Tournament theory provides the basis for an assessment of the impact of pay disparity on performance. New evidence is provided regarding tournament theory by assessing two questions: (1) whether pay disparity leads to incentives for managers to engage in strategies that benefit the shareholders of the firm and (2) whether governance quality moderates the pay disparity-performance relationship, consistent with agency theory. Four measures of corporate governance are examined in order to assess governance's moderating role on the relationship between pay disparity and firm performance. The results suggest that while pay disparity can provide incentives for better performance, consistent with tournament theory, it can become destructive if it is reflective of agency conflict.
