CEO INCENTIVE CONTRACTS, MONITORING COSTS, AND CORPORATE PERFORMANCE

The after-tax real wage of the average worker in the United States has fallen 13 percent in the last 20 years, while the average chief execu tive officer has received a pay raise of over 300 percent. This glarin g contrast has sparked a flood of papers analyzing CEO compensation co ntracts. One of the main justifications for the extraordinary pay of t op CEOs is that they receive contracts that link CEO compensation to t he performance of the firm. The empirical literature, however, has fou nd little evidence that CEO contracts provide such incentives. The com pensation of CEOs appears to respond very Little to the performance of their firms. This article addresses three reasons why the previous li terature may have been underestimating the response of compensation to firm performance. First, only firms where monitoring the CEO is costl y should have CEO compensation that is performance-sensitive. Restrict ing the sample to these firms yields a 67 percent increase in the perf ormance sensitivity of compensation contracts. Second, the parameter t hat measures the performance sensitivity of CEO pay is negatively corr elated to performance, causing it to be underestimated in standard reg ressions. Finally, econometricians do not observe exactly what compens ation boards use as performance measures. Correcting this error shows that the elasticity of CEO pay with respect to firm performance is 10 times higher than previously believed.