Do Pay Caps for CEOs Make Sense?

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The question whether CEO pay is excessive or adequate often leads to heated discussions. In an election year in Germany, the Social Democratic Party of Germany has recently made this topic the subject of headlines with their plan to cap CEO salaries. The argument that is usually brought forward in favour of CEO pay caps is a push toward “social justice”. This poses four important, consecutive questions: First, how can it be determined how much pay a manager deserves for his work? Second, do CEOs currently earn more than they deserve? Third, if so, at the expense of whom does this rent extraction occur? And fourth, would a cap on CEO salaries resolve potential issues?

A large part of the recent increase of income inequality has been due to developments at the very top end of the income distribution (I have previously written about income inequality and provided a brief update recently). For example, Atkinson et al. (2011) and Alvaredo et al. (2013) conclude that there has been a surge of the income share of the top one percent, especially in Western English-speaking countries, and that this development is to a large degree due to rising wages at the top. Although capital incomes have contributed to this development, the statement made by Piketty & Saez (2003) that “the working rich have replaced the rentiers at the top of the income distribution” still carries great weight and often illustrates the way CEO salaries are thought of today. The numbers related to CEO pay are often staggering and easy to incorporate in sensational headlines. In the US, top CEOs earn 335 times more than the average worker, in the UK 129 times more, in Canada the number is 193 and in Germany, where salaries are currently discussed to be capped, top CEO pay is 50 times as high as the average wage.

But just because CEO pay is very high, this does not automatically imply that it is “unfair” or that they “steal” from other workers (I have looked at this issue from a different angle when I discussed player income in the German football league). The true performance of any worker, leave alone the executive of a large firm, is inherently difficult to measure. This leads us to the first two, closely related questions: How is CEO pay determined and is it currently too high? Not very surprisingly, different economists give very different answers to these questions. Gabaix and Landier (2008) find that they can explain much of the growth and dispersion of CEO pay with developments in firm size. Bebchuck & Fried (2004) argue that CEO pay has become increasingly detached from their performance, using their entrenched positions to influence their own remuneration. Looking more generally at top incomes, Piketty et. al (2014) come to the conclusion that the increase of top-end salaries is mostly due to increased bargaining instead of increased performance. Unfortunately, the questions how CEO performance can be measured and whether CEO pay is currently excessive remain to a large degree ideological ones.

Let us assume for a moment that CEO pay is exceeding CEO performance. Then, at the expense of whom does this rent extraction occur? Proponents of CEO wage caps often interpret too high CEO salaries as “stealing from the average worker”. However, the CEO does not negotiate his or her wage directly with the workers, but predominantly with the company owners. Bebchuck & Fried (2004), who conclude that CEO pay is excessive, argue that this excessive pay comes at the expense of the shareholders. There might be a spill-over effect to the wage bargaining of other workers, but it is unclear how low-wage workers should be able to cut into shareholder profits just because CEOs earn a couple of millions less.

This leads us directly to the last question whether CEO wage caps resolve the issue that they are intended to resolve. If the only issue is that CEO pay is “unjust” (as I have argued on this blog before, justice is a tricky concept) and socially unacceptable, a simple cap can be the solution. However, if the goal is to tackle more fundamental issues like income inequality, CEO pay caps may fall short for a couple of reasons. First, it is likely that CEO wage caps predominantly benefit capital owners. Since capital ownership, especially stock ownership, is still highly concentrated (Piketty, 2014), a cap might simply shift income from one part of the one percent to the next. Moreover, in the US executives of large companies account for merely about five percent of very high incomes (the top 0.01 percent), while the rest is accounted for by financial service sector employees, lawyers and professional athletes and other wage earners and capital income earners (see Kaplan & Rauh, 2010, who can only account for about 25 percent of top incomes). A CEO wage cap might thus make for an impactful initiative in an election year but only covers a minor part of top-end inequality developments. Furthermore, wage caps are a strong interference in ownership rights that might be hard to legally justify, especially when it is highly uncertain whether high CEO wages are unambiguously harmful. Lastly, if a CEO pay cap is designed as a ratio, it might also lead CEOs to outsource low-wage jobs.

A broader initiative that not only impacts a minor subgroup of top income earners and is not as strong in its moral verdict can be a reform of the tax system. This might include an increase in top income tax rates, especially for capital income or a broadening of the tax base by abolishing tax exemptions and constraining channels for tax evasion and avoidance. Whether or not CEO pay is excessive is still an important question, since taxes might disincentivise effort. However, there is little evidence that high top income tax rates have stunted economic growth in the past. Moreover, high top-end tax rates do not necessarily condemn high incomes as harmful and unfair in the way wage caps do but rather can also be justified with the ability-to-pay principle.

CEO salaries are often perceived as excessive. However, it is mostly unclear how “fair” wages should be determined and whether CEO pay is currently really “too high”. Moreover, CEO wage caps that affect a small share of top income earners do not seem to be a measure well equipped to tackle income inequality or serve the vague purpose of “social justice”. A reform of the tax system might be a more effective way to approach inequality issues and is probably less ideologically charged.

Since I’m doing a lot of writing and reading for my master’s thesis at the moment, I can’t make enough time to post here frequently. But I am looking forward to summarise my master’s thesis, which develops a new model of income inequality and technological change, on this blog soon.

I have outlined how I would design a tax system from scratch in the article “Daydreaming About Inequality – A New Income Tax System“. Cheers!


References

Alvaredo, F., Atkinson, A. B., Piketty, T., and Saez, E. (2013). The top 1 Percent in International and Historical Perspective. The Journal of Economic Perspectives.

Atkinson, A. B., Piketty, T., and Saez, E. (2011). Top Incomes in the Long Run of History. Journal of Economic Literature.

Bebchuk, L. A. and Fried, J. M. (2004). Pay Without Performance : The
Unfullled Promise of Executive Compensation. Harvard University Press.

Gabaix, X. and Landier, A. (2008). Why has CEO pay increased so much?
The Quarterly Journal of Economics.

Kaplan, S. N. and Rauh, J. (2010). Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes? Review of Financial Studies.

Piketty, T. (2014). Capital in the 21st Century. Cambridge: Harvard Uni.

Piketty, T., Saez, E., and Stantcheva, S. (2014). Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities. American Economic Journal: Economic Policy.

written by Jonas

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Author: Jonas Send

I analyse current topics that interest me in opinion pieces and share my research in economic articles. the10thmanblog.wordpress.com

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