Executive compensation and economic inequality

Oceans of ink have been consumed writing about the subject of widening economic inequality, declining social mobility, and a shrinking middle class in the United States over the last 40 years. More recently, the subject has emerged as a social and political flash point.

The most commonly cited reasons for this phenomenon are globalization and technology adoption. Improvements in technology, such as more powerful computers and industrial robots increase the incentive to substitute capital for labor. Increased trade competition from imports made in lower cost countries, and the threat of exporting jobs to those countries put pressure on wages and employment. Others point to excessive monopoly power, market consolidation and the hollowing out of labor unions.

For the ordinary working-class American there is plenty to be mad about. While wage growth has remained relatively stagnant for decades, an Economic Policy Institute study reports that extravagant chief executive officer (CEO) pay is a major contributor to rising inequality, contributing to the growth of top 1 percent and top 0.1 percent incomes.

The report found that the CEOs of the top 350 US companies by sales raked in an average of $21.3 million last year, an increase from about $18.7 million in 2018. This means that the average CEO made 320 times as much as the average worker earns in wages and benefits. CEO pay went crazy in the 1990s. In 1976 it was 36 times what an average worker earned, 61 times in 1989, and 131 times in 1993.

The authors of the report argue that this “growing earning power at the top has been driving the growth of inequality in our country.” The report attributes the increase to the rapid growth in vested stock awards and exercised stock options tied to stock market growth. Stock-based compensation accounted for about three-fourths of the median CEO’s compensation.

The rise of executive compensation practices linked to stock prices has been the mantra of America, Inc. over the past several decades. In 1982, the Securities and Exchange Commission adopted Rule 10b-18, allowing companies to buy back their own stock without being charged with stock manipulation. Starting in the 1990s many companies introduced stock option grants as a major component of executive compensation. The idea was to better align management interests with those of shareholders. A small circle of highly influential pay consultants, academics, and activist shareholders argued that American firms must pay top dollar for top candidates because they compete in a global market for talent.

While beneficial in some ways, this new form of compensation also created problems quite apart from resentment and lower morale among rank and file workers. For example, the incentive for executives to manage earnings through any means, fair or foul, and focus on the short-term earnings game become strong. Making matters worse, a favorite corporate America trick is to use stock buybacks to manipulate their companies’ stock prices. By increasing demand for a company’s shares, open market buybacks lift the stock price and help the company hit quarterly earnings targets. It makes sense. Stock buybacks enrich investors, including company executives who receive most of their compensation in company stock.

There are many ideas to solve the policy of extravagant executive compensation, ranging from higher marginal income tax rates for those at the top to banning stock buybacks to allowing greater use of “say on pay,” which allows a firm’s shareholders to express dissatisfaction with excessive pay.

While ideas have influence, it’s rarely just because of their singular force they are implemented. Instead, there has to be a confluence between the ideas themselves, the zeitgeist of the times, and the interests of “the great and the good” who find the ideas congenial. The pandemic may serve as a wake-up call for boards of directors and institutional investors to circumcise executive pay.

Closing the carried interest tax preference

Those who can often be found at the very top of the earnings scale – people who manage private investment funds such as hedge funds or private equity and venture funds – enjoy a tax loophole that allows the money they make by investing money for others (their “carried interest”) to be taxed as capital gains rather than earned income, even though they earn the money from work, not as a return on investing their own money.

In plain terms, they reap a benefit even though they don’t put their own capital at risk. It’s a loophole that allows the rich to get richer, and its demise is long overdue. That is why some of the wealthiest Americans pay lower tax rates than their secretaries. Proponents argue that taxing those who run these funds at the same rate that everyone else pays on their earned income would drive away trillions of investment dollars.

These are the same folks, the 1-percenters, who can enjoy indulging in any of the 40 items on the Forbes cost of living extremely well index (CLEWI). The list, which should not be shared with progressive friends, includes such items as a Learjet, 45 minutes with a shrink on the Upper East Side of Manhattan, Russian sable fur coats, a Har-Tru crushed stone tennis court and more. Forbes says, the CLEWI is to the very rich what the CPI is to “ordinary people.”

The term carried interest goes back to medieval merchants in Genoa, Pisa, Florence, and Venice. These traders carried cargo on their ships belonging to other people and earned 20 percent of the ultimate profits on the “carried product.”

Today, those who manage investments in private equity funds are typically compensated in two ways: with a 2 percent fee on funds under management and a 20 percent cut of the gains they produce for investors. The 20 percent in profits these managers pocket, known as carried interest, is currently treated as a long-term capital gain and taxed at 23.8 percent: the capital gains rate of 20 percent plus the Obamacare surcharge of 3.8 percent on their income. The 2 percent management fee is taxed at the higher ordinary income tax rate.

Presumptive Democratic presidential nominee Joe Biden has put forward an economic policy platform under which he would repeal many of the tax cuts that went into effect on Jan. 1, 2018. The proposals include increasing the federal corporate tax rate from 21 percent to 28 percent and restoring the top individual tax rate to 39.6 percent for taxable incomes above $400,000, up from the current 37 percent; taxing capital gains as ordinary income for individuals and couples with over $1 million in annual income and increasing the Social Security earnings cap by applying the payroll tax of 12.4 percent to earnings above $400,000.

While these sweeping tax proposals do not specifically address carried interest, it might be reasonably inferred that carried interest would be taxed as ordinary income rates. In the past, Biden has said he’d like to eliminate the carried interest giveaway. Both Presidents Obama and Trump campaigned on closing the carried interest dodge, yet it’s still there. Their proposals to abolish the carried interest preference were met with pregnant and deadening silence in Congress.

Eliminating the carried interest provision that allows fund managers to get away with bargain basement tax rates should be low-hanging fruit given the inequality of wealth and income in the United States. Yet despite its unpopularity this is the tax break that just won’t die. Well-connected lobbyists and trade groups for private equity, hedge funds, and others have mobilized their resources and fought successfully to keep carried interest as is. The nine lives of carried interest are more evidence, if any more evidence is needed, that big money gets its way in Congress. Here’s hoping that the conceit of closing the carried interest loophole will gain traction but for sure it’s a long shot.

Models aren’t crystal balls

Every day, while folks are stuck at home, politicians, public health officials, and slick talking heads point to charts showing the latest statistics on the coronavirus pandemic as they attempt to predict what might happen next in your neck of the woods. Underlying these graphics are various forecasting models, which you should approach with a healthy dose of skepticism.

It is tempting to view the models as oracles that will help predict how the disease will spread, tell you what to do and when to do it. But these models are simplified versions of realty. Reality is reality. Models should be read with the greatest care. They are not a substitute for controlled scientific experiments that generate relevant data.

Models certainly provide information that can create a framework for understanding a situation. But models, including those used to predict COVID-19′s trajectory, aren’t crystal balls. A model is simply a tool. It consists of raw data, along with assumptions based on our best guesses at the time, that together shape an overall forecast.

A model is only as good as its underlying data, which is in short supply. For example, there is still plenty of uncertainty about how many COVID-19 deaths may occur over the next six months under various social distancing and mask wearing scenarios. Also, a model’s accuracy is constrained by uncertainty about how many people are or have been infected.

Assumptions aren’t facts. Put another way, models are constrained by what is known and what is assumed. Understanding these underlying assumptions helps explain why some forecasts have a sunny disposition, while others can’t be pessimistic enough.

There are also economic models. Financial mavens develop them to take stock of how the pandemic has impacted the economy and where they see it and markets heading. With so many countries experiencing sharp declines in gross domestic product, there is a lot of forecasting about what shape the recovery will take. Will there be a quick V-shaped recovery or will it be U-shaped? Or maybe a little bit of both?

These models also have their limitations. Recall how Long-Term Capital Management, an industry-leading hedge fund run by a renowned team of mathematical experts that included two Nobel Prize winners, developed complex quantitative models to analyze markets and placed huge bets on the assumption, among others, that Russia would never default on its bonds. They did a lousy job of stress testing their assumptions and they bet wrong. In September 1998, the firm had to be bailed out by a consortium of Wall Street banks to prevent the bottom dropping out of the financial system.

This episode was a coming attraction for the harrowing financial crisis a decade later in September 2008, which was perhaps the biggest event of the 21st century until COVID-19. Prior to the 2008 crisis, a key assumption in many models was that housing prices would always go up. Indeed, one cause of the meltdown was the quant movement: the proliferation of quantitative models for designing and analyzing financial products as well as for risk management. Many finance professionals mistakenly believed that quantitative tools had allowed them to conquer risk. Products such as derivatives, subprime mortgage-backed securities and activities that relied heavily on quantitative models were at the heart of how financial firms expanded their activities to take more and greater risks.

And of course, with the presidential election just months away, Americans still remember how 2016 election models forecast Hilary Clinton waltzing into the White House. Between now and Nov. 3, many people will take election forecasts with an extra grain of salt or three.

Given the events of the last several months, people should keep a simple fact in mind: Models should not be asked to carry any more than they can bear. So when you hear about models put on your hmmm face.