AN EMPIRICAL INVESTIGATION:CAN HUMAN CAPITAL THEORY EXPLAIN CEO COMPENSATION?LEON SCHJOEDTDoctoral StudentUniversity of Colorado at BoulderCollege of Business and Administration andGraduate School of Business AdministrationDepartment of ManagementCampus Box 419Boulder, Colorado 80309-0419E-mail: [email protected] cross-sectional study found that Human Capital Theory explains CEO compensationacross twenty industries, but that Human Capital Theory’s explanatory value varies fromindustry to industry. The study was based on 1996 data from 594 CEOs in twentyindustries that had more than two years tenure as CEO and who were not founders. Firmsize and performance were controlled for in the study. Using Pearson correlations andstepwise regression analysis, it was found that Human Capital Theory effects varied fromindustry to industry. Also, Human Capital Theory did not explain all variance, whichindicates a spurious relationship between human capital and CEO compensation.AN EMPIRICAL INVESTIGATION:CAN HUMAN CAPITAL THEORY EXPLAIN CEO COMPENSATION?INTRODUCTIONMuch research on compensation has focused on performance and compensation forindividuals, especially for Chief Executive Officers (CEO) (Zajac & Westphal, 1995).This is not without reason, because the CEO may be the person that can impact theorganizational performance the most, as an individual (Fama, 1980). The CEOinfluences a variety of organizational aspects which in turn affect the organizational goalsand performance, e.g., choice of accounting methods (Gomez-Mejia & Balkin, 1992).Because the CEO’s potential impact on the organization in a fundamental way, the CEO-function is unique to the organization. This raises the question: Does the uniqueness ofthe CEO-function mean that the CEO is compensated differently than otherorganizational members? If the CEO is compensated as other employees in theorganization, then the CEO-compensation is based on theories such as Human CapitalTheory (Becker, 1975). If on the other hand, the CEO is compensated based on theorganizational performance (e.g., sales and profit), then the CEO-compensation can beexplained by other theoretical concepts: Marginal productivity theory, Managerialism,Agency theory, Structural theory, Tournament theory, or CEOs as figureheads. Theresearch question that this paper will attempt to answer is: Can Human Capital Theoryexplain CEO-compensation?Many different theories have been suggested in explaining executives’ compensation.The classical and neo-classical economic theories have provided the well-knownMarginal Productivity Theory (Gomez-Mejia, Tosi, & Hinkin, 1987), and the governancetheories of Managerialism (Berle & Means, 1932) and its extension Agency Theory(Fama, 1980). The governance theories hold that managers may seek other goals than theowners’ and, therefore, executive compensation should be aligned with the goals of theowners. Structural theory (Simon, 1957) comes from the sociologist tradition and holdsthat CEO-compensation has a direct relationship with the number of organizational levelsbelow the CEO. Executive pay can also be seen as symbolism. In Tournament Theory(Lazear & Rosen, 1981), the CEO is seen as a winner of a lottery and the chance forwinning the lottery is extremely small. The CEO can also be seen as the figurehead ofthe company (Cyret & March, 1963), where the CEO functions as a boundary spanner forthe company that interacts with the company’s stakeholders. Therefore, the CEO iscompensated for behaviors and perceived performance in satisfying the internal andexternal stakeholders (Weick, 1979). The final theory commonly used in investigatingCEO-compensation is Human Capital Theory (Becker, 1975).Human Capital Theory holds that individuals’ earnings can be attributed to their humancapital accumulated through learning over time. The amount of human capital at anygiven point consists of the individual’s total learning at that given point. The threeprimary factors that contribute to learning are formal education, experience, and training(Becker, 1975).Human Capital Theory has been chosen as the theoretical perspective for this paper. Thisis because it is the only theory that focuses on pay level only, and that is not based onassumptions of perfect employment markets, information, etc. as with the marginalproductivity theory. Also, using Human Capital Theory makes it possible to compareCEO compensation across industries based on objective factors, such as educationallevel, age, and tenure with the company and as CEO. By using these objectivemeasurements, it is possible to have an indication of the amount of human capital anindividual CEO has at a given time. Using Human Capital Theory makes it possible tocontrol (Cook & Campbell, 1979) for industry specific factors, e.g., turbulence, whenindividuals’ compensation are compared. Also, Mincer (1975) suggests that it is possibleto calculate a ‘rate of return’ on human capital investments, such as education. Finally,Human Capital Theory has also been used in a multitude of studies on executivecompensation, such as Gerhart & Milkovich (1990) and Cooper, Gimeno-Gascon & Woo(1994).Human Capital Theory (Becker, 1975; Gomez-Mejia & Balkin, 1992) prescribes that theamount of human capital is equalivalent to the value perception a company has of anemployee at any given point in time. This, in turn, means that the human capital isequivalent to what the company is willing to pay for the employee’s services. Since,compensation for CEOs can be measured at two levels (salary and total compensation,the latter includes salary, bonuses, stock gains, and other compensation), two hypothesesare necessary to test whether human capital theory can explain CEO-compensation – oneat each level. Acknowledging that the total compensation for CEOs may be influencedby firm performance, a third hypothesis is needed to separate the human capital effects onCEO-compensation from the firm performance effects.H1: Human capital effects - differences in age, level of education, firm tenure, and tenureas CEO - are related to CEO salary.H2: Human capital effects - differences in age, level of education, firm tenure, and tenureas CEO - as well as firm size and performance are related to CEO total compensation.H3: Firm size and performance effects are related to differences in CEOs’ totalcompensation, but not CEOs’ salary.METHODSDataThe 1996 annual survey of