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CEO compensation is not a significant driver of inequality

by / 0 Comments / 89 View / June 24, 2015

A recent blog post in The Wall Street Journal claims that CEO-to-worker compensation has risen, that this gap is a major driver of inequality, and that CEO pay could be regulated down without a drop in performance. This argument is based on a study from the Economic Policy Institute which, despite its name, is not a scholarly research institution, but a liberal think tank. The article contains come questionable premises and severally flawed logic.

Firstly, let’s consider the methodology. CEO compensation is considered for only CEOs of the top 350 corporations in America. This number is compared to “production/non-supervisory workers” (and not all workers, such as middle management, within the company). The result is a CEO-to-worker compensation ratio of 303.4 today, compared with a ratio of of 20 in 1965.

A few red flags should stand out here: calculating CEO compensation for the 350 best paid individuals is hardly representative of “CEO compensation,” even though that condition is buried in a note below the graph. This ignores the many other CEOs of small businesses and start-ups. The EPI estimates compensation for the top 350 CEOs to be about $16.3 million, whereas compensation for all CEOs consists of a $155,492 median salary and bonuses typically in the tens of thousands of dollars (more specifically, total compensation for most CEOs ranges from $72,675 – $411,126). That distinction matters because, even if we took issue with Fortune 500 executives, the vast majority of CEOs are creating value and are rarely fully compensated for their efforts. A recent article from The Wall Street Journal showed that entrepreneurs who graduated from elite universities were actually less satisfied than other entrepreneurs. This is due to the fact that many graduates from highly ranked programs pull in more money landing jobs in management consulting or financial services than do their start-up classmates, without so much of the risk.

Another issue with this methodology is that it ignores (or, at best, misunderstands) economies of scale. Larger businesses run more efficiently, so can therefore pay workers better than smaller operations do. CEOs at a handful of the most profitable corporations in the world are managing a large number of workers in a fairly complex business; owning a local store is simpler. The size and scope of the Fortune 500 companies has grown since 1965, which is a good thing since, in addition to higher CEO compensation, it allows more people to work at better paying jobs.

Lastly, it is deceptive to casually discard supervisory or middle management position in calculating “worker compensation.” Larger and more complex corporations promote more employees into middle management, so a higher percentage of individuals see lucrative compensation packages than they did decades ago.

With flawed methodology comes flawed conclusions. Lawrence Mishel and Alyssa Davis of the EPI write:

The growth of CEO and executive compensation overall was a major factor driving the doubling of the income shares of the top 1% and top 0.1% of U.S. households from 1979 to 2007.

The authors present no serious reasoning to support this conclusion. Currently, there are 149 million working individuals in the US, and about 116 million households: the “top 0.1%” consists of more than 100 thousands households. It is difficult to argue that 350 CEOs significantly shift wealth onto a hundred thousand households, let alone the million household in the top 1%.

Furthermore, there is no rationale presented for why regulating the compensation at a few corporations, other than noting that this particular metric has increased over time, would have no impact on performance. As stated above, CEO compensation for Fortune 500 companies has reasonably increased due to managing more employees in more diverse roles on a scale that did not exist a few decades ago. CEOs are still employees and must perform to keep their jobs. A few months ago, Don Thompson, the CEO of McDonald’s, was replaced because of corporate-wide under-performance. McDonald’s, unsurprisingly, pays out one of the highest packages for its executives. The job is also difficult, and the company has to attract talent that would otherwise accept less demanding positions.

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