Does a Salary Cap Really Work?
47 Pages Posted: 3 Feb 2010 Last revised: 21 Dec 2010
Date Written: November 16, 2010
Limiting executive compensation through a salary cap has emerged as one of the latest global governance initiatives. We investigate the effectiveness of a form of an executive salary cap system and find that only firms with a high level of effective external monitors set their salary cap significantly sensitive to firm performance (cap-performance sensitivity). The difference between the salary cap and actual pay (the gap) varies by the level of monitoring. Therefore, the existence of an efficient external monitoring system may be critical for a salary cap system to be successful. We also find evidence suggesting that incentive structures created by a salary cap may properly work only in the presence of an effective external monitoring system by improving better pay-performance sensitivity. Since it is almost impossible to determine an optimal level for a salary cap, we conclude that improving firm-level governance may be more important to thwart highly excessive compensation than legalizing the upper limit.
Keywords: Executive compensation, Salary cap, Corporate governance
JEL Classification: G32, G34, G38
Suggested Citation: Suggested Citation