Are CEOs Overpaid?--Posner

The media are full of stories about the compensation of chief executive officers of American companies. The theme of the stories is that CEOs are paid too much. The economics of compensation are fascinating. In the simplest economic model, a worker, right up to the level of CEO, is paid his marginal product--essentially, his contribution to the firm's net income. But simple observation reveals numerous departures from the model. For example, wages vary across the employees of the same rank in the same company by much less than differences in their contribution to the company, and employees who do satisfactory work can expect real (that is, inflation-adjusted) annual increases in their wages throughout their career with the firm, even though their contribution will not be increasing at the same rate, and eventually not at all. Let us see what sense can be made of the curious pattern of CEO compensation. American CEOs make much more on average than their counterparts in other countries--about twice as much. You might think that this was because Americans at all levels earn more than their foreign counterparts, but this is not so; the difference between U.S. and foreign wages is much smaller below the CEO level. In other words, wages are more skewed in favor of CEOs in American companies. The disparity is related to the fact that salaries are a much smaller fraction of American CEOs' incomes (less than a half) than of foreign CEOs' incomes, with the rest consisting of bonuses but mainly of stock options. Both the fraction of CEO income that is nonsalary, and total CEO income, have been rising, dramatically in the United States, over recent decades. But there is a recent tendency of foreign CEO compensation policies toward convergence with the American practice. One can speculate about the causes of some of these differences. Stock options and other incentive-based compensation methods impart risk (variance) to CEOs' incomes, which reinforces the risk inherent in the fact that a CEO's human capital (earning capacity) may be specific to his firm, so that if he lost his job because his company had been doing badly (perhaps for reasons beyond his control), he would take a double hit--lower pay as the company declined and lower pay in his next job. Because business executives (as distinct from entrepreneurs) do not like risk, they demand a higher wage if the wage is going to have a substantial risky component. This may explain some of the difference between American and foreign CEO compensation, but surely not all or even much of it--especially since job turnover at the CEO level is actually greater in Europe than in the United States. Another possible difference is that stock ownership tends to be more concentrated abroad than in the United States. The more concentrated it is, the more incentive shareholders have to monitor the performance of their firm's managers because they have more at stake. The more effective that monitoring is, the less need there is to create incentive-based compensation schemes: the stick is substituted for the carrot. Cultural factors may be important. European countries in particular are more egalitarian than the United States, suggesting that envy is likely to play a bigger role in compensation there. Astronomical ratios of CEO to blue-collar wages in the same company cause little resentment in the United States compared to what they would cause in Europe, though wide disparities between workers at the same level does engender resentment here even if the disparities track differences in productivity. Envy might reduce average incomes at the same time that it reduced variance in incomes, if the more generous compensation of American CEOs merely reflects the greater contribution that they make to their companies' success. But there are two reasons to doubt this, and thus to suspect that American CEO incomes are padded to some degree. First, the most significant "incentive" component in these incomes--stock options--are not well correlated with the CEO's contribution to the value of his company and thus of the value of its stock. Many things move a company's stock besides the decisions of its CEO. To tie a CEO's income to the value of his company's stock is a bit like tying the salary of the President of the United States to the U.S. GNP. Second, the choice of stock options as the principal method of providing nonsalary compensation to CEOs seems related to the fact that traditionally the income generated by these options, unlike salary or bonus income, was not reported as a corporate expense. Of course security analysts and stockholders large enough to follow closely the affairs of the companies in which they invest can calculate the expense of stock options, but the ordinary public cannot, and this is important because even in the United States envy is a factor that can influence policy and public opinion. A spate of recent articles has explained the ingenious devices by which CEO compensation that would strike the average person as grossly excessive is concealed from the public, and these articles, along with well-publicized corporate scandals, may place some downward pressure on CEO compensation. Companies cannot afford to ignore public opinion completely, because adverse public opinion can power legislative or regulatory measures harmful to a company or an industry. It might seem that, provided the shareholders--the owners of the company--are made aware of the actual compensation received by the CEO, competition will drive that compensation down to approximately the level at which the CEO is just being paid his marginal product, with appropriate adjustment for risk. But given the size of companies, the cost to a major company of even a grossly overpaid CEO is so slight when divided among the shareholders that no shareholder (assuming dispersed ownership) will have an incentive to do anything about that excess expense. What about the board of directors? Their incentive to minimize what from the overall corporate standpoint is only a minor cost is also weak, and may be offset by rather minor economic and psychological factors. The board is likely to be dominated by highly paid business executives, including CEOs, who have a personal economic interest in high corporate salaries and a natural psychological tendency to believe that such salaries accurately reflect the intrinsic worth of their recipients. Becker in his comment on this post (below) cites an interesting paper by Gaibaix and Landier which argues that the increase in CEO compensation is a function of the growth in the market value of firms. The basic idea is that the CEO of a more valuable firm is more productive, since if he increases value by say 1 percent the increase in absolute value will be greater the more valuable the firm is. If there are two equally skilled managers and one manages a grocery store and one manages IBM, the manager of IBM is probably creating greater value. The theory is too new to evaluate with any confidence. I am somewhat skeptical because rapid increases in CEO compensation should attract more talent to management, and the resulting greater competition for CEO positions should dampen the increase in compensation. An alternative explanation for the correlation between firm value and CEO compensation, one that is consistent with the evidence that such compensation is often excessive from an efficiency standpoint, is that the greater the firm's market value, the easier it is to "hide" the compensation of the top executives. Suppose that a 10 percent increase in value is associated with a 3 percent increase in CEO compensation; then the percentage of the firm's value that is going to the CEO will have fallen. This may be one reason why many mergers fail to increase earnings per share, although the overall value of the enterprise will be greater after the merger (there will be more shares): the increase in overall value enables the CEO to increase his compensation regardless of whether he will be creating greater value as the manager of the larger enterprise.

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