Wage Gap and Stock Returns

We propose an asset pricing model in which the optimal wage gap between managers and workers increases with managerial skills. In a world with noise traders and short-sales constraints, we show that firms with lower wage gaps should trade at a premium, and therefore yield below-par returns. Using a unique data set of German firms, we provide strong support for the model's predictions. We find that a long-short portfolio of stocks with high and low wage gaps respectively yields positive and robust risk-adjusted returns. The results suggest that pay inequality within firms has important implications for asset prices.