The growing gap between CEO and median worker pay is often cited as evidence of capitalism run amok. Free market critics claim it’s yet more evidence capitalism is corrupt and must be ended as soon as possible. But this mindset misunderstands the market forces governing CEO pay, and it’s also, at its core, a moral proclamation masquerading as an economic critique.
It also leads to all sorts of bad policies.
For example, legislation that would tax companies based on the gap between CEO-to-average-worker pay is currently working its way through California’s Senate. Backers of the bill, unsurprisingly, see pay inequality as proof that discrimination and exploitation has taken place. But these kinds of bills ignore labor markets, differing sectors, business models, and other relevant metrics in calculating wages.
CEO Pay: Fact and Fiction
While it’s true that CEO compensation has grown tremendously since the 1970s, it doesn’t even begin to tell the whole story. Economists Xavier Gabaix and Augustin Landier conducted a study on CEO pay, in which they found that the six-fold increase from 1980-2003 coincided with the six-fold increase in market-capitalization of large companies throughout that period. In other words, CEO pay is largely tied to the value of the company, not at the expense of the company. This, of course, also works the other way. In a later study focusing on CEO pay trends during the Great Recession, it was found that executive compensation declined at a similar rate as firm valuation. These results reflect market forces working properly.
Another factor to consider, as economist Tyler Cowen points out, is the changing role of the modern CEO. Expertise in the industry is no longer sufficient for a CEO. Now, and increasingly more, CEOs must be attuned to broader market forces, global supply chains, geopolitical affairs, and emerging technology. More importantly, with the advent of social media and the 24-hour news cycle, even the most introverted CEOs have to be adept at public relations.
Put simply, much more is demanded of CEOs these days.
This isn’t to suggest that there aren’t egregious examples of overpaid CEOs, but the most intelligible critique of CEO pay growth is actually one of an agency cost. That is, the CEO is extracting wealth from the value of the company by pursuing goals that maximizes executive compensation, rather than what’s best for the corporation. And, even then, that has to be supported with stronger evidence than mere observations of an increased salary.
Presuming misconduct without evidence can lead to misguided regulatory fixes. Take, for example, the “say-on-pay” mandates included in the 2010 Dodd Frank Act. These mandates required most public companies to hold an advisory shareholder vote on executive compensation a minimum of once every three years. But what was supposed to be a check on corporate governance only further exacerbated the problem that Congress sought to address.
As it turns out, labor unions, through stock holdings of employee pension funds, have played a central role authorizing lucrative executive packages. In fact, according to legal policy website Proxy Monitor, labor unions have been influential in advancing 48 percent of these executive compensation package proposals to shareholders.
Shareholders approve 98.5 percent of them.
More concerning, shareholder proposals authorizing political spending has largely been backed by labor union-affiliated funds. This has led the US Department of Labor to suggest that these proposals might be governed by “personal, social, legislative, regulatory, or public policy agendas,” rather than enhancing the value of the company. All this to say: this is a classic case of regulatory capture. As a result of a more expansive regulatory regime, highly-influential labor unions can more effectively groom their CEO’s to protect labor initiatives and back their political candidates, while paying them quite handsomely in the process.
This, of course, is what often happens when careful policy-making becomes secondary to an impetus to change economic outcomes. Until recently, wage growth was commonly understood to reflect productivity gains in the economy. But now many people—including former labor secretary Robert Reich—believe that worker wages should grow in proportion to CEO compensation, regardless of market forces. Higher-skilled workers’ productivity, however, has far outpaced the productivity gains of lesser-skilled workers in recent years.
This is a concerning trend, but the most plausible explanations don’t involve payment structures within firms at all. Rather, this phenomenon can be explained by the fact that technological advancements have overwhelmingly benefited higher-skilled sectors, and also that there is a decreasing demand for goods-producers in an increasingly service-based economy.
Some solutions might involve regulatory reforms designed to allow sectors employing lesser-skilled workers to more easily integrate technological advancements. Reforming the education system to better match the demands of the 21st century labor market would go a long way, too. But these solutions require a lot more work than just selling everyone the narrative that greedy CEOs hoard their wealth.
It’d be nice if people would actually take the time to understand the market forces at work in economic decisions before proclaiming that something underhanded is going on. But, as the famed economist Thomas Sowell once put it, “the first lesson of economics is scarcity: there is never enough of anything to fully satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.”