Wage Gap and Stock Returns

Abstract

Is the difference in compensation between managers and workers related to the quality of the firm? We propose an asset pricing model with unsophisticated traders and short-sales constraints, in which the optimal wage gap increases with managerial effort. In equilibrium, we show that firms with lower wage gaps should be overpriced. Using a unique data set on German firms' employee compensation, we provide strong support for the model's predictions. We find that a long-short portfolio of stocks with high and low wage gaps, respectively, yields positive and robust risk-adjusted returns. We also show that the overpricing of low wage gap stocks is explained, at least in part, by the presence of inequality-averse investors. Overall, pay inequality within firms has nontrivial implications for stock prices, and seems to reflect fair compensation rather than agency issues.

Keywords: Wage Gap, Stock Returns, Asymmetric Information, Inequality Aversion

JEL Classification: G10, G12, G14, G32