Should the CEO Pay Ratio be Regulated?

Abstract

Starting from January 2017, all publicly listed firms in the United States are required to disclose a pay ratio of annual CEO compensation to the median employee compensation (Pay Ratio). Opponents of this legislation have argued that this additional Pay Ratio disclosure would simply add to the costs of compliance without providing any new information to the market over and above the existing CEO Pay Slice variable, known as the ratio of CEO’s pay to top five executives’ compensation. Using hand-collected data, this paper finds that both variables are related to CEO power, but the Pay Ratio variable provides new and additional information over and above the Pay Slice variable. Furthermore, the Pay Ratio variable is more informative about the agency costs excessive CEO power imposes on shareholders. The cost of capital increases significantly as Pay Ratio increases and Pay Ratio dominates and eliminates the explanatory power of Pay Slice. Our empirical finding suggests that to understand the costs imposed on shareholders by excessive CEO power, we also need to pay attention to the Pay Ratio variable.

Keywords: Pay ratio; Pay slice; CEO power; Cost of capital

JEL Classification: G38, G34, K22