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Saturday, January 03, 2009

Should Executive Pay be Capped?

Robert Frank argues against capping executive pay (with one exception). He says that a high marginal tax rate is a better option:

Should Congress Put a Cap on Executive Pay? , by Robert Frank, Commentary, NY Times: It's no wonder that voters’ outrage over exorbitant executive pay is mounting. After all, the government just had to bail out financial firms that paid big bonuses last year to many ... executives who helped precipitate the current financial crisis.

Nor is it any wonder that Congress is considering measures to limit executive pay... One popular proposal would cap the chief executive’s pay ... at 20 times its average worker’s salary. But while Congress may well have compelling reasons to limit executive pay in companies seeking bailout money, voter anger is not a good reason to extend pay caps more generally.

To be sure, executive pay in the United States is vastly higher than necessary. Executives in other countries, whose pay is often less than one-fifth that of their American counterparts, seem to work just as hard and perform just as well. ...

So why not limit executive pay? The problem is that although every company wants a talented chief executive, there are only so many to go around. Relative salaries guide job choices. If salaries were capped at, say, $2 million annually, the most talented candidates would have less reason to seek the positions that make best use of their talents.

More troubling, if C.E.O. pay were capped and pay for other jobs was not, the most talented potential managers would be more likely to become lawyers or hedge fund operators. Can anyone think that would be a good thing?

In large companies, even small differences in managerial talent can make an enormous difference. Consider a company with $10 billion in annual earnings that has narrowed its C.E.O. search to two finalists. If one would make just a handful of better decisions each year than the other, the company’s annual earnings might easily be 3 percent — or $30 million — higher...

Critics complain that executive labor markets are not really competitive — that chief executives appoint friends to their boards who approve unjustifiably large pay packages. But C.E.O.’s have always appointed friends, so that can’t explain recent trends.

One reason for these trends is that companies themselves have become bigger. ... Beyond growth in company size, executive mobility has also increased. In past decades, about the only way to become a C.E.O. was to have spent one’s entire career with the company. ... Increasingly, however, hiring committees believe that a talented executive from one industry can also deliver top performance in another. ... This new spot market for talent has affected executive salaries in much the same way that free agency affected the salaries of professional athletes.

If the market for executive talent is competitive, critics ask, why are C.E.O.’s in an industry paid about the same, regardless of performance? That’s because no one knows with certainty how a particular executive will perform. ... Executives whose record predicts good performance command a high rate. Their leash, however, has grown shorter. In the past, a C.E.O. could often stay in the job for many years despite lackluster performance. Today, a C.E.O. who fails to deliver is often dismissed after a year or two.

In short, evidence suggests that the link between pay and performance is tighter than proponents of pay caps seem to think. Since the fall of the former Soviet Union, no one has seriously challenged the wisdom of relegating a high proportion of society’s most important tasks to private markets. And the market-determined salary of a job generally offers the best — if imperfect — measure of its importance.

The financial industry, however, may be an exception. A money manager’s pay depends ... on the fund’s rate of return relative to other funds. This provides strong incentives to invest in highly leveraged risky assets, which yield higher average returns. But as recent events have shown, these complex assets also expose the rest of us to considerable systemic risk.

On balance, then, the high pay that lures talent to the financial industry may actually cause harm. So if Congress wants to cap executive pay in financial institutions receiving bailout money, well and good.

Elsewhere, however, the more prudent response to runaway salaries at the top is to raise marginal tax rates on the highest earners, irrespective of occupation. Again, relative salaries drive job choices. The jobs with the highest pretax salaries will still offer the highest post-tax salaries, just as before, so this step will not compromise the price signals that steer talented performers to the most important jobs. ...

When I look at these markets and ask if the conditions for competitive markets are satisfied, conditions like free entry, homogeneous products (as opposed to "small differences in managerial talent [that] can make an enormous difference"), perfect information about product quality (as opposed to "no one knows with certainty how a particular executive will perform"), it doesn't seem to me like they are. So even with "free agency," I don't think the market necessarily provides the correct economic incentives, i.e. the correct relative prices (of, say, executive salaries relative to the salaries of painters). If this is true across the board for high salaries whether or not they are executives, for the most part anyway, then differential treatment of high incomes is not warranted. But the fact that these salaries are "vastly higher than necessary" does mean that a high marginal tax rate can be used to overcome the distortions that the higher than necessary salaries bring about. So in this case the tax would not be creating a distortion, it would be correcting one.

Since part of the column talks about the growth in executive salaries in recent years, it's probably also useful to note that much of the change in the distribution of income recently has been driven by high salaries in the financial services industry (and the vaunted spot market spread this huge distortion to other markets by raising compensation generally). Saying that these salaries - which were based upon bubble values rather than underlying fundamentals, and which put upward pressure on executive pay generally - provide the correct economic incentives is, it seems to me, hard to defend.

    Posted by on Saturday, January 3, 2009 at 02:43 PM in Economics, Market Failure, Taxes | Permalink  TrackBack (0)  Comments (48)


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