Pay transparency may be good for employees but bad for companies in a downturn

By Stuart Pallister

SMU Office of Research – Pay transparency, in terms of knowing what your peers are earning, may be good for employees but can potentially lead to companies going to the wall. That’s the verdict of Associate Professor of Accounting at Singapore Management University Sterling Huang, who has written a paper called ‘Pay Transparency and Cost Stickiness: Evidence from Pay Transparency Laws’ in conjunction with his co-researchers from the University of Hong Kong, Hong Kong Polytechnic, and Southwestern University of Finance and Economics in China. The paper, which has yet to be published, has already been awarded best management accounting paper at the 2023 American Accounting Association annual meeting.

“Pay transparency is good for employees in the sense that employees will have more bargaining power, given that they know each other’s salaries and they can judge whether they are fairly compensated,” Professor Huang told the Office of Research. “So, this is good for employees, but our paper shows it may not be good for the company because in an economic downturn, when the company needs to adjust costs downwards, it may become much harder for them to do so.”

The researchers had been interested in understanding how labour policies in the US affected corporate performance, which they believe makes this a novel study. They initially conducted a comprehensive literature review and subsequently “found a nice angle to look at – what we call ‘cost stickiness’ in our paper,” Professor Huang said, adding: “that is, to what extent managers adjust labour costs asymmetrically, depending on whether it’s economic boom or downturn.”

“From our own personal experience, when you’re not allowed to talk about each other’s wages and you keep everything in the dark, it helps managers when they want to cut costs. The manager can ‘cherry pick’ to cut the salaries of individual employees and this is very helpful in an economic downturn. But when everything is transparent and you know each other’s salaries, reducing an individual’s compensation or wages is much harder.”

Under US Federal law, employees are prohibited from disclosing their pay and, if they do so, are potentially breaking the law. However, Professor Huang said, “these laws are never enforced. So that’s why some States have chosen to do their own thing and implement pay transparency laws which allow employees to talk about their pay. They’re not really prohibiting employees from discussing compensation. That wasn’t the intention of the law.”

 “What we’re showing here is that there are unintended consequences when laws are implemented,” Professor Huang said. “Their intention was to promote transparency and discussion about wages that would lead to fair compensation eventually. But, because of that, firms may react differently, especially in a downturn. And that leads to unintended consequences, which can lead to cost stickiness, especially in a downturn.”

The researchers deployed a difference-in-differences design for the study. As not all States have implemented pay transparency laws, these could be treated as a control group. “So, we’re comparing those States that have passed the law versus those States that haven’t, to see how their cost structures differ after the State passes the pay transparency law. This allows us to make a causal inference for our study.”

The researchers also examined the economic conditions of neighbouring States in their analysis. “Our assumption is that for firms that lie on the border of the States, their economic conditions might be quite similar within the local region, but the pay transparency policy discontinues at the border. So, to the left of the border firms are subject to pay transparency laws, while to the right of the border other firms aren’t. Comparing these firms allows us to draw a tighter inference.”

The paper concludes by stating that “optimal, merit-based cost-cutting is important to firms’ survival in bad times, and comparatively dispersed and secret wage adjustments facilitate such cost cutting. Our findings thus could indicate that the increase in cost stickiness due to pay transparency distorts the efficiency of pay practices, which in turn can hamper a firm’s survival in difficult times.”

In addition, Professor Huang said, when employees are union members, they have “greater bargaining power and can refuse the wage cut in a downturn.”

That said, some firms may still be able to reduce their labour costs in States with pay transparency, if employees trust their bosses that this will be a temporary measure.

“Communication plays a very big role here. The firm needs to communicate their intention clearly, honestly, and credibly to employees. And employees need to buy into the explanations for a pay cut to work. Some employees might view this as ‘I’m doing this for the firm and I’m willing to take a pay cut right now for the firm to survive.’”

“So, if they buy into that argument, then labour costs won’t be ‘sticky’ after the passage of pay transparency laws, because these intentions can be better communicated to employees.”

But, Professor Huang added, “there are two sides to the coin.”

“On the other hand, if employees view this as an unfair pay cut, this might result in employees resisting a pay cut and make it more difficult for managers to cut costs, especially in those times when it’s needed.”

Back to Research@SMU November 2023 Isssue