April 17, 2023
Okay, that may not be as dramatic as imagining world peace, but hey, I’m an economist. And, as I will argue, more reasonably paid CEOs would be a pretty big deal.
Just to set the table, CEOs have always been well-paid. At least in principle, it is a demanding job requiring skills in many areas. I said “in principle” because the corporate scandals of the last few decades have surfaced many examples of CEOs whose primary skill seems to be in the art of bullshitting. But there can be little doubt that maintaining a well-run company does require serious skills and hard work.
However, being a well-paid CEO means something very different today than it did fifty years ago. Back then, CEO pay was twenty to thirty times the pay of a typical worker. That would translate into roughly $2 million to $3 million a year given current pay structures.
Today, the average CEO of a major company is paid almost 400 times what an average worker earns, or roughly $25 million a year. There are issues of measurement that could make this figure higher or lower, but there is little doubt about the basic story where CEO pay has soared relative to the pay of ordinary workers and even relative to most other highly paid workers. [1]
While many of us might be offended by $25 million paychecks (the pay of 800 workers putting in a full year at the federal minimum wage) even if CEOs in some sense “earned” their pay, there is good reason to believe they don’t. There have been many studies showing that CEO pay does not closely correspond to returns to shareholders. A few examples are here, here, and here. Lucian Bebchuk and Jesse Fried’s book, Pay Without Performance, presents a wide range of evidence on this issue.
There is a simple story as to how CEO pay could become so divorced from their actual value to the companies they run. The basic picture is that there is no one to hold their pay down. We all understand how the pay of ordinary workers — retail clerks, assembly line workers, table servers in restaurant — are held down. Managers are supposed to keep their pay as low as possible, in order to maximize corporate profits.
If a company finds that they are paying their workers more than their competitors, they are likely to cut their pay to bring it into line. If current managers aren’t up to the task, the bosses find managers who will cut pay.[2]
But there is no remotely corresponding mechanism for CEO pay. The people who are supposed to hold their pay in check are the corporate boards of directors. The boards of directors ostensibly answer to shareholders, who elect the members of the board at regular intervals. However, as a practical matter, it is very difficult for shareholders to displace board members. More than 99 percent of the board members who are nominated by the rest of the board for re-election win their seats.
Being a board member is a very cushy job, typically paying well over $100,000 a year, and sometimes $300,000 or $400,000, for less than 400 hours of work, so board members generally want to keep their jobs. Since being re-nominated by the board virtually guarantees re-election, the best way to ensure that you get to hold onto your seat is to stay on good terms with other board members.[3]
This likely means not asking pesky questions like “can we pay our CEO less money?” Since top management plays a large role in selecting board members, it is not surprising that corporate boards tend to identify with them rather than shareholders. In fact, a recent survey of corporate directors found that the overwhelming majority did not even see limiting CEO pay as part of their job. Instead, they viewed their main role as serving the goals of management.
In this context, it is easy to tell a story where CEO pay can spiral upward almost without limit. Corporate boards are sitting on huge piles of money. They like their CEO and want to keep them happy. This means that they want to make sure their CEOs are paid at least as much as CEOs at their competitors. They do surveys so that they know what their competitors pay, and then add a ten or twenty percent premium.
And then their competitors do the same thing. They repeat this process every few years. In this story, CEO pay can only go up.
CEO Pay and Other High Earners
There has been much research in recent years showing how the pay of ordinary workers might bear little relationship to their actual output. There are two main stories. First, it appears that monopsonistic employment relationships are far more common than had previously been appreciated.
Rather than being an exceptional case, where for example there is one large employer in a small town, it seems many, if not most, employers have some degree of monopsony power. This means that rather than facing a horizontal supply curve, where they can hire as many workers as they want at the prevailing wage, paying one worker more money will also require paying other workers more money as well. In this context, workers will typically get paid less than their marginal product.
The other issue is that it seems workers may not typically be aware of their actual value in the labor market. They may not recognize how much they could earn at a different job, and therefore may accept pay that is less than their marginal product.
In both of these stories we can get situations persisting indefinitely where large numbers of workers may be earning substantially less than their marginal product. While this view is increasingly accepted for workers at the middle and bottom of the wage distribution, it is worth asking whether we may see comparable distortions at the high end, although in this case it would be a story with workers earning above their marginal product.
It is relatively easy to tell this story for CEOs and other top management, as discussed above. There basically is no market mechanism that would ensure CEO is kept in check. The corporate boards, that are supposed to work for shareholders in restraining in pay, tell us that they don’t even see this as part of their job. Of course, even if they said they were trying to rein in CEO pay, that is no guarantee they succeed, but when they tell us they are not even trying, we can be reasonably certain that they are not succeeding.[4]
But if pay for CEOs and other top managers is out of line with their marginal products, is it reasonable to believe that this is also likely the case for other highly paid workers. The story here is that the pay of CEOs and other top managers are a point of reference for other top-tier executives and high-level workers outside of the corporate sector.
We can think that workers enjoy a pay premium above their marginal product based on how close they are to corporate CEOs, both in the corporate hierarchy, and also in society more generally for people working outside the corporate sector. For other top-level executives this premium may be a large fraction of the CEO’s premium — say, something like 50 percent. This would mean that if the CEO gets $20 million more than their real value to the company, the chief financial officer and other C-suite executives get $10 million more than their real value.
For the next tier, the fraction might be something like 10 percent. In this case where the CEO is overpaid by $20 million, the third-tier executives will end up with $2 million more than their value to the company. There may still be some premium lower down, but once you get to the assembly line worker, it’s a safe bet it is zero.
To be clear, a third-tier executive is not getting inflated pay directly as a result of the inflated pay going to the CEO. Rather the CEO’s inflated pay is setting a pay structure (we use to talk about “wage contours”), that leads both workers and the people setting pay to think that the work of the third-tier executive is worth more than it actually is.
The same would apply to people working outside of the corporate sector. A university president may get something like an 8 percent CEO pay premium, which would mean that $20 million in excess pay for the average CEO is raising their pay by $1.6 million. The next level of university administration may get something like a 4 percent CEO premium, with excessive CEO pay adding $800,000 a year to their paychecks.
If this story is accurate, then it would not be easy to disrupt the pay structure. If a top university decided to pay its president $1 million rather than $2 million, it would be seen as an insult, given prevailing pay scales. An incumbent president would likely leave if they faced this sort of pay cut and many potential candidates for an open position offering half of the prevailing pay for university presidents would opt not to seek the job.
The norms around pay have real power in the world. If workers, and especially high-end workers, don’t feel they are being paid fairly, it is likely to show up in their performance. And, even if the pay for CEOs may exceed their value, a CEO or high-end worker who is trying to sabotage their employer is definitely in a situation to do considerable damage. This means it is difficult for an individual company to try to make the pay of their higher-level employees more closely reflect their actual value.
This suggests that bringing the exorbitant pay of CEOs, and other high-level workers, back in line with their value, will have to involve a process that takes place through time, similar to the process that led to the run-up in pay over the last five decades, but in the opposite direction. And, it should start at the top.
Setting the Ship Straight – Getting the Incentives Right
There have been various proposals for lowering the pay of CEOs, many of which involve some form of direct government intervention, such as a tax penalty for companies with overpaid CEOs. While corporations, with or without overpaid CEOs, can certainly afford to pay more taxes, I respect their enormous ability to avoid taxation. (Here’s my scheme for cracking down on corporate tax avoidance/evasion.)
I prefer a route that changes incentives. At it stands now, the corporate boards that most directly determine CEO pay have essentially zero incentive to try to lower pay. We should take seriously what these boards tell us; they see their jobs as serving top management. They are sitting on piles of money, which are not theirs. They know that they can keep top management happy by giving them generous paychecks. In this context, bloated CEO pay should not surprise us.
But we can change the incentives. The Dodd-Frank financial reform legislation included a “Say on Pay” provision, which required companies to send out their CEO pay package for shareholder approval at three-year intervals. The vote is simply a yes or no vote. There is no direct consequence for a pay package being voted down, but presumably it is an embarrassment to both the CEO and the board.
As it stands, very few pay packages are voted down. Less than 3.0 percent of Say on Pay votes lose. It is very difficult to organize diffuse shareholders, and since there is little consequence to a “no” vote, there is not much incentive for anyone to try.
However, we could put some meat on the bones. Suppose that the board of directors would lose their pay for the year if a CEO package was voted down. This would be a clear substantive outcome that might encourage more shareholders, who are disturbed by an excessive pay package, to make the effort to try organize among shareholders.
It is also likely that this would get the attention of corporate boards. My guess is that once two or three boards were forced to sacrifice their paychecks as a result of losing a Say on Pay vote, directors would become far more careful in dishing out dollars to top executives. In that world, they may decide it is actually a good thing if their CEO was paid somewhat less than their peer group. And, over time, we might see CEO pay fall back in line with their actual productivity.
While many people seem to view this plan to punish directors for excessive CEO pay as a left-wing proposal, it is hard to understand what is radical about giving shareholders more control over the company they ostensibly own. Presumably, this is exactly what fans of the free market would want.
After all, what possible incentive would shareholders have for paying a CEO less than their true value? This would mean that they would get lower returns on their stock if they ended up with an inept CEO because they weren’t paying the market price for a competent one.
Of course, it is hard to say how corporate boards would respond, and maybe CEOs really are worth their eight-figure paychecks, in spite of the evidence to the contrary. But it seems worth a try. We know that under the current system, there is no one who has the job of keeping CEO pay in check, and we pay a high price in the form of inequality, and less money for everyone else, as a result of the bloated pay structure at the top.
There seems little harm in trying to get the market to function as the textbooks say it does, and have the CEOs actually work for shareholders.
[1] The analysis cited, by Josh Bivens and Jori Kandra, excludes the pay of Tesla CEO Elon Musk. In 2021, the year analyzed, he cashed out stock options worth $23.5 billion. Had this been included in the sample of CEOs, it would have pushed average CEO pay for the sample to almost $100 million. On the other hand, Bivens and Kandra use the realized value of stock options rather than the value at the point where they are issued. Arguably, the latter is a better measure of compensation, since that is most immediately what the CEO is paid.
[2] There are exceptions, like Costco, who quite explicitly pay their workers more than competitors, but this is done with the idea that they will get more loyalty and more productive workers. This is a deliberate policy — it is not an accident.
[3] The board dynamics around CEO pay are discussed in Steven Clifford’s great book, the CEO Pay Machine.
[4] It is sometimes argued that the pay of CEOs at companies owned by private equity provides a good test of the true worth of CEOs, since there is no issue of diffused shareholder ownership. The pay of CEOs at private equity owned companies tends to be comparable or higher than their pay at publicly traded companies. However, the meaning of this comparison is questionable. Private equity firms usually look to hold a company for only a few years, working a major restructuring and then reselling it as a publicly traded company. This means both that they are likely making extraordinary demands on a CEO during this period, and that they face exceptional risk from bad performance. If they paid less than prevailing CEO salaries, they might get poor performing CEOs who would doom their project.
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