Facing pay cuts in a crisis, employees focus on ‘greater good’
Performance-based pay cuts lead to higher collective performance during economic crises compared to equal-share cuts, but only under certain conditions
When crisis forces a company to institute pay cuts, intuition says employees would see equally shared cuts as fairer than performance-based cuts. But new research suggests the opposite is true, with collective effort for the greater good playing a significant psychological role.
Performance-based pay cuts also result in higher collective organisation performance than equal-share pay cuts, according to the research paper Keeping up with the Joneses during an economic crisis: The effect of different types of pay cuts on employee performance, in the Journal of Management Accounting Research. Moreover, when employees perceive cuts as necessary to address a crisis, with pay ultimately restored, they don’t appear to hold a grudge – in fact, their performance may even improve over the pre-pay-cut period.
“Although we may intuitively think that equal-share pay cuts are fairer than performance-based pay cuts because it shares the sacrifice equally among employees, we find the opposite,” explained Mandy Cheng, Professor in the School of Accounting, Auditing and Taxation at UNSW Business School, who co-wrote the paper with Suyun (Sue) Wu, Assistant Professor of Accounting and Information Systems at the University of Texas at El Paso, and Dr Di Yang, senior lecturer in the School of Accounting, Auditing and Taxation at UNSW Business School.
“Employees feel that performance-based pay cuts are fairer – we attribute this to our research setting (which resembles a typical economic crisis), where employees know that their collective effort can help the company through the crisis and allow normal pay to be restored,” Prof. Cheng added.
A closer look at pay reductions
Many companies facing profound challenges implement pay cuts to reduce labour costs and restore organisational stability, with frontline managers and employees shouldering much of the burden. Seen as a better alternative to layoffs, this tactic has become an increasingly common and accepted response aimed at shoring up a firm’s survival during a crisis – as has been evident in two global economic crises already this century.
“During the pandemic, many companies responded to a sudden drop in profit by temporarily cutting their employees’ pay,” Prof. Cheng said. In the first few weeks of pandemic restrictions in Australia, for instance, payroll wages fell 6.5%; a year later, they had rebounded to 1.4% above mid-March 2020 levels.
Previous research has shown that cutting pay is generally a dangerous move for a business, as employees find reductions unfair and may respond by putting in less effort at work or retaliating in other dysfunctional ways, Prof. Cheng noted. “However, pay cuts were widespread during the pandemic-induced economic downturn, and it seems to be considered socially acceptable (in fact, pay cuts started to be seen as more acceptable in the last global financial crisis, but it was even more obvious during the pandemic),” she said.
“This suggests that employees may react to pay cuts differently in situations where the pay cut is seen as ‘legitimate’; that is, when employees can see that their company really has no choice but to temporarily cut pay and that their pay will be restored to normal once the crisis is over.”
In addition, Prof. Cheng observed that different companies have different approaches to pay cuts. “For example, KPMG Australia cut 20% pay of all their staff for several months, whereas PwC Australia cut pay based on employees’ billable hours instead of a fixed percentage,” she said. “Yet, research to date gives us little guidance on what types of pay cuts companies should adopt. It makes sense to us that evidence-based research is needed to better understand how employees react to different pay cut practices.”
The fairest way to cut pay
The researchers sought to compare the effect of equal-share cuts, where all employees at the same level receive the same decrease in pay, and performance-based cuts, where the reduction is proportional to employees’ previous performance.
“We focus on a setting where employees’ collective effort can lessen the impact of an economic crisis and increase the chance that the firm can survive and return to normality,” they wrote.
“We draw on social comparison theory to argue that performance-based pay cuts (compared with equal-share pay cuts) will encourage employees with relatively lower performance to exert more effort and improve their performance during the pay cuts period, whereas those with relatively higher performance will be unaffected by the type of pay cuts. Consequently, firms will benefit from implementing performance-based pay cuts rather than equal-share pay cuts during a crisis.”
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To test their theory, the researchers conducted an experiment in which participants received a fixed wage to complete a task in pairs during a training period, followed by three formal periods in which the participants could observe each other’s work. Ahead of the third session, participants (identified as either high or low performers based on measurements of their relative performance in the second period) learned that a decline in economic conditions necessitated the institution of pay cuts in the upcoming work period. The researchers then applied the two types of pay cuts, informing participants the reductions would be reversed if the employees’ collective effort successfully supported the firm through the crisis.
They found that, consistent with their predictions, performance-based pay cuts resulted in higher collective performance than equal-share pay cuts, as lower performers achieved higher performance in the pay cuts period in the first case than in the latter. In contrast, high performers achieved similar performance under both conditions. “Compared to the pre-pay cuts period, we find that only equal-share pay cuts resulted in reduced team performance in the pay cuts period,” the paper stated.
Moreover, the study showed that temporary pay cuts do not have lasting effects, with performance improving once the crisis ends and pay is restored. “In other words, employees don’t seem to ‘hold a grudge’, and their performance even improves from the pre-pay-cut period once their pay returns to normal,” Prof. Cheng explained.
Self-serving fairness bias
While prior studies have suggested that “disadvantageous pay dispersion” causes employees to respond by lowering their effort, Prof. Cheng and her co-authors argued that fairness concerns would be lower when employees consider pay cuts ‘legitimate’ and believe their collective effort can help overcome a temporary crisis.
“Self-serving fairness bias refers to the tendency for us to conflate ‘what benefits me’ with ‘what is fair’,” Prof. Cheng explained. “For example, when we don’t get what we want (e.g., a bonus, a promotion, a preferred work assignment), our first thought may be, ‘This is unfair!’”
The belief that equal-share pay cuts would seem fairer to employees stems from concerns that performance-based cuts result in unequal employee pay. “Those who receive a larger share of the pay cut may consider performance-based pay cuts unfair; after all, they have also put in time and effort to perform the same task, but they end up with less pay,” Prof. Cheng said.
“Interestingly, we find that this is not the case in our experiment,” she added. “Our results are similar to prior studies showing that the effect of self-serving bias is weaker when 1) it is clear that others do not have an unfair advantage, and 2) maximising combined welfare is important.
“Putting this in the context of our research: when there is performance transparency (i.e., employees can see who performs better and understand how this performance is determined), and when working together can help the company through a crisis and allows everyone’s pay to be restored, then performance-based pay cut does not appear to cause significant fairness concerns,” she said.
“Instead, performance-based pay makes it clearer to employees the importance of each individual’s performance towards addressing the economic crisis.”
Lessons for employers
The study’s findings have important implications for employers and managers keen to prepare for future economic or organisational crises. “When employees recognise that their collective effort can support their firm through the crisis and restore their pay, temporary pay cuts are a viable way to manage labour costs,” Prof. Cheng explained.
“When firms can make the reasons and basis of temporary pay cuts transparent, and where employees are comfortable with how performance is measured, a performance-based pay cut results in better outcomes than equal-share pay cuts,” she added.
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Finally, noting the “obvious human cost to those who find themselves struggling financially” when a company resorts to even temporary pay cuts, Prof. Cheng also pointed out that the study exemplifies how experiment as a research method helps promote understanding of a business problem.
“By using an experiment, we can ‘recreate’ an economic crisis and then test how people react to the way companies respond to the crisis without actually harming anyone – in our case, we can look at how pay cut is implemented without having to actually cut pay for real employees or to wait for another crisis to occur before testing our idea,” she concluded.