Compensation Gaps Among Top Executives: Evidence of Tournament Incentives or Productivity Differentials?

Abstract

We explore the determinants of compensation gaps between a firm’s CEO and its other top executives, and compare the ability of two competing optimal contracting theories, namely tournament theory and productivity theory, to explain the cross sectional variability in these gaps across firms. We find little evidence that firms design their executive compensation policies in a manner consistent with tournament theory. Our strongest evidence against tournament theory is from firms most likely to conduct tournament contests for selecting CEOs, which is prior to CEO turnovers, especially planned retirements, and in industries where firm-specific human capital is high. Empirically, we find that tournament predictions have weak explanatory power in these samples. In contrast, we find robust evidence that compensation is strongly linked to senior executives’ productivity measures, and that productivity differences among executives explain a large part of the cross sectional and time series variability in firm compensation gaps.

Keywords: compensation gap, executive compensation, tournament, productivity, agency theory

JEL Classification: J30, J33, G35