Does executive compensation negatively affect executive ability? Evidence from inside debt

Purpose Using a sample of 1,073 US firms from 2007 to 2020, this study aims to employ two empirical measurements: the executive ability index and its industry-year ranking developed by Demerjian et al. (2012). To address endogeneity concerns, this study uses: two-stage least squares regression with instrumental variables based on state-level income and capital gains tax rates. Propensity score matching: dynamic analysis using next-year executive ability measures; alternative measurements of inside debt. Design/methodology/approach This study investigates the relationship between inside debt held by top five executives and their executive ability. This study examines whether the debt-type compensation component incentivizes or discourages executives from contributing their management abilities to firms. The research aims to bridge two important literature streams – the growing research on inside debt and studies on executive ability – by providing novel evidence on how debt-based compensation influences management skills. Findings This study documents strong empirical evidence that firms with higher inside debt holdings experience significantly lower executive ability scores and rankings. The negative relationship remains robust after addressing endogeneity concerns through various empirical techniques. The findings suggest that inside debt serves as a disincentive for top executives, leading to reduced contribution of their management abilities. This negative association challenges the conventional view that all forms of executive compensation positively correlate with management ability. Originality/value This study makes novel contributions in two ways. First, this study extends the inside debt literature by documenting its previously unexplored negative impact on executive ability, showing that debt-based compensation’s influence goes beyond financial decisions to affect fundamental management capabilities. Second, this study contributes to executive ability research by identifying inside debt as a significant determinant that discourages executives from fully utilizing their management skills. The findings have important policy implications for corporate governance and executive compensation design, suggesting companies should reconsider heavy reliance on inside debt that may inadvertently suppress executive talents.