The Study Of Incentive Effect And Control Effect Of Executives’ Hierarchy Mechanism

China is an emerging economy in transition. Compared with mature western economies, it has two major differences in administration and regulation systems. First, the fundamental contracts of the society consist more of implicit contracts rather than the explicit ones, which is largely because the explicit contracts such as the legislation system in China are poorly enforced. Second, the government drives contracts between individuals and it plays a leading role in most aspects of social developments. These two differences lead to following reflections in the area of executive compensation. First, the implicit incentives have become a tradition and take a more important position than in other countries because of the implicit contracts’ role in China’s history and society. Second, SOEs, a significant part of China’s economy, have relatively closed internal labor markets where political hierarchy incentive plays a dominant role. Third, regulations on cash compensation weaken the effects of cash compensation, which impedes it from achieving all the incentive purposes. As a result, the implicit political hierarchy and perks become supplementary measures to cash compensation. Last, through incentive effect and control effect, the government can not only promote economic growth, but also achieve other goals.For the government, the political hierarchy mechanism has several benefits:(1) ensures the implementation of the country strategy; (2) saves the cost of contract; (3) maintains the historical tradition and social stability. Using political hierarchy mechanism, the government can take tens of thousands of SOEs under its supervision with very low cost. For the executives, the higher political hierarchy means greater income, bigger option, larger spiritual rewards and more rigorous and comprehensive supervision and control. These benefits will incentive executives to work hard and reduce opportunistic behaviors, called incentive effect and control effect. And stronger ’lock-in’ effect and more intense competition further enhanced them.Under the differences and theoretic analysis discussed previously, this paper carries out the empirical study of the incentive effect and control effect of hierarchy offered to executives in Chinese listed companies. First of all, we discuss the relationship between executives’ compensation and hierarchy incentives. The positive relationship can support the incentive effect argument. Secondly, we discuss the relationship between firm performance and hierarchy incentives. The theoretic incentive effects of political hierarchy to firm performance must be proved by empirical evidences. We get some evidence from accounting performance and stock return. Then, we discuss the relationship between political hierarchy and over investment and investment efficiency. This step not only offers a path from political hierarchy to performance, but also gives some implications to the control effect. Finally, if the control effect of hierarchy incentives is important enough, we’ll find some evidence on companies’ stock price risk as well. Detailed contents and discoveries of the studies are as follow.(1) Executives’ political hierarchy and executives’ compensation. We test the relationship between political hierarchy and compensation. The results show the positive relationship between perks and political hierarchy. That’s to say, the higher the political hierarchy of executives, the more implicit benefits executives get. This also suggests that political hierarchy may be a deeper incentive than perks. This step offers the basic support for incentive effect of political hierarchy.(2) Executives’ political hierarchy and firm performance. We test the relationship between political hierarchy and firm performances of the executives in SOEs. The results show that the performance tends to be better with executives with higher political hierarchy. The following tests show that the incentives function of political hierarchy will be strengthened with the younger executives and the shorter tenure of the executive. This step offers the direct support for incentive effect of political hierarchy.(3) Executives’ political hierarchy and firm investment. If the executives with higher political hierarchy promote the performance more, then we must observe some similar evidence in investment field. The empirical results show that the higher the political hierarchy of executives, the fewer the over investment, the smaller sensitivity between free cash flow and over investment, and the larger efficiency of investement. The evidence from over investment supports the control effect of political hierarchy. The following tests show that the relationship mainly exists under the circumstances with the younger executives. This step offers a detail path to incentive effect, and provides some implications to the next step.(4) Executives’ political hierarchy and the risk of firms stock price. Not only will political hierarchy incentives affect the firm performance but the executive’s attitudes towards risk as well and it will further affect the firm’s financial behaviors. SOE executives with higher level of political hierarchy will behave more cautiously out of professional attentions. We test the relationship between executives’ political hierarchy and stock price crash risk and stock price synchronicity. The results show that the higher the political hierarchy of executives, the smaller the stock price crash risk and the less the stock price synchronicity. The following tests show that the relationship mainly exists under the circumstances with the younger executives and the shorter tenure of the executive. This step confirms the long-term impact on corporate governance and finance imposed by executives’ political hierarchy.Generally speaking, having learnt from the results above, the implicit incentives, which have a series of impacts on the behaviors of executives, take an important part in the motivation system of executives in listed companies of our country. The boundary of the hierarchy incentives is not set randomly, but it results from the equilibrium between contract revenue and cost function. The possible important meaning of the passage might be as follows:(1) The passage is the first to exactly present that the hierarchy incentives take an important part in the incentive system of executives in the listed companies of our country. We cannot copy the theory and practice of the motivation model from the western completely under the unique regime circumstance, but we should make efforts to realize two points:firstly, the produce and prosperity of implicit incentives, which cannot be rashly interrupted when there is no proper substitutes, has a rational side rooting from the deeply regime background. Secondly, this implicit institutional arrangement is located upstream which might have a profound influence on a series of decision making for both the internal and the external of firms, like future performance, risk selections and so on. It cannot be ignored.(2) The specific study of the political hierarchy of executives is the first to theoretically explain that this kind of regime arrangements is sufficient to be the factors of executive motivation, to provide with the theoretical framework and empirical evidence of the motivation effects of executive political hierarchy,to present the political hierarchy effect of incentives and constricts on executives, to enlarge the study of executive incentives, to provide an important institutional explanation to make a fully understanding of micro-foundation of China’s economic development. In addition, the research also puts forward a systematic and reliable measurement method of executive political hierarchy, contributing to the promoting of the empirical research of this researching field in the future.(3) The institutional explanation of implicit contract provides a scarcely empirical support for our understanding of the increase of economics in China on a micro level. It probably becomes an effective supplementary for macro explanation of federalism (for example, Qian and Roland,1998) and the motivation of regional administrative leaders.