We study the relationship between pay gaps among top executives and firm value using the insights from a principal-agent framework. Large pay gaps on one hand reduce managerial shirking by imposing a large promotion incentive, and on the other hand they can induce counter-productive rivalries. Hence, both the pay gap level and its impact on firm value are jointly determined by the firm's optimizing pay gap so that the marginal benefit of reducing managerial moral hazard is balanced against the

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... xpected marginal costs of uncooperative manager behavior. We find that complex firms tend to have larger pay gaps, and their firm values increase with the pay gap level. On the other hand, R&D intensive firms tend to have lower pay gaps, and the effect of pay gaps on their firm value is much lower and can even become negative. We also find a substitution effect between pay gaps and other mechanisms used to control moral hazard problems. When strong corporate governance and high equity delta reduce managerial moral hazard, the marginal benefit of having a large pay gap declines significantly. Using the 2003 dividend tax cut as a quasi-natural experiment that exogenously increases effective managerial ownership, we find additional evidence reinforcing our primary findings, which provides further support for our main hypothesis. JEL classification: G30, G35, J33