Should Executive Pay Indeed 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...

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.

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.

Comments

[pockyclips ...:]

So what shall we do? I don't see any CEOs taking a 40 to 50 % pay cut.
The "free market system": internalize profits, externalize losses. Heads they win,
tails we lose.

Jan 04 11:01 AM

[Fairness:]

I wholeheartedly agree to the fact that executive pay is outrageously, despicably, obscenely excessive. Today's executive pay is nothing less then a shameless fraud perpetrated against the company shareholders, an albeit legal self-serving salary gauging conspiracy. A white collar highway robbery nevertheless...
None of today's executives, as proven by the present crisis (housing, auto, financial, or otherwise) are capable of saving any company from distress. Their claim that they are responsible for millions of dollars is nothing more then a shameless self-serving justification to defraud investors.
Nowadays, any responsible but obscure college graduate can bring as much value to a company's leadership and bottom line as the brightest executive. Believe it or not, a decent college graduate is worth way more then a bright crooked executive; way, more in terms of shareholders' value and company performance, employee satisfaction, product development, company reputation advancement, and just plain decency and fairness.
Today's hoards of executives are just simple conspirators to defraud the shareholders of their assets, of the value created by the company they administer like their own fiefdom.
I believe, in the name of fairness, decency, and reasonableness, all executives pay should be directly correlated with their employees pay, in no way more then 10 times their least paid employee. In addition, no executive is worth more the US president.
To my opinion executive pay should also be capped at 75% of the US president's salary.

Jan 04 05:22 PM

[Tom Armistead:]

I think executives should receive the bulk of their pay in restricted stock, the restriction being they would have to hold it for 5 or 7 years. That would give them a long term perspective on the decisions they would make.

These gentlemen have a lot of responsibility, like a ship's captain. So, in financial terms, if the company sinks they should go down with the ship. The restricted stock would achieve this objective.

If they needed more cash than this would provide they could do forward sales of the stock, appropriately discounted, or borrow against it.

Jan 04 07:22 PM

[Steven Hansen:]

"I think executives should receive the bulk of their pay in restricted stock, the restriction being they would have to hold it for 5 or 7 years. That would give them a long term perspective on the decisions they would make. " - tom armistead

this is the correct approach but i would push the range to 5 to 10 years. the basic corporate problem in america has been too short of vision. short term maximize profits - we worry about tomorrow, tomorrow.

i believe the execs are paid too much but this is supposed to be a free market where you are allowed to be stupid.

Jan 04 09:22 PM

[who:]

"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."

Your final comment says it all. Top executive pay should be based on building sustainable income for the company and not one hit wonders. As another writer wrote, CEO are like captains, but I think they are more like to Admirals and the captains are out in the field acting on the directions given them from the top. Unfortunately, most people in businesses are not independent enough thinkers and follow the heard. Nor can do they have sufficient experience or knowledge to lead very complex and large companies.


An CEO of financial company not involved with the loan derivatives would probably been ousted a few years ago when others were making money for themselves and investors.

Jan 05 12:13 AM

[driftwood2:]

Executives have managed to manipulate the payment system to their advantage. The solution is to simply prevent them from doing so. Capital gains should be taxed at the same rate as regular income. Also, exercised options should need to be held for a certain period of time like 5-10 years. Lastly, CEOs should never be able to nominate board members. I'm against super high marginal tax rates because I think they are fundamentally unfair. A 35% rate is adequate.

Jan 05 12:39 AM

[M-P:]

I have sat in front of executives who made $3-5M or more in the previous year. Many of them were not worth the money. Most were smart, but smarts are not enough. The pay for performance contract has been breached, and we all know it.

The real difference in comp has been around options and the other non-salary comp components. Some of the best CEO's are paid the least and some of the worst, the most. One has to only look at the latest emblematic CEO's with the financial firms - $50M+ comp packages, while the ship is being loaded with explosives and patched with duck tape. A classic case of mortgaging the future - literally and figuratively. Read The Halo Effect for a good perspective on how we view performance and all its attributes. Most CEO's just need to be on the right side of the business cycle to be called geniuses. When performance is good (the Halo) we only see the good - commanding, open, value driven, etc., etc. When performance drops and the business cycle changes - the take can be millions (over a few years) and the parachute package even greater.

I have no issue paying for genuine Alpha (beating a relevant and credible benchmark), esp. over a period of time (e.g., restricted stock becomes worth more if there is Alpha over X period of time). My issue is paying for incompetence and malfeasance - how many can we name - Enron, ML, Citi, Fannie/Freddie, GS, Countrywide, etc. It's too many to be an exception. I never did like private gains and public losses -and with the way we are spending taxpayer money today - I like it even less.

Jan 05 07:53 PM