Target Ratcheting, Short-Term Salaries and the Ratchet Effect

Abstract

This paper analyzes the relation between target ratcheting and the ratchet effect. Empirical results are mixed about the extent to which target ratcheting leads to a ratchet effect. My contention is to show that short-term salaries mediate the relation between ratcheting targets and the ratchet effect. Anecdotal evidence indicates that firms differ in the amount of periods for which they keep salaries fixed. Accordingly, I distinguish between long-term and short-term salaries depending on whether salaries consider past performance. Firms have to adjust salaries and/or targets for retention purposes after persistent shocks in the economic environment. The analysis suggests that 1) short-term salaries can dampen, increase or even completely offset ratchet effects induced by ratcheting targets, and 2) the extent of the ratchet effect is independent of asymmetries of target adjustments after positive and negative variances if a firm applies short-term salaries. These insights help to explain the mixed evidence about the ratchet effect and provide new arguments for empirical studies in the field of target ratcheting.