Incentives

Introduction

Incentives in organizations take many forms. They can include monetary compensation and promotion as well as informal benefits, like influence or access, and social rewards (e.g. accolades, status, titles). They’re meant to improve employee and organizational performance. It is possible to incentivize behavior toward an ethical goal in an unethical manner. Incentives can mutually benefit an organization and its employees, or serve as a means for bosses to manipulate their subordinates. Incentives can also degrade performance when poorly implemented. Some are obvious motivators; others, subtle nudges. Many have unintended consequences. Often, if incentives toward ethical aims aren’t actively managed, a variety of counterproductive incentives can emerge and guide behavior in unpredictable ways. Each organization must choose for itself what is ethical, but deeper thinking and increased awareness can prepare organizations to act purposefully in these areas.

To determine whether incentives are having the intended effect, many outcomes other than short-term financial performance (revenue growth, profitability, etc.) should be considered. For example, incentives toward an ethical outcome, like reducing unproductive workplace conflict, may be expected to improve (or at least not detract from) organizational performance on other fronts, such as DEI (Diversity, Equity, Inclusion), environmental sustainability, responsible risk-taking, perceptions of justice and fairness, and employee voice (speaking up). In other words, in crafting incentives, it is important to consider longer-term effects on other valued outcomes, which might include relationships with stakeholders. These can include but are not limited to: employees, customers, supply chain partners, executives, stewards, investors, communities, or people affected by the activities of business or other organizations.

Applying ethical incentives effectively depends on paying attention to the psychology of individuals as well as to small- and large-scale collective behavior. There are complex interactions between incentives, situations, and individuals that make decisions difficult. This research page explores the evidence for theories and practices relevant to ethical incentives.

Theories related to ethical incentives

Here are some of the most commonly cited or most helpful theories on how incentives change behavior, and how those incentives are viewed.

Achievement Goal Theory: People engage in four different types of goals, from the combination of two dimensions. The first dimension consists of learning/mastery or performance goals. The second dimension, valence, is why the goal appeals to the individual—either to approach (move toward) an achievement or to avoid (move away from) failure. For example one may have a sales goal to avoid criticism at work (performance and avoidance) or a goal to master spreadsheets so that they can gain an employable skill (learning and achievement). Pursuing these goals involves different motivations. And, as incentives, these goals can vary in effectiveness. To some extent, engaging in learning goals indicates the belief that capabilities are malleable, while performance goals can function even if capabilities are fixed. (Dweck & Leggett, 1988; Elliot et al., 2011; Noordzij et al., 2021)

Agency Theory: Emphasizes the importance of any relationship where an organization (the principal) relies on the actions of an individual (the agent) to carry out organizational aims in their best interest. However, each agent has interests that may conflict with those of the organization (known as goal incongruence) and knowing and seeing what each agent is doing is impractical. Agents usually know more about their own role than superiors, so the relationship between agent and organization involves trust as well as risk (Eisenhardt, 1989)

Equity Theory: Motivated by a desire for fairness, individuals expect pay commensurate with their work inputs, in line with what other coworkers receive. As a result individuals seek information to know if they are receiving equitable outputs from the job in exchange for their inputs (Adams & Freedman, 1976; Beatty, 2021).

Goal Setting Theory: Setting goals influences the direction and intensity of motivation, consistent with the difficulty and importance of the goal. Originally focused on conscious performance goals, the theory now encompasses subconscious processes, learning goals, and other facets of motivation (Locke & Latham, 2019)

Moral Utility Theory: People attempt to maximize subjective expected utility when making decisions, often automatically or out of habit. The likelihood of moral transgressions depends on the benefits compared to expected costs (Hirsh et al., 2018).

Organizational Justice Theory: People view fairness as a result of both the reality of the design and implementation of systems and perceptions of them, which results in various attitudinal, emotional, and behavioral outcomes. Typically divided into distributive, procedural, and interactional justice, it may be more accurate to say there are multiple organizational-justice theories (Rawls, 1971; Husted & Folger, 2004; Gilliland, 2018).

Prospect Theory: When making risky decisions, people tend to undervalue certain outcomes (e.g. probably but not certain), discard other outcomes (those that exist for all choices), and respond differently to potential gains versus losses, all of which are contradictory to what would be expected based on utility maximization (Kahneman & Tversky, 2012).

Role Congruity Theory: People judge the competencies and appropriate behavior of others (and themselves)partly based on the groups (e.g. race, gender, class) to which the person belongs, and on the common or stereotypical social roles of those groups. This is most frequently applied to explain why females struggle to be seen as leaders or to be rated as highly as males in business contexts, because stereotypical female behavior is more nurturing and supportive than the competitive and aggressive behaviors thought to embody leadership (Eagly & Diekman, 2005; Eagly & Karau, 2002; Wang et al., 2019).

Self-determination Theory: Focuses on the difference between being autonomous and being controlled. It is adapted to tackle issues such as “the effects of social environments on intrinsic motivation; the development of autonomous extrinsic motivation and self-regulation through internalization and integration; individual differences in general motivational orientations; the functioning of fundamental universal psychological needs that are essential for growth, integrity, and wellness; and the effects of different goal contents on well-being and performance” (Deci & Ryan, 2012).

Signaling Theory: When two parties, such as an organization and an individual, have access to different information (asymmetry), they can choose what to share and must operate on the information the other party chooses to share (the signal). Feedback from the receiver of a signal, costs of signaling, and multiple signalers, can complicate the theory and situations where it is applied (Connelly et al., 2011).

Social Exchange Theory: Views social interactions in terms of transactional risks and rewards, where the balance of what one gives and gets determines their future participation in person-to-person relationships. Relationships with others are also informed by the expectations created through previous interactions with other people. Ultimately social exchange theory posits that people ask “what’s in it for me” and engage in a process of predicting if they will receive adequate benefits in exchange for the effort the relationship will require (Cook et al., 2013; Tulane University, 2021).

Social Identity Theory: A major component of one’s identity is created through identification with groups, both formal (demographics, career, education) and informal (activism, preferences, lifestyle). People are motivated to feel they belong to positive groups and to avoid belonging to negative groups. Emotions and behavior can be partly determined by group membership. When someone identifies with one side of an issue, they can react negatively to someone from a group on the opposing side (Scheepers & Ellemers, 2019; Tajfel, 1979)

Virtue Theory (in organizations): An organization demonstrates moral excellence through structure, decisions, and policies that benefit the common good, stakeholders, and employees. A virtuous organization could be thought of as having good character, like a person with positive traits. Determining what is virtuous is a multifaceted and multi-level organizational concern (Gotsis & Grimani, 2015; Neubert & Dyck, 2016).

Incentivizing Ethical Behavior

On the whole, people believe organizations can and should incentivize ethical behaviors. The Ethics Center of Australia reported that both monetary and recognition-based rewards are effective (Smith, 2019), and that organizations and their employees should align to forgo short-term rewards (e.g. earning more on a single customer interaction) in favor of longer term rewards (e.g. customer loyalty and reviews). In their synthesis of available literature, Park and colleagues concluded that there are three primary processes through which incentives influence ethical behavior: cost–benefit, motivated reasoning, and prosocial motivation. (Park et al., 2022)

There are several objections to incentivizing ethical behaviors (Murphy, 2011). One is that these incentives are simply paying people separately for what should already be a part of their job. Another is that ethical behaviors are too subjective or too difficult to detect and assess. Others object because there are legal implications, such as liability once unethical practices are known about. There’s also pushback against the attempt to determine what is ethical and requiring individuals to adapt accordingly.

What employees view as ethical incentives likely depends on company culture. In a study where participants were asked to award bonuses to employees based on how they conducted themselves, the participants chose employees who conformed to company norms regarding justice and fairness (Oberman et al., 2021). Larger value systems also seemed to make a difference, as Christian-based firms included in the research allocated bonuses differently than others.

Incentives go beyond pay, bonuses, praise, and notoriety. The very structure of an organization can influence the likelihood of ethical behaviors (James, 2000). The reward systems we think of as incentives can be thought of as one of five major organizational aspects: attraction–selection–attrition, socialization, decision-making, and organizational learning (Verbos et al., 2007). If, for example, individuals are selected for ethical values, one source of incentive/reward for being ethical later on will be internal as they are motivated to confirm their self-identity.

Incentives and compensation assume a certain amount of agency on the part of the recipient, yet the very ideas of “responsibility” and “agency” may be more complex than they are typically conceived, determined in part by entanglements with people and organizations (Painter-Morland, 2011). A more relational view of responsibility would target systems and social factors for change and control as opposed to individuals.

Framing may also matter for successfully incentivizing ethical behaviors. Behaviors like misrepresentation, or strategic deception, are viewed as more appropriate in a business than ethical frame (Rees et al., 2021). In addition there are cognitive processes accompanying decision-making: cost–benefit analyses, concern for others, and psychological distance from outcomes (or construal level). These can specifically be influenced to shape ethical behavior.

For example, a business frame is associated with more cost-benefit analysis, so effective incentives for ethical behavior may need to work outside of the business frame, or specify that ethical behaviors with poor cost-benefit ratio can still be rewarded as strictly ethical. Ending gender-pay gaps, or other unjustified pay gaps, might not benefit the organization enough for benefits to exceed costs (calculating the benefits might be difficult or impossible.) But in an ethical frame, it’s the correct behavior.

Incentivizing Whistleblowers

Some organizations believe that rewarding whistleblowing will help monitor internal ethics, while providing an outlet valve that keeps complaints internal. Both routine reporting of wrongdoing and exposing unexpected violations can be increased by rewarding these behaviors (Murphy, 2011).

Conversely there are concerns that this undermines trust with employees, or that the fear of policing each other leads to worse relationships between coworkers. Reduced information sharing could be extremely damaging, for example, if whistleblowing places a chill on free communication in the workplace.

Financial incentives may be effective in increasing whistleblowing related to less serious offenses, while for serious offenses the severity of the offense alone may be adequate to motivate blowing the whistle (Andon et al., 2021).

Unintended Consequences of Incentives

When even the most basic business motivators like goal setting have a potential harmful component (Bazerman, 2020), it’s safe to say that incentivizing desired outcomes is complex and difficult to do ethically. Goal setting is an excellent example of something that comes with non-obvious unintended consequences: hyperfocus on goals can crowd out other concerns, encourage unethical behavior aimed at meeting the goals, reduce intrinsic motivation, and introduce many other harmful consequences. However, these are manageable with appropriate awareness and thoughtful consideration of the complex interplay between incentives, psychology, and behavior.

Often incentives are used in ways that are on their face ethically acceptable, such as to increase performance. However, this may sometimes have a negative unintended consequence. For example, a laboratory experiment demonstrated that students performed better with piecemeal incentives plus framing the failure to earn those incentives as a loss (Nagel et al, 2020). However, in this condition where performance was best, cheating was also high. This is consistent with prospect theory (Kahneman & Tversky, 1979), and the idea that people will take more risks (e.g. cheating) to avoid losses than to earn rewards because losing something already owned or earned feels worse than failing to receive additional rewards.

When an organization’s stated values do not align with reward systems, the result is ethical ambivalence (Jansen and Von Glinow, 1985). This can undermine the effects of ethical culture and leadership, because the mixed messages leave the employee unsure which influence to follow, which confuses or disengages them with respect to ethics.

The use of extrinsic rewards in general tend to have unintended consequences, primarily reducing intrinsic motivation. As organizations try to motivate their employees with the company’s purpose and values, extrinsic rewards for specific behaviors may erode the intrinsic forms of motivation tied to the company’s purpose and values (Coccia, 2019). A crowding out effect (self-determination theory; Deci & Ryan, 1985) is often cited as the reason for this, where the motivation for doing something is replaced by another motivation. Intrinsic motivators such as doing a good job, or being ethical, may be less prominent after time spent doing the same behaviors because it pays. Research shows, for example, that professional musicians feel that rehearsal is more like work, while amateurs view it more as leisure (Juniu et al., 2017).

Research on green-supplier championing suggests that incentives toward this goal are likely to be ineffective, even counterproductive, when the organization relies on obedience instead of ethical leadership and is largely unaware of what it takes to comply (Blome et el., 2017). Incentives should be put in place only when the organization is able to detect compliance and has ethical leadership in place, or else the incentives may increase greenwashing.

Companies can incentivize the wrong behaviors by mistake. In the famous example where Volkswagen published false information about vehicle emissions, one contributing factor was probably the presence of performance incentives throughout the organization (Regele, 2019). Inadvertently this incentivized short-termism, and the motivation to obtain performance goals may have overshadowed competing expectations that the employees act ethically and honestly. The company promoted transparency and billed itself as a place where it was acceptable to admit to mistakes; however it appears that, at least for one segment of the company, the motivations to appear eco-friendly and meet performance goals may have been stronger. The competing values framework can account for this outcome (Quinn & Cameron, 2011).

Finally, a common unintended consequence of making an outcome a target is that it can become corrupted by the very process that places scrutiny and importance on it. Campbell’s (or sometimes Goodhart’s) law is a common name for this, and it can apply to research or rewards related to a particular outcome (Rodamar, 2018). If targets are highly manipulable or susceptible to fraud/fakery, then putting a spotlight on them will incentivize circumvention of the honest or assumed path through which the target would typically be achieved. This can result in indiscriminate business decisions or actions with hyperfocus on targets, such as choosing an inferior but “green” supplier or promoting or hiring candidates solely or excessively on demographics, as examples.

Goal Setting

Goals can be inherently incentivizing or tethered to financial incentives. Either way, they’ve been a standard of motivating employees for a very long time, though perhaps there is also a problem of relying on goals too much (Ordóñez et al., 2009). Goals can be very effective (Locke & Latham, 1990, 2013), but like financial incentives in general, are an extrinsic motivator. The effectiveness of goals also depends on how well the goals are constructed and the extent to which they fit to the situation and individual.

The most widely known framework for effective goals is “SMART.” These goals are specific, measurable, assignable, realistic, and time-based; however, the acronym varies depending on source (Rubin, 2002; Sull & Sull, 2018). More specifically, difficult goals lead to greater performance in general, but with increased risks to employee well-being and ethical behavior (Barsky, 2008). Easier goals can lead to job satisfaction or a sense of accomplishment, and are less risky, but can amount to nothing more than “do your best,” which isn’t effective in improving performance (Locke & Latham, 1990; Nagel et al., 2021). Good goals avoid unethical pressure on the employee (or team) responsible for the goal. Remaining focused on the ethical implications, smart goals are likely to be ethical because what is expected, what is realistic, and the time required, can be agreed on in advance. As a quick reference, smart goals can be helpful, but more rigorous examination of existing literature is needed to truly implement goals ethically as part of an incentive strategy.

Learning goals may be more effective and ethical than performance goals because they are less stressful and more achievable (Seijts et al., 2012; Cianci et al., 2010). Goals that are aimed at or framed as mastery of a subject or role may also be superior to more typical performance goals (Noordzij et al., 2021). Mastery and learning goals are measured by improvement in the knowledge or proficiency of the employee (and sometimes by social comparisons), giving both employee and employer benefits even in the absence of a specific performance outcome.

When goals (or another motivator) creates too much pressure, this can motivate unethical behaviors justified in pro-organizational rationalizations (Chen & Chen, 2020; Umphress et al., 2010). Goals and their specificity can particularly drive this problem as the exact desired outcome, often all or nothing, is known, rather than general expectations which one may view as flexible if the alternative is to behave unethically. A strong ethical culture can combat this (Welsh et al., 2020) by making known values and expectations, and can be seen as a prerequisite for ethically setting difficult goals. While goal difficulty generally is positively related to pro-organizational unethical behavior, at the highest levels of difficulty this is no longer true. Perhaps this is because the goal seems unreachable, or because it leads an employee to view the organization setting such a goal more negatively, and so they become unwilling to act unethically on behalf of the organization (Fukushima, 2021).

The excess pressures of goals may set leaders up to behave destructively (Bardes & Piccolo, 2010; Mawritz et al., 2014). Goal-directed leadership consumes the emotional/cognitive resources of supervisors as they try to meet expectations (Rice & Reed, 2021), again leading to negative outcomes when goals are too difficult or unrealistic.

Goals with increasing difficulty may be viewed as unfair or lead to lower commitment (Stalnaker, 2018). This can be good to know in contexts where growth is a norm and “ratcheting up” performance is what’s expected . High performance goals, while they appear to reach intended aims, may change the way employees perceive questionable conduct, eroding their moral engagement, potentially harming both employees and the organization (Welsh et al., 2020). Goals may also have cyclical effects, where good performance leads to reduced effort, reduced effort leads to lower performance, lower performance leads to greater effort, and greater effort leads to good performance, and so on (Deschamps & Mattijs, 2017).

Feedback on goals can also ethically matter. It tells employees where they stand, what to do next, and what to expect (Latham, 2004). Simply providing progress feedback does not make goal-setting ethical; an ethical culture supports employees with their goals and avoids punitive outcomes when they fall short. Feedback can be a good companion to compensation to support employee success (Christ et al., 2016; Lill & Muncy, 2020), by focusing monetary rewards on one aspect of multidimensional goals and providing early feedback when pay incentives for the goal are also present. Feedback can increase or reduce effort, depending on how difficult the goal is and if the feedback is motivating or not, or unhelpfully stressful (Chen et al., 2013). When a goal is not reached there can be negative consequences, and this should inform whether it was wise to set the goal in the first place. Specifically, failing to achieve a goal can lead to lower self-esteem, decreased motivation, and more negative affect/emotions (Höpfner & Keith, 2021).

Goals applied uniformly across individuals may be unethical in certain circumstances. For example, people may have different abilities and access to resources that could help attain goals (Latham, 2016). For those without enough ability or resources, reaching a goal may be unreasonable or stressful. Goals that are the same for everyone may also not take into account the individual goal commitment and conscientiousness of those it affects, leading to a subset of these people resorting to unethical behavior (Barsky, 2008). cConscientiousness and feedback can jointly influence performance. Research shows that negative feedback induces the most performance-hindering stress among the most conscientious people (Cianci et al., 2010).

For these reasons, expertise in goal setting at the individual and organizational level could contribute to the long-run success of organizations.
Organizations can have goals that stakeholders value (Neubert & Dyck, 2016). These broader goals could include employee well-being, environmental sustainability, company reputation, community impact, etc. Goals might be considered met if the organization and its stakeholders are well served, with less attention paid to individual achievement of specific goals. More research is needed on the value of this approach.

CEO Compensation

There is little agreement among investors, or people in general, on what fair CEO pay actually is (Arnold & Grasser, 2018). Whether someone is outraged about the high earnings of CEOs depends on several factors, including the extent to which they see themselves as potential CEO material. For many people, the level of pay CEOs currently receive is already above their outrage threshold, but most are also unaware of what CEOs actually earn. High CEO pay ratios may lead to dissent from shareholders, but only at the most extreme where pay ratios are in the top 10% (Crawford et al., 2021).

The way CEO pay decisions are typically envisioned may not match the reality of how they are determined (Edmans et al., 2021). Directors and investors may disagree what matters most, with investors focusing more on avoiding controversies with external entities, while directors are more attentive to the difficulties of attracting and retaining CEO talent. Both acknowledge that CEOs expect “fair” pay that is competitive with respect to colleagues at companies in similar industries and of comparable size, and may be less motivated or more likely to leave if this expectation is not met. The fear of controversy creates a pressure to pay CEOs within a narrow band that is neither so high or low as to garner criticism, and with a one-size-fits all approach that signals fairness. While excess CEO pay can be problematic, losing a talented and ethical CEO could be the more problematic outcome for the company and investors alike. Industry-wide action may be necessary to resolve this conundrum, and investors may be positioned to apply the pressure to make this change a reality.

The relationship between CEO pay and performance seems to be inconsistent and difficult to explain (Aguinis, Gomez-Mejia, et al., 2018; Aguinis, Martin, et al., 2018; Al-Shammari, 2021; Tosi et al., 2000), and performance gains may be offset by shareholder disapproval (Zoghlami, 2021). These findings are inconsistent with the claim that expensive CEOs are necessary to maintain success. There may be problematic factors influencing CEO pay, such as their physical attractiveness (e.g. Li et al., 2021) or social-psychological mechanisms (e.g. Schwering et al., 2021).

Some argue that CEO pay is not driven by unfettered greed, but rather by the increasing difficulty of the position in a period of stronger governance (Cowen, 2019), noting that salaries have risen faster, not slower, concurrent with increased governance since the 1970s. A role not only spearheading a business, but also managing social and environmental issues, meeting increasingly stringent compliance demands, always under a microscope, the job may be both more challenging for one person to perform in and less desirable. The company may also feel increased pressure to secure the best performers at higher costs to manage these risks.

Further, there is evidence that CEO pay has risen due to a combination of advancing technology, communication, increasing idiosyncratic volatility, and winner-takes-all markets (Skott & Guy, 2013). These changes, combined with the principal-agent problem central to hiring a CEO, may have motivated companies to become increasingly convinced that expenditure on the CEO is justified. CEOs make countless consequential decisions at a fast pace, and with high levels of information asymmetry, all in farther-reaching ways than ever possible before. This would mean that the problem is an institutional one, but better understood in the technological and regulatory context that may have driven skyrocketing pay.

Sometimes the impact of chance events is also overlooked in the eventual success of a company, which is not something a CEO can influence and yet may account for an increase in their performance-based pay (Mochari, 2022; Skott & Guy, 2013). Factors such as being in the right industry at the right time may lead to skyrocketing performance despite average leadership, while top-notch leadership may be required in a weaker industry, while only maintaining current corporate performance.

Incentives and CEO behavior

The amount and type of pay CEOs receive can affect important decisions, particularly around the willingness (or not) to engage in risky transactions and/or strategies. It’s an ethical question for several reasons, including the amount of pay CEOs receive compared to their employees, and because CEO behavior is influenced by compensation. For example, the proportion of pay in cash versus equity-based instruments and the design of equity-based pay (including stock and leveraged/restricted stock options, equity bonus, cliff vesting, performance criteria, etc), are all important considerations when predicting risk-taking CEO behavior, (Devers et al., 2008).

There may be unintended consequences of ethical CEO pay management. For example, greater investment in equity-based pay could lead to underfunding of pensions when the CEO’s current stock options are high in value (Martin et al., 2020), or incentivizing of other behaviors that run counter to the ethical intentions of the plan.

Gender

Female CEOs may be paid less, in part because leadership and risk-taking are less consistent with female than male gender norms (Wang et al., 2019). Taking more risks may improve perceptions of a female CEO in male-dominated industries but backfire in female-dominated industries. And of course, taking risks just for the sake of being seen doing so is not a good justification for those actions.

Having more female directors on a board is correlated with lower CEO incentive compensation (bonuses and equity-based pay). Incentive compensation is one channel through which CEO compensation has continued to balloon, and being paid this way often leads to additional earnings management (e.g. inflating earnings) in order to meet the goals necessary to receive the incentive compensation. Female board membership moderates the positive relationship between earnings management and CEO incentive compensation (Harakeh et al., 2019). Other research suggests there is no relationship between the gender makeup of boards and excessive CEO compensation. However, having one or more females on the compensation committee is associated with less excessive CEO compensation (Bugeja et al., 2016).

While there is some evidence that female CEOs may participate in less earnings management, this may only be true where equity-based compensation is low, and when it is high the gender difference does not exist (Harris et al., 2019).

Social Responsibility

Investment firms and boards of directors have seen some success incentivizing business leaders by tying CEO pay to ESG metrics. A majority of S&P 500 companies are doing this to some extent. (Newbury & Delves, 2020). However, many are also questioning if tying CEO pay to ESG metrics is a good idea (Edmans, 2021). In the U.S., 51% companies use ESG metrics to some extent as part of their incentives. Salesforce is one example, where executive pay is tied to various diversity goals for employees and leadership in particular (Segal, 2022). Salesforce also has emissions-related goals for itself and its suppliers, clearly staking out their values and intentions. This creates incentives for creative travel (or travel avoidance) solutions internally, while also incentivizing companies that want to supply Salesforce to make specific changes.

So why is there skepticism around ESG-based incentives? Obviously compliance toward ESG goals is a near certainty when tied to powerful incentives, but there is also evidence of greenwashing or simply rewarding executives for what was inevitable (Clouse, 2022). For example, if a company was already going to replace air travel with video conferences, and increase their use of electric vehicles, then executive incentives for smaller carbon footprint are actually just extra pay for no real change. ESG targets may also not reflect the actual responsibility of the company. A company like Marathon might pollute air and water, or violate human rights, but publicly tout their reduced emissions of carbon, a quintessential example of greenwashing. Businesses may even be motivated to participate in highly public metrics that will look good, to offset or distract from harmful behaviors.

More socially responsible companies tend to compensate CEOs less, consistent with the idea that at some level their pay is excessive (Rekker et al., 2014). The relationship between social responsibility and pay is more positive (or less negative) for female than male CEOs, perhaps because the companies with higher ratings of social responsibility are acting to avoid or correct gender discrimination.

A frequent suggestion is that CEO pay should be linked to Corporate Social Responsibility metrics—the CEO gets paid based on meeting responsible business goals. However, CEOs may simply switch their efforts from tactics like earnings management to CSR metric improvement, in order to increase their pay (Li & Thibodeau, 2019). This can even serve the interests of CEOs by reducing criticism about excess compensation, relating their pay to more acceptable business activity. The difference in pay between CEO and workers actually appears to be larger for more sustainable businesses, indicating that these companies do not impose limits on CEO pay as part of their sustainability approach (Gómez-Bezares et al., 2019). Gómez-Bezares and colleagues recommended that CEO pay gap or ratio be included as part of sustainability rankings, and noted that companies led by female CEOs tended to have smaller pay gaps between CEO and employees.

CEOs may view social responsibility as a way to align with their stakeholders, mitigate problems inside the company, and ultimately increase firm value (Karim et al., 2018). CEOs that do are more likely to have a lower pay ratio and higher equity-based compensation. This incentivizes stability and growth, increasing the profits or value of which they receive a portion, some of which is delayed.

Compensation structures for CEOs can also shape behavior, such as deviating from institutional norms in the context of foreign market entry (Benischke et al., 2020). For example, those with greater equity risk bearing may favor higher legitimacy risk and lower business risk than the norm. Therefore the CEO compensation structure (in concert with institutional norms and host-country regulations) may influence risk taking and long-term firm value.

In China, where institutional (versus state) ownership is related to higher CEO pay, this difference is smaller for gender-diverse boards (Ullah et al., 2020). A more gender-diverse board may be a private-sector protection against excess CEO pay.

Experimental evidence suggests that disclosure of pay ratios (versus pay amount) may lead to more negative perceptions of high CEO pay (Kelly & Seow, 2016).

Socially responsible companies may have a form of protection or insurance against firm risk, in particular against CEO incentives that might lead to hyperfocus on serving shareholders without a commitment to consider a wider range of stakeholders (Chakraborty et al., 2019).

Broad-based employee equity compensation

Compensating rank-and-file employees, or managers, with stock options or purchase plans has a different impact than salary or hourly pay. Generally stock compensation has well-documented benefits, but not without some risks related to employee-stock price financial entanglement.

There is extensive evidence for the benefits of employee stock-based compensation, as well as potential drawbacks.

For instance, the amount of stock given to employees as compensation may be positively linked to fraudulent activity (Call et al. 2015), though not to the exclusion of other explanations (Sloan, 2016). Researchers found that during periods of misconduct, companies give more stock as compensation. And, among those companies participating in fraudulent activities, those giving more stock were less likely to have a whistleblower. Whether hush money or skin in the game, it could be that stock disincentivizes reporting the problems (despite potential compensation from Dodd Frank laws). However it could also be other decisions or conditions that means these behaviors occur together frequently, but aren’t caused by one another.

Earnings management (problematic but not necessarily illegal) is also positively associated with rank and file equity compensation. The association is stronger when the compensation enhances performance incentives, and weaker with closer monitoring (Holderness Jr. et al., 2019). Because earnings management in a context where ordinary employees hold stock enriches the lower ranks, the belief that earnings management is ethically justified is sometimes referred to as an example of the “Robin Hood” effect.

Holding stock options may also lead to less proactive, and only reactive, responses to scandals and potentially scandalous activity (Jimenez-Andrade & Fogarty, 2019). This may be because the incentive is to avoid admitting there is a problem, because doing so may cost the individual via stock price. But, once there is a scandal, the same financial incentive encourages a strong response to restore reputation and value.

Finally, while mostly an individual concern, employee stock plans may put employee long-term financial interests at risk through over-investment (inadequate diversification) in their employer. This may be of particular interest where employees who receive stock are not particularly financially savvy. Organizations in such a scenario may want to consider providing resources or access to advisors to ensure that employees are making an informed decision.

Incentivizing Health Behaviors

Incentivizing health behaviors, and the extent to which it is appropriate for businesses, raises immediate ethical concerns. Jobs partly responsible for busy schedules and sedentary behavior may have an obligation to encourage healthy behaviors to offset the damage of workplace stress and working conditions. Conversely, such efforts are an intrusion into people’s personal lives, and may be viewed as judgmental based on physical fitness, ability, or weight.

To reach optimal ROI when incentivizing health behavior change, employers may need to spend three times as much on average as they currently do (from $143 to $367 per employee per year; Basu & Kiernan, 2016). Optimizing employee health rather than ROI may be a more ethical approach, however ROI can include health insurance costs which reflect employee health, in addition to work-centered metrics like absenteeism.

Poorly designed incentives for health behaviors can do harm, and this harm may also disproportionately affect already at-risk minority groups (Sherman et al., 2021; Robert Wood Johnson Foundation, 2020). Flawed incentives can lead to gaming the system, or unhealthy behaviors such as over-exercising, starvation, etc. Those less able to reach reward-driven goals due to existing inequities may be at a disadvantage, and so on. So well-designed goals such as participation or progress, rather than specific outcomes, may better promote health.

Financial incentives don’t necessarily shape health behaviors uniformly. Older adults, for example, are more skeptical of these incentives (Tambor et al., 2016). They tend to view the rewards as bribery. They think it rewards unhealthy/irresponsible people at the expense of healthy/responsible people, and threatens autonomy and intrinsic motivation. They think the advice is inappropriate not coming from one’s physician, and view the effort to shape health behavior as potentially a waste of limited resources. Being aware of these beliefs may help in constructing programs that older people see as credible and inclusive. Some ways to do this may be guaranteed rewards (versus a lottery), customized incentives for individuals, and providing evidence for the effectiveness of these incentives.

Ethical incentives for health behavior must not have longer-term harm that outweighs short-term benefits, but unfortunately this can be the end result (Marteau, 2009; Mantzari, 2015).

A systematic review of the acceptability of financial incentives for health behaviors identified five dimensions: fairness, messaging, character, liberty, and tradeoffs (Hoskins et al., 2019). Regarding incentivization of health behaviors, “the importance of both behaviorally and ethically-informed design that incorporates stakeholder perspectives cannot be minimized.” Whether employees are able to accept an incentives program shapes their impressions of it, as well as the degree to which they participate in it based on those impressions.

Incentives and Innovation

There is a long-held belief that innovators may need to push ethical boundaries, or even blatantly cross ethical lines, to succeed and break new ground (Vincent & Kouchaki, 2015; Gino & Wiltermuth, 2014; Gino & Ariely, 2012; Montiel Méndez et al., 2020) [Important context: Gino has several publications retracted or under review]. Entrepreneurs are both praised and reprimanded for not staying within the usual lines of thought and behavior, but also may be crafty enough to circumvent rules and conceited enough to believe they’re above those rules.

Simply defining ethics by rules is overly simplistic, as rule-breaking is highly connected to innovation (Brenkert, 2009). Brenkert argued that immoral actions may lead to ethical outcomes due to the value that disruptive and destructive entrepreneurship brings.

The logic of how immoral acts are excused and rationalized has been thoroughly studied. Brenkert (2009) gives three examples: 1) immoral acts that lead to successful outcomes may be forgiven, as indicated by the common colloquialisms promoting begging for forgiveness rather than asking for permission. 2) an immoral act may change the moral and ethical landscape such that what was previously considered a wrong act becomes an acceptable act (Pygmalian effects). 3) immoral acts may be tolerated due to viewing the role of a trickster, one who can outsmart the system, as a valid or even enviable persona.

It’s possible to think of creativity (and innovation) as a collective virtue, like honesty (Astola et al., 2021)—a potential obligation mostly within the capability of everyone. The long-lasting and consistent successes at Pixar are given by Astola and colleagues as an example of a culture embracing this approach. They credit not a system of motivating incentives, but instead hiring for and nurturing intrinsic motivation, stemming from a genuine interest in animation and films. Kieran (2018) further suggests that curiosity and a desire for knowledge are motivations underlying creativity, so incentivizing these may be a path to increasing creativity at a group level. Then guardrails from leadership, as well as management of performance pressures, may be helpful in avoiding “creative unethicality,” where creativity serves unethical aims (Mai et al., 2021).

It may be possible to encourage more responsible research and innovation (RRI) through carefully crafted industry-specific incentives, certifications, and other systems of incentives (Gurzawska et al., 2017). These efforts are most successful when created with specific conditions in mind, supported by internal and external governance, and when recognized as investments rather than costs.

Managing business systems independently likely will not be as effective as more coordinated efforts, because efficiencies may not be enough to satisfy motives stemming from profit and competition (Dobson & Chakraborty, 2020). An example of companies voluntarily coordinating to incentivize innovation can be seen in the Courtauld Commitment 2025, wherein participants agree to reduce participant and packaging waste in the food industry. As a result, companies are incentivized to innovate new ways to reduce waste, even without competitive advantage or cost savings.

Take the example of supply chains. Implementing ethical incentives for innovation in this domain may require significant multi-stakeholder engagement to determine what outcomes should be, including collaboration between governments, businesses, and industries to share the responsibilities (Gurzawska, 2019).

While most work on responsible innovation, and incentives for it, has been conducted in Europe and the United States, some of the same principles may apply more broadly. In a South Korean study it was found that companies participate in voluntary RRI, or comply with compulsory RRI, because they also see the competitive and performance benefits (Ko & Kim, 2020). Therefore, the ability to demonstrate these benefits may be one of the most ethical ways to incentivize RRI, ensuring genuine buy-in from participating companies. Keeping in mind the risks mentioned previously regarding equity incentives, stock options for non-executive employees may be effective for increasing innovation, particularly if you are seeking more radical versus incremental innovation (Su et al., 2019). Promoting innovation with employee stock options may even be more effective than the same strategy aimed at CEOs.

How do we determine how much pay is ethical?

Perhaps the most broadly relevant ethical question surrounding compensation remains, “Are employees paid enough?” The question is particularly pertinent for lower-level positions and companies earning billions.

One perspective on this topic looks to free-market forces to determine what counts as an ethical wage for which people are willing to work. However this position is weakened by situations in which the voluntariness is questionable given costs of living and lack of attractive alternatives: a worker must take what they get and the choice is essentially an illusion. Others approach the issue from the needs of a worker, and demand that a living wage is the only ethical wage, meaning that a particular quality of life can be maintained from a given pay rate. For a business, these perspectives are mostly important as a way to understand how their pay rates and working conditions will be assessed by employees, investors, and customers.

Internal comparisons may be more appropriate for determining ethical pay than external comparisons. This is where an organization has the most control, and comparisons across industries ignore limitations such as a manufacturing company that must produce physical items versus a technology company that creates only digital products. This means looking more at the vertical comparisons, and the compensation of employees from the resources a company has or can achieve.

Communicating ethical wages to the public is important to gain the benefits from positive customer and investor perceptions. Because these entities rarely have the time to investigate company wages and appropriateness, a company may instead benefit by seeking some form of living wage accreditation where an impartial group can consider the balance of wages, worker capability, and externalities to determine if employees are in fact paid enough to at least sustain themselves. The costs of paying people more, without communicating the benefit, might be the riskiest although seemingly most altruistic path.

Low-wage paying companies suffer significant reputational damage from being seen as failing to contribute to society—or even worse, as creating a class of individuals who are dependent on government benefits despite being employed. Walmart, Yum Brands, and McDonalds are well known examples, as many of their employees receive assistance of some kind (Miao, 2020; O’Connor, 2014), and in 2014 Walmart’s employees alone accounted for over $6 billion dollars in government assistance. While legal, and these companies are in competitive low-priced product markets, their ethical reputation is legitimately harmed by not paying enough to meet basic needs.

Another comparison to be aware of is companies in similar industries. Walmart and Costco run similar stores where employees do similar tasks, yet the difference in median employee pay ($23k, $31k) and CEO pay ($5.6 million, $25.6 million) is vast (Tsui et al., 2018). This weakens any argument about necessity or employee abilities, suggesting that Costco is simply run differently and in a way other companies could emulate. Tsui and colleagues also argue for higher wages based on the idea that the pay increases end up paying for themselves through improved productivity, health, and social comparisons—essentially, that paying for adequate self-care and self-esteem benefits the company. A less circumspect benefit also appears to be improved commitment and reduced turnover (Zeng & Honig, 2017)

The concept of an ethical wage also applies to employees above the lowest ranks. While most, and probably far too much, attention is paid to the lowest-paid employees and exorbitantly paid CEOs (Enderle, 2018; Tsui et al., 2018), an ethical inquiry into wages should look at all levels of pay and rank within an organization. This appears to be an opportunity for organizations to take the lead by analyzing, adjusting, and communicating about their approach to pay across their entire hierarchy (or other structure).

Ethical compensation decisions can be tainted by too much influence from external comparisons. The propensity of organizations operating under similar environmental conditions to resemble one another is called isomorphism (Srikantia & Bilimoria, 1997). Isomorphic strategies can cause problems (DiMaggio & Powell, 1983; Shani, 2018; Benischke et al., 2020). They may, for example, be incompatible with the culture or structure of an organization, lead to missed opportunities to do something better, and lead to entrenchment in the same path even when change becomes desirable.

External equity is very important (Della Torre et al., 2015), but there is a difference between consideration of what others are doing, and conformity. Internal equity means looking at the relative compensation and other factors within your organization to determine if the distribution, considering the impact of differing job roles, is ethical (Aguinis et al., 2018). This latter internally-directed sense of ethical pay has typically been the focus of ethical compensation research, and is strongly related to important employee outcomes (e.g. satisfaction, retention; Della Torre et al., 2015)

There is an assumption that pay and amenities are a trade-off such that the same resources are distributed either to pay or amenities, and you can expect only one to be high. But recent research suggests this isn’t true, and that higher-paying companies also have greater amenities, reflecting a company’s higher investment in employees (Sockin, 2021). The reason for this could be many things, such as a focus on retaining employees for more years. Alternatively it could be that employees experiencing greater amenities also have higher levels of satisfaction and performance, enhancing the bottom line of the company through their behaviors and therefore making higher wages affordable.

Given the many externalities—social, health and longevity, psychological, tax burden (Searle & McWha-Hermann, 2021)—related to low wages, the issue of ethical wages may become an increasingly important factor in ESG ratings and investments. Currently, ESG pays less attention to the people (or social) aspect of ESG, compared to profits and planet (Gallagher et al., 2018). And for investors who favor an ESG approach, higher wages aren’t just an additional cost. Paying a living wage, and making this known to consumers, can add value to a product (Guerrero Medina et al., 2020). For non-prosocial customers, who are more interested in personal benefits of consumption than benefits to others, a product that supports a living wage is more attractive and valuable than one that supports fair-trade practices, perhaps because the living wage designation benefits someone they feel closer to as a consumer.

Incentives and Diversity

A growing and highly visible way to incentivize diversity is to tie executive pay to DEI (diversity, inclusion, equity) outcomes.

Diversity and inclusion can also be supported through company compensation strategy as well as the organization’s broader culture and values. Manager accountability practices, including incentives for diversity goals, are effective in achieving racial diversity among managers (Richard et al., 2013; Triana et al., 2021). However the effectiveness of these practices depends also on firm size; they are generally more effective in smaller firms. They are also more effective for some racial groups (Asian, African) than for others (Hispanic) due to perceptions, biases, and stereotypes regarding race.

Incentives to act like a leader can reduce the gender gap in up-and-coming leaders. Females with more dominant personalities than a male counterpart only engage in more leadership when there is also an incentive to do so (Lips & Keener, 2007). This confirms assumptions of role-congruity theory, which suggests that for women, leadership is not the default or congruent role, but when incentivized, or otherwise made an explicit part of the role, then the behavior feels more appropriate or expected.

Pay Transparency

On the face of it, pay transparency would appear to promote more ethical compensation, given that inequalities are more visible, and indeed it is a popular topic of conversation in today’s workplace. Transparency is proposed as a partial remedy for gender and race/ethnicity pay gaps, and may be beneficial in closing such gaps (Castilla, 2015; Heisler, 2021). Transparency may accomplish this by allowing employees to more accurately assess their value and to make more effective pay demands (Gürtler & Struth, 2022). In diverse organizations, pay transparency (as part of greater transparency throughout the organization) may reduce biases and possibly even lead to better employee performance (Galinsky et al., 2015).

Despite potential benefits, the effect may instead be to yoke workers’ pay together within similar titles and roles. Due to equilibrium effects, greater transparency may actually lower pay for the average worker (slightly) while equalizing pay between similar employees. Individual bargaining power is decreased with high transparency because an employer views the increase for one employee as an increase for all comparable employees, resulting in more hesitation to grant increases or attempts to manipulate the information employees receive (Cullen & Pakzad-Hurson, 2021; Gürtler & Struth, 2022). This does not mean that certain individual underpaid employees would not experience a net gain from transparency, but it may come with a downside.

A preference for more pay transparency varies internationally (e.g. much higher in Germany than in Spain), and in general is more popular among younger and lower-paid individuals (Scott et al., 2015). There is also the problem that the prevailing norm is to respect the privacy of others, and asking about salary is taboo (Cullen & Perez-Truglia, 2018). The amount of transparency a company chooses to operate under results in differing satisfaction levels between employees based on their age and culture.

Equity

Organizations have significant control over internal and individual equity for their employees. Internal equity means paying people what they are worth based on their education, experience, job demands, and performance, while individual equity is paying people roughly the same as others providing similar contributions (Romanoff et al., 1986).

There are multiple forms of equity related to compensation and incentives, and the way these form overall perceptions of equity can vary across industries. Procedural equity refers to the process by which pay is determined, while distributive equity refers to the allocation of pay an individual receives compared to other people.

Research suggests that people may care as much about procedural equity as distributive equity (Cohen-Charash & Spector, 2001; Williams et al., 2006). However the most consistent finding is that all types of equity are important, and overall equity perceptions are likely to suffer if there is weakness in any area. A study of university faculty that measured distributive equity by its component parts (internal, external, individual) alongside procedural equity found that procedural equity was more important than any one component of distributive equity, followed by individual equity (comparisons with the same job in their organization) and external equity (comparisons to the same job at different organizations). Internal equity (comparisons with different roles in their organization) was the least important Terpstra & Honoree, 2003). One’s ability to see and understand how decisions are made, through fair and transparent processes, may be more central to equity than the relative amount of pay for university faculty.

In a business sample of managers and executives, the opposite was found—aspects of distributive equity were more important than procedural equity (Till & Karren, 2011). Differences between university faculty and business people are just an example of how these dimensions of equity may differ depending on the industry and other factors, like job level. Maybe it’s an ESG issue if employees aren’t able to know how pay distribution is determined within their organization, or when pay is not comparable to what others receive for the same work somewhere else.

Alternative types of incentives

Nudging

A nudge is something that changes behavior or decision making but without typical incentives such as monetary reward or requiring/forbidding any behavior (Selinger & Whyte, 2012). Nudges are gentler than other forms of incentives, but can also feel like programming or unrelenting cues that manipulate individuals inappropriately. One of the most studied nudges is a reminder to climb stairs (usually instead of an elevator). A nudge in these situations causes your mind to think about the choice to use the stairs, but doesn’t make you do so, and is still resolved by your own internal preference. When there is information included in the nudge it may influence that decision, but the only reward or punishment is internal if you feel a certain way about your own decision (Forberger et al., 2022).

Gamification

Gamification integrates game-like elements in non-game contexts (Ruhi, 2015). Gamification strategies have the benefit of tapping into intrinsic motivation (Huotari & Hamari, 2017), so long as adequate gamefulness is maintained. Engagement is also mostly voluntary and generally equally available to all, making gamification for engagement less risky than it might be for more consequential outcomes (e.g. time to complete tasks, customer-dependent outcomes, goals subject to chance/luck). Gamification can help people become intrinsically motivated to perform certain tasks. Because this has the effect of equalizing intrinsic motivation levels across individuals, gamification may be helpful in managing issues around diversity.

Gamifying should be approached systematically. This would include measures of how effective gamification is at providing cognitive and affective benefits (Deterding et al., 2013; Klevers et al., 2016). Ruhi (2015) outlines how to successfully implement gamification, which includes but is not limited to aligning it with business goals, reporting on it frequently and openly, collaborating with experts, and personalizing it for employees.

Conclusion

Ethically managing incentives can be a complex task. There’s ample research to assist in navigating these challenges. Companies can realize the benefits of incentives while minimizing negative consequences. Examining your organization’s values and most important outcomes can be a key starting point to ethical compensation programs. This means not implementing certain compensation programs just because it’s what other organizations are doing. Rather than choosing to conform, organizations can apply incentives where and how they serve their real needs. Incentives play out over time, and across individuals and groups, in intricate ways, and can lead to unintended consequences, but a better understanding of how these dynamics unfold can enable organizations to apply them with greater efficacy.