Public outrage around the world is increasing over the seemingly excessive compensation packages granted to top executives. Some view the ‘Wall Street bonus culture’ as a root cause of the recent global financial crisis. In response, governments in some developed countries have recently imposed stringent limits on what are perceived to be excessive compensation packages granted to executives despite the failure of their firms. ‘Excessive’ top management pay can also affect morale within an organization.

In order to better understand whether widening pay differences between top management and other employees affects a firm’s efficiency, CEIBS Professor of Finance and Accounting Oliver Rui has co-authored a study that examines the impact of compensation policies on the productive efficiency of listed firms in China. The results show a sharp tension between top management interests and other workers’ feelings in an organization. Managers work hard to improve firm performance when they are rewarded for doing so. However, high top management pay without reciprocal increases in pay for other employees leads workers to feel alienated. Their resentment leads to a decline in their efficiency, which in turn reduces their firm’s productivity. This effect is more pronounced in labour intensive firms. This is consistent with other research findings on happiness and relative income that indicate individuals may derive utility not from the absolute level of their own income but rather from their level of income relative to others. Therefore it is important for companies to balance executive pay and relative pay as both are important to corporate performance.

While pay disparities in China have increased in recent years they are still far below those seen in developed countries. For example a study done in 2009 showed that for the average S&P 500 firm in 2003 the CEO earned 300 times what the average production worker earned. This was up from 30 times more in the 1970s.

Prof. Rui and his co-authors, Michael Firth of The Lingman University of Hong Kong and T.Y. Leung of City University of Hong Kong, believe China is a particularly interesting setting for this research because of its transition from a centrally-planned economy to a free market system. Though China’s government has had an ambivalent attitude toward top management pay, the local and central governments have issued a variety of regulations and guidelines that limit managers’ compensation in state-owned firms. However, having adopted a market economy, both private and state-owned Chinese firms have been increasingly forced by competition to adopt incentive pay systems that mirror those in Western countries in which executive remuneration contracts are structured to incentivize managers to create shareholder value by allowing managers a share in those gains.

Though the results of their study are specific to China, Prof. Rui and his co-authors believe they may have resonance in other transitional economies that are going through major economic and ideological changes, for example Vietnam and Myanmar. The results of the study appear in a paper entitled ‘Pay Incentives and Firm Efficiency in a Socialist Capitalist System’.  

Click here for a video of Prof. Rui discussing the findings of his research on pay incentives.