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.

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