JULY 01, 1958 by HANS SENNHOLZ
Dr. Sennholz is Professor of Economics at Grove City College, Pennsylvania.
A favorite point of attack against capitalism is the impressive height of the salaries of top business executives. Labor union leaders especially tend to be critical of executive salaries and bonuses amounting to a hundred thousand dollars or more. People unfamiliar with the principles that determine wage and salary rates are apt to become envious and receptive to ideas that are hostile to our free economy.
The selection of corporate management confronts stockholders with choices similar to those we all must face in our daily purchase decisions. Should they look for management at bargain rates? Should they shop for medium-priced management, or search for the best possible men who demand top salaries? As in everyday life, the best is often the cheapest in the long run.
The stockholder must hire the men who do the actual work for him. He is aware that the mistakes of corporate executives can consume a large percentage of net income or even eliminate it altogether. On the other hand, the right men may earn large profits and greatly enhance the value of the corporation. Depending on the size of the business, the selection of management may mean a difference of millions of dollars in profits or losses, which emphasizes the importance of the right management.
In the history of the automobile industry the stockholders of dozens of independent companies had this choice to make. Many of them chose management at bargain rates — and lost their investments when the companies fell by the wayside. The managerial salaries in those cases, no matter how low, proved to be no bargains after all. At the same time, the obscure and failing Maxwell-Chalmers Corporation hired Walter P. Chrysler who built it into one of the big three of the industry. His compensation, no matter how high, constituted a real bargain to the corporate owners.
Not only the owners but also the workers gain from superior management. Contrary to much union propaganda, the workers’ interests are served best under superior management. Wages tend to be higher in a profitable and expanding enterprise than in a failing one. Fringe benefits are higher and jobs more secure. Rejoicing about cheap management can be very shortsighted — and short lived.
Finally, there are the consumers who, indirectly at least, demand efficient management. Production efficiency makes for better and cheaper products which can meet the pressures of competition.
Corporations Must Compete for Management
The important problem of executive remuneration is to attract and hold the best men. The value of a company is determined by the men who run it and work for it.
The corporation need not necessarily pay the total amount which good management adds to net worth. What must be paid to attract and hold the men may constitute merely a fraction of the amount they actually earn for the corporation.
In bidding for managerial services in the executive labor market, each corporation acts in competition not only with all other existing corporations but also with the opportunities for the manager to organize a business of his own. Of course, this competition is reflected not only in salaries but also in pensions, bonuses, and other benefits. And the calculations are in terms of net salaries and net benefits after taxes.
In order to attract a man from other employment a corporation usually must outbid its corporate competitors. And in order to hold its man the corporation must pay him at least as much as he could earn in other employment.
To move from one employment to another involves a serious decision. It often entails a change of residence which is both inconvenient and costly. The home may have to be sold, perhaps at a loss. Children may have to change schools, and many other problems arise through resettlement. It is obvious that the net inducement in the form of higher salary or advancement must be great enough to exceed the disadvantages of such a move.
Confiscatory Taxes Have Leverage Effect
Let us assume that a net salary improvement of $5,000 annually will induce an executive to move to a different community to work for a different company. And assume further that the man is in the 80 per cent income tax bracket. Therefore, his $5,000 net raise will cost the company $25,000, with $20,000 going to the government and $5,000 to the executive. If he should be in the 90 per cent tax bracket, the corporation would have to boost his gross salary by $50,000 in order to attract him. The question is whether or not the new executive will add at least the gross amount of his remuneration to the company output. A skilled executive who adds millions to the net worth of his company undoubtedly meets this condition.
The large salary figures often criticized by labor union leaders are the inevitable result of the progressive taxation of large incomes. Without this taxation the net salary that suffices to attract and hold the executive would constitute the total salary. The government share in the executive salary would remain in the company as profit. Of course, such an economy without income taxes would allow rapid capital accumulation and business expansion which in turn would intensify corporate bidding for executives and thus raise their remunerations. But it is doubtful that salaries soon would reach the present figures which are so largely conditioned by progressive taxation.
We are assuming here that capable executives who are the entrepreneurs in a corporation add far more to the output of the business than their own employment costs. This assumption seems justified in the light of corporate experience. Walter P. Chrysler’s salary, for instance, undoubtedly was merely a fraction of the net worth he added to the company.
As we have said, competition largely determines how much the corporation has to pay for a good manager. When an executive is hired, his future contribution can merely be estimated. Economic prudence therefore requires that he be paid merely the amount that suffices to induce him to accept employment. This minimum is determined by competition in the executive labor market. Once he proves to be a capable entrepreneur who adds profits to the company, his remuneration tends to go up. For the corporation now must increase his remuneration lest he accept employment with a competitor who also recognizes his ability to create profits.
To avoid the leverage effect of confiscatory taxation on executive salaries, often involving tax rates higher than the corporation otherwise would have to pay on profits, many companies resort to forms of remuneration that are taxed at lower rates. For instance, they may grant purchase options that give executives the right to buy from the company a certain number of shares of stock at prices that are lower than the market price. Besides the tax advantage, this method has an additional attraction. The executive becomes co-owner, giving him new incentives for doing his utmost in the service of the company.
Company Profits Set Salary Ceilings
The upper limit of an executive salary ultimately is determined by the profits which his employment yields to the company. The executive’s productive contribution minus his employment costs constitute this profit on his employment. This explains why an executive is apt to be replaced as soon as another executive can be found whose productive contribution minus his employment costs yields a larger profit to the company. The new man may be more productive for the same money, or equally productive for less money, or in some other way afford the company the maximum profits on his employment, which is the major factor that determines the executive selection.
Of course, these economic principles of the determination of executive salaries are moderated and may be frustrated by personal factors, such as ignorance, inertia, friendship, hopes and illusions, and other feelings.
The Case of Poor Management
We have been discussing superior management and its compensation, but must not neglect the cases of poor management which undoubtedly exist. Inferior management is apt to make costly mistakes and inadvertently inflict losses on the company. It is obvious that the services of such executives are not worth the salaries they are paid. In other words, their productive contributions are worth less than their costs. Prudent corporate owners will dismiss them without delay.
To unseat an inefficient management of a huge corporation is difficult when hundreds of thousands of stockholders are involved. It may be that no one man or group owns enough shares to exert working control. In this case, stockholders seem to have only the choice of selling their securities. Such selling or shunning of shares may result for the time being in lower price-earnings ratios and higher yields on the stock. But in that event, various promoters and speculators may see an opportunity for unseating the inefficient executives through soliciting the support of dissatisfied stockholders. They wage costly proxy fights and occasionally succeed in obtaining working control.
But modern interventionism with its confiscatory taxation even hampers this last safeguard for efficient management. Proxy fights are very costly. Without assurance of success they may consume hundreds of thousands of dollars of a man’s own funds. Few men still can dare to lose these sums for the sake of corporate control, the eventual fruits of which they must again share with the government. Therefore, proxy fights have become relatively infrequent, and inefficient management may stay in office indefinitely. Thus does interventionist government encourage and perpetuate inefficient management.
Executive salaries ultimately are determined and paid by the consumers. Through buying or abstention from buying, consumers determine which corporations are to earn profits or suffer losses. They determine the remuneration of Frank Sinatra, Marilyn Monroe, and Rocky Marciano. And they also determine and pay the workers’ wages as well as the executive salaries at General Motors and U.S. Steel.
Ideas On Liberty
The Search for Profits
It is the search for profits which governs the whole delicate fabric of capitalist society. In a capitalist economy if mines are sunk and ores and minerals worked, if trains run along the railways and ships plough their way across the ocean, if iron is beaten at the forge and steel rolled at the mills, if fibers are spun and textiles woven at the loom, it is in order that some person or group of persons may make a profit. It is true that they can make a profit only by satisfying a demand; and the search for profits has in the course of centuries wonderfully enriched and widened the life of men.
Ivor Thomas, Socialism and Communism