27 December 2010

The Drivers And Costs Of CEO Pay and Inequality

I've written before about the pay of superstars in sports and entertainment, and the portion of a New York Times article discussing that point covers little new ground. The shorter version is that their performances reach a very large number of people.

Entity Size And Profits Drive Corporate Pay

The article's analysis of high corporate pay, however, bears closer attention. It attributes rising pay for the executives in the "real economy" to the increasing scale of big business, and rising pay inn the finance sector to profits made possible deregulation.

In 1977, an elite chief executive working at one of America’s top 100 companies earned about 50 times the wage of its average worker. Three decades later, the nation’s best-paid C.E.O.’s made about 1,100 times the pay of a worker on the production line. . . . in the 1970s found that executives in the top 10 percent made about twice as much as those in the middle of the pack. By the early 2000s, the top suits made more than four times the pay of the executives in the middle. . . . Two economists at New York University, Xavier Gabaix and Augustin Landier, published a study in 2006 estimating that the sixfold rise in the pay of chief executives in the United States over the last quarter century or so was attributable entirely to the sixfold rise in the market size of large American companies. . . .

In 2007 . . . . financial companies accounted for a full third of the profits of the nation’s private sector. Wall Street bonuses hit a record $32.9 billion, or $177,000 a worker. . . . Financiers had a great time in the early decades of the 20th century: from 1909 to the mid-1930s, they typically made about 50 percent to 60 percent more than workers in other industries. But the stock market collapse of 1929 and the Great Depression changed all that. In 1934, corporate profits in the financial sector shrank to $236 million, one-eighth what they were five years earlier. Wages followed. From 1950 through about 1980, bankers and insurers made only 10 percent more than workers outside of finance, on average. . . .

By 2005, the share of workers in the finance industry with a college education exceeded that of other industries by nearly 20 percentage points. By 2006, pay in the financial sector was again 70 percent higher than wages elsewhere in the private sector. A third of the 2009 Princeton graduates who got jobs after graduation went into finance; 6.3 percent took jobs in government.

The authors attribute the gains in the tides of financial industry pay largely to government regulation, which tightened during the Great Depression and on through about 1959, and then was relaxed in the late 1980s and 1990s.

A critical point to keep in mind is that the increased pay have top executives in big business or finance has a great deal to do with ability to pay and very little to do with actual competence.

Big businesses and financial firms offer an amount based on the scale of their enterprises and the amount of profit their firm creates, in the hope of attracting the best talent. But, while there is considerable evidence to indicate that better pay does lure better rank and file professionals to an industry or enterprise, there is very little evidence to indicate that big businesses are able to accurately discern which applicants for exhorbitantly paid top jbs are actually the best one, and there is considerable evidence to indicate that big businesses do an absolutely mediocre job of removing top executives who have failed to live up to the expectations upon which they were hired from their posts.

The Diminishing Marginal Returns Of Winner Take All Compensation

Put another way, if big businesses had hired someone from the same pool as the person actually hired who was willing to work for half a much compensation, there is very little to indicate that the business would be run any less well. One can find very compentent managers willing to work for $1,000,000 a year, and the marginal benefit accrued by offering $10,000,000 a year instead is not at all obvious.

This concern is particular great in the case of successor CEOs. One can argue that founders of firms have earned their great wealth by creating the firms that generate it. But, this point is much harder to make when a successor is appointed to manage to wealth created by his or her predecessors.

The divide between the rich and the megarich is driven by the concentration of economic activity into a smaller number of firms that is largely a product of economy of scale incentives in the economy, not by the fact that there is an immense divide in talent between the rich and the megarich.

Indeed, the concentration of rewards at the very top can actually create counterproductive incentives:

If only a very lucky few can aspire to a big reward, most workers are likely to conclude that it is not worth the effort to try. The odds aren’t on their side. Inequality has been found to turn people off. A recent experiment conducted with workers at the University of California found that those who earned less than the typical wage for their pay unit and occupation became measurably less satisfied with their jobs, and more likely to look for another one if they found out the pay of their peers. Other experiments have found that winner-take-all games tend to elicit much less player effort — and more cheating — than those in which rewards are distributed more smoothly according to performance.

Counterproductive winner take all effects are the private sector equivalent of the Laffer Curve, the notion that at some very high marginal tax rate (far in excess of anything found in the U.S. or even European economies), increasing taxes reduces tax revenues because it creates an disincentive to work. There is a point at which increasing compensation to top performers actually decreases the productivity of the economic unit as a whole.

The Drivers and Economic Impacts Of Income Inequality

The article also notes the trend towards exceptionally high income inequality in the American economy, and its tenuous relationship to economic growth (emphasis added):

Since 1980, the country’s gross domestic product per person has increased about 69 percent, even as the share of income accruing to the richest 1 percent of the population jumped to 36 percent from 22 percent. But the economy grew even faster — 83 percent per capita — from 1951 to 1980, when inequality declined when measured as the share of national income going to the very top of the population.

One study concluded that each percentage-point increase in the share of national income channeled to the top 10 percent of Americans since 1960 led to an increase of 0.12 percentage points in the annual rate of economic growth — hardly an enormous boost. . . . Since 1980, the weekly wage of the average worker on the factory floor has increased little more than 3 percent, after inflation. . . . According to the Organization for Economic Cooperation and Development, the average earnings of the richest 10 percent of Americans are 16 times those for the 10 percent at the bottom of the pile. That compares with a multiple of 8 in Britain and 5 in Sweden. . . . There is a 42 percent chance that the son of an American man in the bottom fifth of the income distribution will be stuck in the same economic slot. The equivalent odds for a British man are 30 percent, and 25 percent for a Swede.

Keep in mind tha the 3% real increase in wages for factory workers since 1980 has not been 3% per year, but instead is 3% total. On an annualized basis, that is an increase of about 0.1% per year -- for example, a rate of about $40.00 per year for someone making $40,000 a year.

What the international comparisons citred by the New York Tiems do not reveal is the root causes of the differences in income inequality between the United States and continental Europe. It turns out that the bulk of the difference is due to government policy. The less well off are better in Europe because the net deal of taxes paid v. transfer payments received there is better than it is in the United States.

The pre-tax, pre-transfer payment earnings of the less well off are just as stagnant in Europe as they are in the United States, but Europeans have sweetened the pot for the average person to share the wealth their economies have grown, while the Americans have not.

This analysis tends to suggest that the poor in America have a comparatively wretched and insecure existence not because they are less able to contribute economically, but because our political system does not see everyone as being in the same boat to the same degree. It is plausible to hypothesize that this, in turn, has a lot to do with the fact that the less well off are far more likely to participate politically in Europe than in the United States. In Europe, the share of the voting aged population that votes is 50% to 100% greater than in the United States. Non-voters are ignored politically, and the correspondence between those who don't vote (the poor and uneducated, particularly minorities, and children) and those who receive meager governmental support by international standards, is probably not coincidental.

Notably, forcing the beneficiaries of economic growth to share their gains with the rest of the nation has not, as conservative economic intuition would suggest, had any significant effect on the rate of economic growth. In countries with mixed economies where one's earnings still significantly impact one's socio-economic well being, even significant taxation to fund transfer payments doesn't distort the economy very much, because insuring that that there are real economic incentives in earnings for economically productive conduct turns out to be much more important than the intensity of those economic incentives. The ability to capture much of your contribution to economic growth is very nearly as motivating as the ability to caputre almost all of your contribution to economic growth.

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