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.
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 tendency of corporations to use capital to increase shareholder value, rather than investment in the company. As Meyerson writes, investment has slowed down significantly while earnings have been funneled at an increasing rate towards shareholders through stock repurchases (which increase stock price with artificial demand) and dividend payments. The prioritization of shareholder payouts over investment puts a damper on job creation and wage increases, and makes it harder for traditional monetary policy to stimulate the economy. So why the dramatic shift in corporate cash flow 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 capital to stock repurchases and dividends to increase stock prices in the short run.
The trend has troubling implications for the economy. Undoubtedly, declining corporate investment means slower growth in output and employment. But more importantly, if companies aren’t allocating capital to investment, then monetary policy is somewhat crippled. A paper published by The Roosevelt Institute found that in the 60’s and 70’s, an additional dollar of corporate borrowing or earnings led to a 40-cent increase in investment. Today, that same dollar leads to less than 10 cents of new investment. That means that stimulating borrowing with low rates has had an increasingly diluted effect on actually stimulating investment. So it may be time for regulators to re-think whether performance-based compensation is really in the best interest of shareholders – the shift in corporate capital seems to suggest otherwise.