW law. I also show that employment drops by 44% and that the parallel pre-trends assumption holds, which is crucial for the DDD validity.
How does the minimum wage law affect CEO pay?
Analyzing changes in CEO pay around the MW law effective date, I find that a 10-percentage point increase in the share of employees in bound states leads to a 6.5% increase in CEO total pay for affected compared to unaffected firms after MW law. Both salary and incentive pay increase, consistent with the permanent nature of salary and with CEOs demanding incentive pay raises since they boost CEO reputation. Moreover, the CEO and employee pay increases are more pronounced for smaller firms, consistent with the relative proximity between small firm CEOs and rank-and-file employees in terms of responsibilities in the workplace. It is well-documented that smaller firms adopt less formal human resource management practices and are less hierarchical, so CEOs and employees should play more similar roles in smaller firms.
My results are also robust when using different samples – a matched sample based on observable firm characteristics and a sample of bound/unbound firms headquartered in counties within the borders of contiguous states. These robustness checks alleviate the concerns that firm characteristics or different economic conditions across regions may drive the results.
Having established a robust result that employee pay raises lead to CEO pay raises, I confirm that a price floor for workers can narrow the pay gap between CEOs and employees. I provide evidence that an increase in employment share in bound states leads to a drop in the CEO-employee pay ratio for smaller, affected firms compared to unaffected firms after the MW law. However, to effectively implement the price floor policy through the MW hikes, it is also important to understand the underlying mechanism for the link between employee and CEO pay.
Why does CEO pay increase?
I consider several competing mechanisms for the CEO pay increase I find. The first mechanism is based on the fairness hypothesis, which suggests that younger CEOs should receive a larger increase in pay than older CEOs following the MW shock. This is because younger CEOs should care more about being compensated fairly: They face longer horizons, and for them, current pay affects the present value of future pay more by signaling their ability in the executive labor market, for example, due to career concerns or risk aversion. Consistent with this logic, I find that in smaller firms, younger CEOs experience an about 2.5 times larger increase in total pay after the MW law than older CEOs.
Alternatively, one may argue that younger CEOs are paid more because they have greater bargaining power (e.g., due to better outside options). If so, CEOs of high-rent firms should face larger pay increases after the MW law than those of low-rent firms. In contrast, I find that pay of low-rent firm CEOs increases more than that of high-rent firm CEOs, and for both groups, pay increases are insignificant. This evidence is inconsistent with the mechanism based on the bargaining hypothesis.
Another mechanism that can potentially explain the CEO pay increases driven by employee pay increases is based on the efficiency wage hypothesis. The hypothesis posits that pay hikes should motivate employees to work harder. In turn, improved productivity will lead to stronger firm performance, allowing CEOs to reap larger compensation benefits. However, my results show no evidence of smaller firms having significantly better performance after the MW law, which does not support the predictions of the efficiency wage hypothesis.
Policy implications
Moreover, my analysis has important policy implications. Quantifying the semi-elasticity of the CEO pay with respect to MW is crucial for successfully targeting income inequality since the estimate allows us to evaluate the magnitude of the spillover effect of MW on CEO pay. I show that the CEO pay-MW semi-elasticity is equal to 0.045. The economic magnitude of this effect translates into the 41% hike in federal MW leading to a 1.84% relative increase in pay for a median small firm CEO. In comparison, the corresponding relative increase in pay for a median small firm employee is over seven times larger and is equal to 12.97%.
Conclusion
The pay gap between CEOs and rank-and-file employees has been growing over time, generating interest among academics and providing a basis for media, political, and public debates. It is important to understand the relationship between CEO and employee pay since this link can help policymakers assess the efficacy of mandated worker wage increases to narrow the CEO-employee pay gap. However, empirical research on the topic is limited. In my recent paper, I provide novel evidence on the spillover effects of employee pay on CEO pay, using a hike in U.S. federal MW level as a natural experiment, and attempt to disentangle the underlying mechanism. The results are consistent with the fairness hypothesis of executive compensation: Following an exogenous raise of employee pay, CEOs demand a corresponding fair raise in pay. Moreover, younger CEOs require a larger pay increase since their current pay affects the present value of future pay more. Future research may examine the effects of exogenous CEO pay changes on CEO motivation, in accordance with a positive relationship predicted by the fairness hypothesis.
Ekaterina Potemkina is a PhD candidate in Finance at Cornell University.
This post is adapted from her paper, “Do CEOs Benefit from Employee Pay Raises? Evidence from a Federal Minimum Wage Law,” available on SSRN.
