It is very common for people to complain about executive compensation. Rates of compensation for executives have gone up by more than 900% in the past 40 years. The gap between executive pay and the average pay in a company keeps widening. Many people think that this is unfair and that executives get paid more than they should. In response, many people defend executive compensation as merely being a reflection of the market. Executive decisions are hugely important to the success of a business, the skills to make those decisions well are very rare, and the demands on your time for serving as a corporate officer are very high. Because of these things, the value of the contribution made by executives relative to their competition justifies a far greater rate of pay. In general, I support the stance that you should be able to make market rates for your services even if other people are mad about what that rate is. However, in the case of executive compensation, there is good reason to believe that executives are getting paid far more than the market would justify, and are therefore shorting the investors in an amount that reflects this excessive compensation.
To see why this is, we should start with a problem that is commonly found in government. This year you will pay about $40 in taxes that will be handed to large farm corporations. Why? Because those corporations successfully lobbied for subsidies in that amount to be put into the U.S. Farm Bill. These subsidies are opposed by almost all economists, and once the details of the bill are more fully explained to people, by most people (most people actually support the bill, but also don’t understand what it really does). Suppose you wanted to get the bill changed so you could keep that $40. How much would you be willing to pay to do that? Well, if you’re like most people, you wouldn’t be willing to spend much more than $40 per year, and in fact would probably not be willing to spend even that because you should know that your efforts are unlikely to be successful. So, it’s not in the interests of voters to try to stop handouts like this. On the other hand, it is very much in the interests of special interest groups to pay a lot of money lobbying for handouts from the government because $40 per person adds up quickly.
The problem above occurs whenever there are highly concentrated benefits and dispersed costs. If it is more expensive for each person who is paying the cost to try to fight it than to pay it, then those with the power to impose those costs can typically do so with little fear of facing any consequences. So, how does this apply to executive compensation? Well, the people who are harmed by excessive executive compensation when it is carried out in a publicly traded, profitable company are the shareholders. Shareholders end up with a lower stock price if the executives pocket a percentage of the company’s profits that would otherwise go to them. Shareholders, though, are typically in the position of the average voter. The difference in the share price, the great expense of challenging executive compensation, and the high unlikelihood of winning such a challenge against highly paid corporate lawyers all create the same situation of localized benefits and dispersed costs that created the problem in government. If executives want to skim profits off the top, it isn’t in the interests of shareholders to stop them. But, this amount taken off the top would create a salary that was no longer a reflection of market value.
There are people who realized this would be a problem in the business world. As a result, most companies have a board of directors whose job it is to make sure that shareholder interests are taken care of. However, boards are typically comprised of very highly paid individuals whose salaries are determined by the very executives whose salaries they are supposed to approve of in their role of protecting the shareholders. So, at least in this particular matter, it isn’t in the interest of the board to protect the interests of the shareholders; they can make more by just agreeing to take a higher salary in exchange for approving a higher one for the executives than they could by increasing the value of their own shares in the company. So, there is little reason to think that executives won’t take advantage of this situation to increase their salaries at the expense of shareholders.
There is one piece of evidence that further supports the contention that this is happening. In a privately owned company, it would be owner who would be harmed by the decrease in profits caused by excessive executive compensation rather than the shareholders. Since the costs wouldn’t be dispersed in this situation, and since the owner is far more likely than shareholders to know this was happening, we should expect that executives wouldn’t be able to get away with this very easily in privately owned companies. We should therefore expect a difference in executive compensation between privately owned and publicly traded companies. Of course, managing a publicly traded company is harder, so some difference should be expected, but a very large difference would be good evidence that corporate executives at publicly traded companies are screwing over their shareholders. As it turns out, the average pay for executives in publicly traded companies is double the average pay of their counterparts at privately owned companies. It is very hard to believe that this is fully explained by skill or job complexity. Instead, it appears best explained by the situation described above.