Executive pay dispersion, corporate governance, and firm performance

Much of the research on management compensation focuses on the level and structure of executives' pay. In this study, we examine a compensation element that has not received so far considerable research attention-the dispersion of compensation across managers-and its impact on firm performance. We examine the implications of two theoretical models dealing with pay dispersion-tournament versus equity fairness. Tournament theory stipulates that a large pay dispersion provides strong incentives to highly qualified managers, leading to higher efforts and improved enterprise performance, while arguments for equity fairness suggest that greater pay dispersion increases envy and dysfunctional behavior among team members, adversely affecting performance. Consistent with tournament theory, we find that firm performance, measured by either Tobin's Q or stock performance, is positively associated with the dispersion of management compensation. We also document that the positive association between firm performance and pay dispersion is stronger in firms with high agency costs related to managerial discretion. Furthermore, effective corporate governance, especially high board independence, strengthens the positive association between firm performance and pay dispersion. Our findings thus add to the compensation literature a potentially important dimension: managerial pay dispersion. © 2007 Springer Science+Business Media, LLC.