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When Does Higher Firm Leverage Lead to Higher Employee Pay?

Timothy E Dore1, Rebecca Zarutskie1

  • 1Federal Reserve Board, USA.

The Review of Corporate Finance Studies
|February 13, 2023
PubMed
Summary

Newly hired employees receive higher wages when firms increase leverage, likely as compensation for financial risk. Tenured workers do not see similar wage increases, indicating employee turnover impacts debt costs and capital structure decisions.

Area of Science:

  • Labor Economics
  • Corporate Finance
  • Organizational Behavior

Background:

  • Firm leverage decisions impact various stakeholders, including employees.
  • Understanding the relationship between financial risk and employee compensation is crucial for optimal capital structure.
  • Existing models often overlook the role of employee turnover in financial decision-making.

Purpose of the Study:

  • To investigate the impact of firm leverage on wages for newly hired and tenured employees.
  • To determine if higher wages for new hires reflect compensation for financial distress risk.
  • To analyze how employee turnover and labor market conditions mediate the leverage-pay relationship.

Main Methods:

  • Empirical analysis of wage data in relation to firm leverage.

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  • Distinguishing between newly hired and tenured employees to assess differential wage effects.
  • Controlling for local labor market conditions to isolate the impact of firm-specific leverage.

    • Main Results:

    • Newly hired workers earn significantly higher wages as firm leverage increases.
    • These wage increases are consistent with compensating differentials for potential earnings losses during financial distress.
    • No significant wage increase is observed for tenured workers with rising firm leverage.
    • Local labor market conditions substantially influence the firm leverage-employee pay nexus.

    Conclusions:

    • Employee turnover is a critical factor in the wage costs of debt and optimal capital structure.
    • Firms should consider expected employee turnover when making capital structure decisions.
    • The findings highlight the nuanced impact of financial policies on different employee groups.