Pay inequality and firm performance: evidence from matched employer-employee data

A large matched employer-employee data set for Sweden is used to test several predictions from tournament theory. For white-collar workers a positive and significant effect of intra-firm wage dispersion on profits and average pay is found, using various measures of wage dispersion. This result is robust for controlling for firm differences in human capital and firm fixed-effects as well as for instrumenting the wage dispersion variable to take into account endogeneity of wage dispersion. Using data on around 10000 managers, a positive and significant association between pay dispersion and profits is also found for executives. Further results include a positive relationship between market demand volatility and wage dispersion, measured as coefficient of variation in managerial pay, and a negative effect of the number of managers (contestants) on managerial pay spread. The first two results are in accordance with predictions from tournament theory, while the last one is not.