Knowledge@Wharton - How Pay Inequality Affects the Bottom Line
Most private firms have strict policies about salaries: Workers aren’t allowed to know how much money they make compared to their peers. But that’s an unrealistic and outdated notion, especially with so much information available online. Pay inequality is a persistent problem that is getting more exposure than ever before. In her latest research, Wharton management professor Claudine Gartenberg examines how inequality affects individual workers and entire companies.
Her findings are outlined in three papers: “Pay Inequality and Reductions in Corporate Scope,” co-authored with Wharton management professor Emilie Feldman and Julie Wulf of the National Bureau of Economic Research; “Islands of Equality: Competition and Pay Inequality within and across Firm Boundaries,” co-authored with Wulf, and “Pay Harmony? Social Comparison and Performance Compensation in Multibusiness Firms,” co-authored with Wulf.
She spoke to Knowledge@Wharton about why top-tier managers need to pay more attention to this issue.
An edited transcript of the conversation follows.
Knowledge@Wharton: You have three recent papers that look at the issue of pay inequality. Could you tell us about each one of those?
Claudine Gartenberg: These are a series of joint studies with Julie Wulf, at the National Bureau of Economic Research, and Emilie Feldman, management professor here at Wharton, which focus on this question of pay inequality among workers, primarily within companies but also the implications at a societal level. This question of how much pay inequality to tolerate inside of your company is actually a tricky one for managers. It’s one that every manager faces, and it has big consequences not just for HR but also for the company’s strategic position and ability to compete.
In these papers, we have three big findings. The first is that it appears that your pay co-moves more with your colleagues than it would just be predicted for your job itself. Pay moves in lockstep, goes up, goes down, you get some rare bonuses. We attribute that to people comparing pay inside firms more with their colleagues and their co-workers than with just people who work in other companies.
The second thing we find is that it also appears to tie managers’ hands a bit in terms of how firms can respond to competition. We look at a trade shock — this is a free-trade agreement with Canada — and what you would want to do is pay workers more or differently based off how well they’re able to compete and respond to this trade shock. We find that firms respond in lockstep with employees, so they either all give them raises, or they all respond very similarly and not in line with how productive workers are.
Lastly, we find that pay inequality predicts divestitures. If you have firms with very high levels of inequality, it is predictive that they will shed a business unit that is contributing to that. So, it has major strategic consequences; it is not just an HR issue.
“This question of how much pay inequality to tolerate inside of your company is actually a tricky one for managers.”
Knowledge@Wharton:We like to think that our pay is based on what we do and how well we do it. The first two papers seem to show that it’s also about how much our co-workers are making or what’s going on in the larger context of the world.
Gartenberg: Oh, completely. We are social beings. We evaluate our self-worth by how we stack up relative to each other. It’s just in human nature. We’ve seen that behavior in monkeys as well. Once you join a firm, you evaluate yourself against workers inside those firms. That is an inevitable consequence. The thing that is interesting about it is that there’s really two sides of performance pay.
On the one hand, performance pay is a fantastic thing. It’s why it’s been adopted increasingly over the last three decades. You want to give people bonuses for how well they are doing, you want to reward your top workers, you want to make sure people feel valued. On the other hand, performance pay creates pay differences inside firms, and if people perceive those are unfair or unjust, it can create real problems inside firms. In fact, Uber is dealing with this right now. Uber’s cultural issues have received all of the attention in the news, but arguably among the employees themselves the bigger issue is compensation differences. It’s a very real issue that affects companies across the board.
Knowledge@Wharton: There’s been a lot of talk lately about NAFTA and whether it has been good or bad for American business. A part of it that we haven’t heard much about is that NAFTA did affect salaries.
Gartenberg: This is an interesting question. It’s not one that we can get directly at with the data that we have for our research, because we have compensation data for division managers of top companies — real “one-percenters.” These are not your model American workers.
“If you have firms with very high levels of inequality, it is predictive that they will shed a business unit that is contributing to that.”
The interesting thing that we find that I think ought to inform this debate is that the Canada Free Trade Agreement predated NAFTA by five years, but had a very similar impact. It had a very large impact on American companies. The effect of the Canadian Free Trade Agreement was to raise the one-percenters’ salaries. Even though we don’t have the information to prove this, generally people have found that trade agreements lower unskilled worker salaries across the board. If you put those two facts together, these trade agreements should probably widen the gap between the top one-percenters and the 99%. It really does affect pay inequality in a distributional way that is getting a lot of attention and should get more attention going forward.
Knowledge@Wharton: Looking more closely at the third paper, you find companies are more likely to divest divisions where there is more pay inequality. Is there action that can be taken as a result of knowing that?
Gartenberg: This is a really interesting question about corporate strategy that I think has not gotten enough attention out there, which is that companies want to extend into different types of businesses that might be complementary, or they want to acquire companies. A major factor appears to be compensation policies across those business units and how those affect the workers, how those affect post-merger integration, how those affect worker morale, productivity, etc. I think it is something that managers ought to pay attention to.
To give examples from my own experience when I consulted to the energy industry — there was a period of time when energy companies were trying to heavily get into trading operations, sort of Wall Street energy derivative trading operations. To do that well, you need to pay these guys Wall Street salaries. On the one hand, you’ve got a business unit that is paying Wall Street-level salaries. On the other hand, you’ve got your asset side of your business, which is the people operating the pipes in the facilities and moving the product back and forth, and they’re getting paid hugely different amounts. I saw the amount of tension that provoked. These pay differences and the differences of these workers, the way they were treated between these units, it was very, very hard to manage that. That is definitely something that managers should pay attention to when they’re deciding what businesses to operate in.
Knowledge@Wharton: What your research shows is that pay inequality really impacts everything. But companies often believe salaries are a secret, so it doesn’t impact anybody.
“These pay policies are not an HR policy. It’s really a strategic decision that firms need to make.”
Gartenberg: If there’s one takeaway we want from this research, it’s for people to recognize that these pay policies are not an HR policy. It’s really a strategic decision that firms need to make. As much as firms want to keep their pay under wraps, in today’s day and age, that’s increasingly unrealistic. It was unrealistic 10, 20, 30 years ago as well. And it does have major consequences for what firms can do and how they can compete. That is very important to account for.
Knowledge@Wharton: What will you study next?
Gartenberg: The real holy grail behind this research is looking at societal-level inequalities, which are at unheard levels within the U.S. and also other countries around the world, and putting firms and firm strategy into the center of that research. What are the choices the companies are making today in terms of their HR policies and outsourcing? How are those choices influencing inequality? How is societal inequality affecting what managers can do and what type of compensation they can offer their employees? That is a big question, it’s extremely important, and it’s one that we’re just starting to get our heads around.
This article is reprinted with permission from Knowledge@Wharton.
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