Tag Archives: executives

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.