Why do scholars and activists pay such close attention to how executive compensation is structured? Appropriate pay structure has traditionally been seen as a mechanism for reducing agency costs imposed on public firms by managers. But as that view has lost explanatory power in recent years, the intense focus on executive pay structure has become difficult to justify. This Article offers a novel way to understand why we continue to care about how public firm managers are paid. Pay structure may be able to signal information about firm quality to capital markets, thereby increasing the pricing accuracy of those markets. This Article suggests two species of signal that pay structure might be thought to transmit. First, firms may signal firm quality by proxy through governance quality—that is, management‘s attentiveness to shareholder demands, in this case, those regarding pay structure. Whether those demands are arbitrary (or even value-reducing) matters less for the signaling exercise than that firms are obeying them and are therefore more likely to obey other, perhaps more important, shareholder demands going forward. Second, managers may signal firm quality through their public selection of compensation type, thereby betraying optimism or pessimism about future firm performance based on material, nonpublic information. Ultimately, the ability of pay structure to signal firm quality in either fashion faces significant constraints, making our continued attention puzzling from an economic perspective. Nevertheless, while signaling seems unable to independently justify our devotion to perfecting pay structure, it does help explain firms‘ unwillingness to experiment with alternative pay structures. Thus, it suggests that pay structure is an area in which observed outcomes might not be optimal.
November 2014, Vol. 66, No. 6
Lily Kahng, The Taxation of Intellectual Capital