Do stock markets care about income inequality? Proof of compensation ratio disclosure
Stagnant middle-class wages but rapidly rising incomes for high earners have led to a growing debate about income inequality in the United States. and-file employees. Understanding the valuation of income inequality by stock markets is important because stock markets allocate capital and send valuation signals to companies, informing and eventually shaping corporate policies that contribute to or mitigate income inequality. . In this documentwe answer that question by leveraging a new rule that required publicly traded U.S. companies to report the ratio of CEO pay to median worker pay for the first time in 2018.
Experimental and survey evidence suggests that many people are opposed to pronounced income inequality. Aversion to inequality may be self-centered or reflect concerns about future economic growth or the stability of society at large. For some people, high income inequality could violate their view of fairness. allocation of resources. Whether such attitudes matter among financial market participants is an open question, especially since affluent Americans, who are more likely to be equity investors, have been shown to be more tolerant of regard to the inequalities that the rest of the population (Cohn et al. (2019)).
The average pay ratio at the approximately 2,300 U.S. companies that reported their pay ratios for the first time in 2018 is 145, while the median is 65. Specifically, a one standard deviation increase in the compensation ratio decreases a firm’s seven-day cumulative abnormal return by about 42 basis points (bps). The negative market reaction persists for at least several months after the initial release of the earnings ratio. It is also robust in controlling for CEO or worker compensation disclosed at the same time, suggesting that financial markets react to compensation within the firm. disparity regardless of pay levels. The US market reaction to high pay ratios therefore appears to be at odds with previous UK findings that higher pay inequality is primarily a reflection of better managerial talent (Mueller, Ouimet and Simintzi (2017)).
Next, we examine whether the negative market reaction to high compensation ratios represents a cash flow effect due to expected negative reactions from customers, employees, governments, or rather a discount rate effect due to reduced demand. inequality-averse shareholders for high-paying companies. disparities. If the cash flow channel is important, we expect the market response to be stronger for companies whose stakeholders are more averse to inequality. Alternatively, if reduced demand due to shareholder aversion to inequality drives the observed relationship, we would expect to see lower ad returns for firms with shareholders who are more averse to inequality.
Although shareholder or other stakeholder inequality aversion is not directly observable, we assess a firm’s exposure to inequality averse employees, customers, or local governments using political orientation and the redistribution policies of the states in which the company operates. Similarly, we capture the inequality aversion of a firm’s investors using the political orientation and redistribution policies of the home states of a firm’s shareholders. For institutional investors, we also construct an alternative measure of investors’ revealed social preferences as the average MSCI KLD Social Index score of their portfolio equity holdings in 2017.
We find that firms with more inequality-averse shareholders experience a significantly more negative market response to high wage dispersion. This result holds using both location-based and farm-based preference measures. However, firms’ exposure to cash flow risk due to other inequality-averse stakeholders does not appear to play a significant role in explaining the cross-sectional variation in market responses.
Finally, we examine whether, in 2018, the portfolio rebalancing of institutional investors with different degrees of inequality aversion varies with the earnings ratios reported by portfolio companies. Controlling for investor and firm fixed effects, we indeed find that in 2018, institutional investors with higher inequality aversion reduce their allocation to high-reward-ratio stocks more than other institutional investors. Interestingly, it is the revealed social preferences of institutional investors, not their environmental or governance preferences, that explain cross-sectional differences in both initial market reaction and subsequent portfolio rebalancing response to new developments. compensation ratios available.
Taken together, our results suggest that stock markets are concerned about income inequality and negatively value high wage dispersion within firms. Although it is difficult to distinguish between investors’ preferences and their subjective beliefs, our results suggest that investors’ aversion to inequality, rather than concerns about future cash flows, is the primary channel through which wage disparity within companies affects company stock valuations. Finally, our results allow the possibility that investors, through their portfolio decisions and their impact on company valuations, can affect corporate culture and policies. (Heinkel, Kraus and Zechner (2001), Hart and Zingales (2017)). Our results thus suggest an alternative and possibly complementary mechanism to the political process to limit inequalities (Kuziemko et al. (2015), Pasteur and Veronesi (2021)).
The full article is available for download here.