Wednesday, October 19, 2011

$95 Million Pay Day

Several interesting developments this week converged to prompt this post.

- On Monday, our favorite tax fashionista, Lee Sheppard, published an article discussing the relationship between income tax rates and executive compensation. Sheppard argues that Reagan-era cuts to marginal income tax rates have fueled the dramatic inflation in pre-tax compensation payments to C-suite executives. See "News Analysis: Should We Adopt a Millionaire's Surtax?" 133 Tax Notes 307 (Oct. 17, 2011).

- Sheppard mines data compiled by Catherine Mulbrandon from a November 2010 report by Jon Bakija of Williams College, Adam Cole of the Treasury Department and Bradley Heim of Indiana University. The report analyzes the occupations of the top 1% on American taxpayers between 1979 and 2005.

- Sheppard focuses, in particular, on the profiles of the top 0.1% of American taxpayers. Catherine Mulbrandon presents a terrific graphic comparison of the top 1% and the top 0.1% on her website, Visualizing Economics.

- Catherine Rampell, an economics reporter at the New York Times, also discussed the report on Monday. Rampell's analysis contains some good tabular summaries of the underlying data. She gently tweaks the OWS protesters by noting that the large majority of taxpayers in the top 1% are not Wall Street financiers. They are doctors and lawyers and C-suite executives.

- Over the weekend, Kinder Morgan signed a deal to acquire El Paso Corp in a $38 billion transaction. If the transaction is completed, El Paso's current CEO will be eligible for an exit package worth $95 million. Perhaps he can purchase the Greek island of Santorini after closing the deal.

- Today, Paul Caron posted the following chart summarizing the percentage of income earned and income taxed paid across the tax brackets in 2009. Thanks to Peter Pappas for linking. (Note that the data compiled for the Bakija et al study dates to 2005, so the numbers aren't precisely apples to apples.) The average taxpayer in the top 1% earned a comfortable $343,000 in 2009. That's approximately 0.4% of the retirement package for El Paso's current CEO. The doctors and lawyers in the top 1% are no closer to the top 0.1% than the middle-class union members in the middle of the income distribution.

How does this all fit together?

Sheppard argues that American CEOs are "grotesquely overpaid," and I completely agree. According to Sheppard:
Chief executive pay has increased 500 percent in real terms since the 1981 act cut the top marginal rate to 50 percent. Average worker pay has not increased in real terms during the same period. The median chief executive of an S&P 500 company now takes home more than $9 million annually [versus $1 million in 1981, in inflation-adjusted dollars]. The average chief executive of a public company takes home $2.5 million. Research has calculated that executive pay is the equivalent of 10 percent of corporate earnings at the largest companies.
It really is outrageous. I'm a strong believer in free market economics, but executive compensation practices are symptomatic of market failure. No manager of an industrial/energy company deserves a $95 million retirement package. Bill Gates, Mark Zuckerberg ... different stories.

Consultants in the executive compensation space make a killing on "peer benchmarking." For a public company, the board of directors is responsible for hiring and compensating the CEO. Directors hire consultants to "benchmark" the compensation packages granted to CEOs at "peer" companies with somewhat comparable operations, capital structures, etc. The "benchmarking" studies are used to support ever-increasing compensation packages to CEOs. As Sheppard observes, "[n]o board wants to believe that its chief executive is merely average."

The net result is the ridiculous inflation in executive compensation that has occurred during the last 30 years. The benchmarking data contains a "one-way" bias, because boards never pay their executives less than the "average" CEO among the comps. If nobody is ever "below average," there is never a price mechanism to slow the price inflation for executive management. As CEO compensation increases, the consultants incorporate the increased compensation data into their benchmarking analyses. Year after year, the cost of an "above average" manager continues to inflate. The newest vintage of "above average" CEOs needs to be paid more than the last vintage of "above average" of CEOs.

Ironically, CEO pay seems to be the one area where business organizations seek to maximize their costs. Imagine how long a business would last if it committed to paying "above average prices" for the various inputs into its products or services. Competitive markets reward innovative enterprise that can satisfy consumer demand while lowering costs of production. I understand that CEOs play a critical strategic role within their respective businesses. They're distinguishable from commoditized widgets. Nonetheless, corporate boards are consistently failing their shareholders by acquiescing to current executive compensation trends.

(Boards have other incentives to inflate CEO pay. Frequently, CEOs install or support directors who are themselves CEOs of other public companies. This creates an obvious conflict of interest. A CEO of Company A that wears a "director hat" for Company B is more likely to support an outrageous compensation package for the CEO of Company B, because he or she knows that the compensation package will become part of the benchmarking data supporting his or her compensation as CEO of Company A.)

Sheppard discusses various options to curb the inflation of executive compensation, including surtaxes and new brackets for the highest-paid taxpayers. I don't believe that taxes created the problem, so I don't believe that taxes will solve the problem. Instead, corporate boards should adopt guidelines on the relationship between CEO compensation and the median compensation of an employee within the organization. It could be a simple formula: CEO pay for a given period may not exceed 10x or 20x of the median employee pay. It could be more complicated, with performance metrics and clawbacks. No matter how you slice it, corporate boards should begin chipping away at the market failures that are inflating CEO pay.


  1. Market failure? Personally, it doesn't make any sense to me that society values the ability to throw a ball through a hoop as much as it does. Executives making ridiculous amounts of money seems a lot more logical.

    But it should be up to the shareholders to decide whether the compensation practices are ridiculous...just like it's up to the sports fans to decide whether the tickets are worth it or not.

    Wages reflect how much society values those skills. Ceilings and minimum wages lead to an inefficient allocation of labor that negatively impacts our economy to a great degree.

    Coincidentally I just wrote an entry on the same sorta topic...The Dialectic of Unintended Consequences.

  2. Xero,

    Thanks for the comment. I don't think the market for pro athletes is comparable in any way to the market for CEOs. Most importantly, there is a huge pool of "would be" pro athletes, many of whom have the talent or raw physical potential, but most of whom don't have the intangibles necessary to succeed as pro athletes. Oddly, the "pool" of potential CEOs of public companies is much, much smaller.

    I agree that CEO compensation could be approved or rejected each year by shareholder vote. However, the boards have a fiduciary obligation to their shareholders and should exercise it by keeping CEO compensation packages under control. Bottom line is that most CEOs would do their jobs for single-digit million dollar compensation packages instead of double-digit million dollar compensation packages. For reasons I discussed, however, the boards don't necessarily "bargain" to get the best deal possible for their CEOs.