BOGUE: Underworked and overpaid

Market incentives are the best way to address the issue of overcompensated CEOs

On Sunday, voters in Switzerland roundly rejected one of the boldest regulations yet proposed for tackling astronomically high executive salaries. The bill, dubbed the 1:12 Initiative for Fair Pay, would have capped CEO salaries at 12 times that of the company’s lowest-paid worker. With all 26 cantons (member states) reporting, approximately 65 percent of Swiss voters rejected the measure, which was conceived in an atmosphere of growing wealth inequity in the small European nation.

There is hardly a citizen in the developed world who doesn’t see the unreasonably gratuitous salaries of top companies’ CEOs as problematic. According to Bloomberg News, the average ratio of CEO pay to average worker pay across industries in the S&P 500 is currently at 204 to one. Horror stories abound: former J.C. Penney Co. CEO Ron Johnson received a compensation package valued at 1,795 times the average pay of a department store worker in November 2011. Proponents of fair pay in Switzerland were quick to register their disappointment in the results of the country’s referendum on laws aimed at realigning this gross imbalance, which is not a uniquely American problem.

We should not, however, be so eager to join in the chagrin of 1:12 supporters. Top-down regulation from the government aimed at limiting CEO compensation fails to account for the reasons why we have seen executive salaries rise so quickly in the past few decades. The simplest mechanism we can employ to understand this phenomenon is the market. CEOs are compensated not by how much more productive they are than the average worker — is it even physically possible to be 204 times more productive than another human being? — or even by the objective “value” they bring to the company. Rather, they are compensated so generously because there is high demand for CEOs. This demand drives up salaries, as boards compete to keep the people they’ve enlisted to run their massive corporations. Top executives are encouraged to follow the money rather than to exhibit company loyalty or “settle down.” In this environment, paying less than your competitors is untenable. In fact, best to pay a little more, just to be safe. You can follow the logic from there.

On a certain level, there is a great deal of sense behind this system. Governments should never be in the business of deciding how much a service or a product is valued; history has proven that markets do this better and more efficiently (think of China’s abandonment of command-and-control policies in the 1980s). Laws like the one proposed in Switzerland reflect a poor understanding of how to tackle a problem like CEO compensation. We have no reason to believe that the magic ratio of 12 to 1 is any better than, perhaps, 16 to 1, or even 24 to 1. Arbitrary limitations are attractive for their simplicity, but in practice they end up hampering natural business decisions. To reverse the troubling trend of multi-million dollar signing bonuses and Christmas stock options, we ought to work with the powerful impulses of the market.

To this end, the Securities and Exchange Commission (SEC) of the United States passed a measure in September of this year that requires companies to make public the ratio of their CEO’s pay to the median worker’s pay. The thinking is simple: once the embarrassing gap is public knowledge, boards will face pressure to curb their generosity toward CEOs. It is a proposal designed to work explicitly within the pressures of the market: instead of mandating certain behavior from companies, the law helps to change their incentives, leaving them free to act as they wish. At first blush, it seems a promising step in the right direction.

But, as James Surowiecki of The New Yorker points out, the change has not had the desired effect. Instead, in a perverse reversal of expectations, the public disclosure of the ratios has encouraged to boards to pay their CEOs at a ratio at least as high as their competitors, often higher, in order to appear as though they can afford to outspend their competitors. The effect is similar to as if high-end restaurants were required to disclose the salaries of their top chef: every restaurant would compete to pay the most, because doing so implies that the restaurant can afford the highest quality. No one competes for the honor of the least-paid top executive.

What, then, is a government to do? The solutions aren’t clear. What we can conclude, though, is what not to do. Setting arbitrary caps is antithetical to the natural functioning of the market and can make the United States — or whichever company implements the measure — less competitive than other nations. Proposals aimed at increasing transparency, although well-intentioned, also fail to address the problem. In fact, allowing boards a certain amount of discrepancy and secrecy in paying their CEOs may actually decrease pressure to out-spend the corporation next door.

Moreover, proposals aimed at shifting the incentive structure facing companies may yield better results: one such idea would be to offer tax breaks to companies that set their own limits on executive pay. This rewards companies for taking steps to curb the rampant growth in executive compensation. By encouraging boards to make better compensation decisions, instead of imposing burdens from above, we may yet address growing wealth inequality in the United States.

Russell Bogue is an Opinion columnist for The Cavalier Daily. His columns usually run Thursdays.

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