Pay Bosses More!

February 23, 2007 • Commentary
This article appeared in The Wall Street Journal on February 23, 2007.

On a recent visit to the floor of the New York Stock Exchange, President Bush saw fit to decry the rising inequality in America, complaining that corporate salaries, bonuses and stock options were part of the problem. “We need to pay attention to the executive compensation packages that you approve,” he told the audience.

With all due respect: nonsense. Excessive executive compensation harms no one but perhaps the stockholders who put up with it. And stockholders put up with it because there’s good reason to believe that sizable CEO compensation packages help — not harm — corporate performance, which redounds to their benefit, and that of the firms’ workers.

A 1997 study by Harvard economists Brian Hall and Jeffrey Leibman examined 15 years worth of data relating to CEO pay and corporate performance. Messrs. Hall and Leibman found that, for 1994, every additional dollar given to a CEO translated into an average return of $3.90 for the company. While subsequent studies have highlighted the ambiguities associated with studies like this, the evolution of CEO compensation arrangements strongly suggests that corporate boards are increasing compensation packages for a reason — to improve performance.

It helps to step back and think of the salaries, bonuses and stock options offered to corporate executives as simply one of many inputs required to produce goods and services. In this case, it’s a subset of total labor costs. Now ask yourself: What difference does it make to you if Target overcompensates its clerks? Applebee’s its line cooks? Ford its auto workers? After all, executive pay — as a percentage of total labor costs — is small potatoes compared to these line items in the average corporate budget.

If companies overpay for labor and don’t get more productivity as a result, they provide a competitive window of opportunity for rivals that don’t. Companies that spend inefficiently to deliver goods and services will be forced to adjust policy or die, so the problem, if it exists, is self‐​correcting.

If you’re a stockholder, it’s certainly worth worrying about your company’s labor costs. But if you’re not, getting worked up about that company’s executive compensation package is little different than getting worked up about the fact that some company is paying too much for copy paper. Maybe so, maybe not — but what’s it to you?

But doesn’t exorbitant executive pay harm employees? If corporate boards throughout the economy are inclined toward extravagant compensation packages, so the reasoning might go, the price for executive talent goes up. And if corporate dollars are fixed, more money for the boss means less money for you.

Intrafirm compensation is not a zero‐​sum game. If high compensation could improve executive job performance by even a little bit (say, by attracting better executives or providing incentives for better management), then the difference to a company’s bottom line could be huge. That’s obviously what corporate boards are hoping to accomplish with these lavish executive compensation packages, and if it works as intended, it makes lower income employees richer as a consequence. The better a corporation performs, the more it can pay employees, the more labor it can employ, and the more job security it can provide.

Companies pay workers what they must to deliver their products and services to the market, and supply and demand establishes executive compensation packages the same way it establishes consumer prices. Any overcompensation comes out of the firm’s bottom line — at a loss to the shareholders, not the workers.

The inference from Mr. Bush’s statement — that rising CEO pay is fueling income inequality — thus begs the question about whether rising CEO pay is improving corporate performance. If it is, then workers might well be better off if CEOs were paid even more. And if it isn’t, then the market will either punish firms that are overpaying for executive talent, or shareholders would lose. To us, the only excess here is the attention politicians are “paying” to the issue.

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