The Unintended Consequences of an Attempt to Reign in Executive Pay

Thesis: The current tax code has created an incentive for management to focus corporate profits on short-term stock-boosting strategies rather than long-term investment, and thus is a contributing factor to the stagnation of wages in the US.

One of the most troubling issues facing economists studying the United States has been the stagnation in wage growth over the past few decades.  Common wisdom would dictate that as marginal productivity of labor rises, so would wages.  As evidenced by the graph below, courtesy of the Economic Policy Institute, this was the case for some 25 years during the US postwar boom era, but beginning in the 1970’s, wages began to flatten out as productivity continued to rise.

wage growth

 

Economists have attributed this trend to a handful of factors: rapid globalization creating a massive increase in competition in the labor force, technological improvements reducing the supply of jobs, erosion of large-scale union power, and more recently, rising health care costs to employers.  In a recent opinion piece in the Washington Post, Harold Meyerson has added a new factor to the discussion: the recent trend by corporations of using profits to increase shareholder value, rather than re-investing them into the company.  As Meyerson writes, investment has slowed down significantly while earnings have been funneled towards shareholders through stock repurchases (which increase stock price with artificial demand) and dividend payments.  The resulting lack of new value creation and growth has put a damper on job creation and wage increases.  So why the dramatic shift in corporate profit allocations?  I would argue that the single biggest driving force is the rise in stock-based compensation packages for executives.

A little background on the concept of stock-based compensation: in 1993, facing pressure from institutional investors and in an effort to limit the rise of executive compensation, Bill Clinton created section 162(m) of the IRS tax code (wiki), which stated that companies could only deduct the first $1 million of executive pay.  However, the code included a provision that excluded performance-based pay, which is why we see the executive compensation packages we have today: a seemingly meager base salary, under $1 million, with substantial stock options that make up the bulk of pay.  In theory, there are certainly some benefits to stock-based compensation: they help ensure that management’s actions are in line with shareholder goals, as executives have a vested interest in the company’s performance.  But there are two sides to this coin.  Since executives receive such an overwhelming portion of their pay via equity, they have an incentive to boost the company’s stock prices even when it might not be in the best long-term interest for shareholders.  The disparity in time horizons between executives and corporations exacerbates this problem: according to the Wall Street Journal, the average CEO’s tenure is just 9.7 years, meaning that executives rarely stick around long enough to see the company benefit from gradual growth and investment.  Instead of re-investing earnings, an executive is better off allocating profits to stock repurchases and dividends to increase stock prices in the short run.  And the resulting benefits to shareholders contributes less to the economy than continual re-investment would – since the wealthiest 10% of households own 84.5% of US financial assets (source: Fed data on inequality.org), the impact of these shareholder-focused actions have a disproportionate effect on public welfare.  So it may be time for regulators to re-think whether performance-based compensation is really in the best interest of shareholders – the lack of corporate profits being re-invested seems to suggest otherwise.

7 thoughts on “The Unintended Consequences of an Attempt to Reign in Executive Pay

  1. Yichuan Wang

    Wait, what evidence do you have that increasing payouts and buying back stock is bad for shareholder value? In the flagship study of shareholder activism, they find that one of the key issues that most shareholders fight for is an increase in shareholder payouts because that induces better governance. The CEO is no longer able to just sit on a pile of cash and invest it on potential boondoggles, rather she is forced to return cash to the shareholders and, in the case that there are productive investments to be made, raise equity from the same shareholders. This is just shareholder democracy at work.

    1. luctommo@umich.edu'Lucas Morrison Post author

      I’m not arguing that dividend increases nor share buybacks decrease shareholder value. In fact, that is a key assumption in my argument as that is exactly what executives have realized. My argument is that these are actions which will increase share value, but in a completely artificial way that does not bode well for the long term.

      1. Yichuan Wang

        Your argument is that dividend increases lead to a *predictable* decline in long term firm value. In concrete terms, this means that dividend increases lead to a *predictable* increase in current price with a *predictable* decline in prices in the future. A couple of problems.

        1. This seems like a great trading opportunity. Why is not arbitraged in the market already?
        2. What evidence do you have that this relationship between payouts and long term growth is causal? Suppose an executive knows that their industry is in decline. Then it’s no longer worthwhile to plow more money from shareholders into building new plants because the return on capital is too low. The optimal response would be to return the money to shareholders through buybacks + dividend payments. As such, dividend payouts may be the best alternative to management blowing all the money on useless plants.

        For another take on this, see this article which discusses the GM share buybacks

        http://aswathdamodaran.blogspot.com/2015/03/the-gm-buyback-beyond-hysteria.html

  2. Israel Diego

    Remember from your Econ 452 class that wages increase because of an increase in current capital stock or total factor productivity, which shifts your marginal productivity of labor curve and thus increases wages 😉 In the graph above, I think you are alluding to an increase in total factor productivity. There is kind of a disconnect in the blog, because you talk about typical worker wages, but then shift to talking about management. I don’t think you can compare typical workers to management as the relationship of wages between management and typical workers is not one-to-one.

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