Pay inequality and firm performance

The rising pay inequality between CEO and rank and file employees has attracted considerable attention from the public, activists, regulators, and academic researchers. Using a large sample of 1,581 Indian firms during 2017–2023 period, we find that pay inequality leads to better future performance as measured by the ROA, providing prima facie support for tournaments and talent assignment. However, an analysis of drivers of ROA using extended DuPont decomposition reveals that the source of ROA improvement is better profit margins (PM) and asset utilization (ATO). Further decomposition of ATO reveals that pay inequality leads to a significant decrease in labor productivity consistent with inequity aversion. The decline in productivity is more pronounced in poorly governed firms facing low competition. On the other hand, labor intensity increases significantly and is the sole driver of gains in asset utilization. In other words, at least a portion of the gains observed in ROA can be ascribed to the act of hiring more employees.