Internal pay gaps and human capital upgrading

This study examines the relationship between internal pay gaps and human capital upgrading using comprehensive panel data from Chinese listed companies. Contrary to tournament theory predictions, we find that internal pay gaps lead to substantial declines in human capital upgrading, with economically meaningful magnitudes. Mediation analysis reveals that this negative relationship operates primarily through two mechanisms: employee turnover serves as the primary mediating pathway, while reduced R&D investment explains an additional significant portion of the total effect. Combined, these mechanisms account for the majority of the observed relationship. These findings challenge tournament theory's applicability in knowledge-intensive contexts and provide strong support for equity theory and organizational justice frameworks. The results suggest that excessive internal pay disparities create competitive rather than collaborative organizational cultures, systematically undermining human capital development through skilled worker departure and reduced innovation capacity. Our findings have significant implications for compensation design, suggesting that organizations should emphasize internal equity alongside external competitiveness to maintain long-term organizational capability development. The results are robust across various model specifications and sample compositions.