# Within-firm pay inequality

## What is this research about and why did you do it?

There has been growing interest amongst policymakers and investors in firm pay disparities. One view is that high within-firm pay inequality can hurt employee morale and firm value. Echoing such concerns, publicly traded companies in the U.S. are mandated to disclose the ratio of the median employee pay to that of the CEO. However, these concerns are not necessarily warranted if differences in pay inequality across firms reflect differences in talent. We study whether higher within-firm pay inequality is driven by managerial talent or managerial rent extraction and whether, ultimately, firms with larger pay disparities have lower valuations.

## How did you answer this question?

One big challenge of answering this question is the lack of a detailed measure of within-firm pay disparities that is comparable across firms. For example, the comparison of the pay ratio between a manager and an unskilled worker across two firms might not be meaningful as these occupational titles might be capturing different types of tasks across firms. Instead, we use a proprietary data set of U.K. firms in which employee pay is observed at the firm-job title-year level and where job titles are grouped into nine broad hierarchy levels that are comparable across firms.

## What did you find

We show that differences in managerial talent across firms accounts for differences in pay inequality. Consistent with theoretical work by Terviö (2008) and Gabaix and Landier (2008), we find that firms with greater pay disparities are larger and perform better. We further show that there is a positive relation between pay inequality and equity returns. We form a hedge portfolio that is long in high-inequality firms and short in low-inequality firms. We find that the inequality hedge portfolio yields a positive and significant monthly alpha of 0.93% to 0.98%, suggesting that pay inequality is not fully priced by the market.

*Time-series regression of monthly excess returns.** This table reports alphas (α) from time-series regressions of monthly excess returns. Excess returns are computed by subtracting 3-month UK Treasury bill returns from raw returns. Alphas are associated with a hedge portfolio that is long in high-inequality firms and short in low-inequality firms. A firm is classified as “high inequality” in year t if its pay inequality measure in year t-1 lies in the top tercile across all firms in the sample. Similarly, a firm is classified as “low inequality” in year t if its pay inequality measure in year t-1 lies in the bottom tercile of the sample distribution. Thus, pay inequality is lagged by one year. Portfolios are rebalanced at the beginning of each year. Columns (1) and (3) include the intercept (α) and market factor (RMRF). Columns (2) and (4) include the intercept (α), market factor (RMRF), book-to-market factor (HML), size factor (SMB), and momentum factor (UMD). Columns (1) and (2) show results for value-weighted portfolios, and columns (3) and (4) show results for equal-weighted portfolios. Standard errors are in parentheses. The sample period is from 1/2006 to 9/2014 (105 months). *, **, and *** denotes significance at the 10%, 5%, and 1% level, respectively.*

## What implications does this have for the research on wealth concentration or economic inequality?

A deeper understanding of the drivers of inequality is needed to design effective policies instead of using pay inequality as a metric to criticize firms and to dissuade investors from investing in them. Our results are consistent with the idea that more talented managers match with larger firms and employees are paid according to their marginal product. As such, they suggest that regulations mandating firms to disclose pay ratios that often result in “naming and shaming” firms do not appear well suited.

## What are the next steps in your agenda?

Quantifying the importance of firm growth for aggregate income inequality would be an important next step. In Mueller, Ouimet, and Simintzi (2017), we make strides in that direction by documenting a positive correlation between firm growth and inequality across countries.

## Citation and related resources

This paper can be cited as follows: Mueller, H., Ouimet, P., and Simintzi, E. (2017) "Within-firm pay inequality." *Review of Financial Studies*, 30(10), pp. 3605-3635.

Related literature:

- Gabaix, X., and Landier, A. (2008) "Why has CEO pay increased so much?"
*Quarterly Journal of Economics*, 123(1), pp. 49-100. - Mueller, H., Ouimet, P., and Simintzi, E. (2017) "Wage inequality and firm growth.",
*American Economic Review*, 107(5), pp. 379-383. - Terviö, M. (2008) "The difference that CEOs make: an assignment model approach.",
*American Economic Review,*98(3), pp. 642-668.