How executive pay regulations can increase inequality – not reduce it

IN JUST two months, Thomas Piketty’s Capital in the Twenty-First Century has taken the world by storm. In it, he argues that substantial increases in inequality can only be reversed through government intervention. Piketty’s own suggestion is a 2 per cent annual wealth tax, and income tax rates of up to 80 per cent.

In this light, the EU’s alternative proposal to reduce inequality – allowing shareholders to vote on the ratio of executive pay to average worker pay in a firm – seems far more modest. It appears almost ridiculous that industry leaders are opposing it. But even though, in my view, reducing inequality is an important social goal, I fear this proposal will do more harm than good.

Growing executive pay has clearly been a contributor to income inequality. But if pay is a reward for creating thousands of jobs, high-quality products that are bought by millions, and billions of pounds of shareholder value – such as with Bill Gates of Microsoft – then society as a whole has benefitted. If everyone gains, then even if executives gain more than others, it’s better than having no-one gain at all – that would be like trying to solve inequality by making everyone equally poor. The problem arises when executives are paid millions despite their firm collapsing. Thus, executive pay should be tightly linked to performance. But this is very different from linking it to average worker pay.

The logic is simple. If pay is tied to performance, an executive will work hard to increase performance. If pay is tied to average worker wages, an executive instead will work hard to increase average worker wages. And this does not necessarily mean that he or she will pay workers more. One way to increase the average worker wage is to fire low-paid workers and replace them with machines. Another is to outsource low-paid jobs overseas, so that they are not part of the firm and thus included in the average. A third, if only full-time employees are counted, is to make low-paid jobs part-time. All of the above responses will increase, rather than reduce, income inequality.

Is the above unrealistic doom-mongering? Unfortunately not. The history of pay regulations is filled with examples of the law of unintended consequences. For instance, in response to a $4.1m golden parachute awarded to William Agee of Bendix, the US capped golden parachutes at three times salary. This led to many companies adopting golden parachutes when they had never had them before, thinking that the government was implicitly approving parachutes of three times salary. Firms also allowed their executives to exercise their options early, to boost their salary and relax the constraint.

A second problem with reporting pay ratios is that it’s not clear what shareholders should do with the information. Is the correct ratio 300, 52.5 plus the rate of inflation, or 27 times the annual stock market return? We just don’t know. An executive and an average worker do different jobs, so they shouldn’t be compared – just like a footballer’s salary shouldn’t be compared to that of a financial controller at his club. Instead, we assess whether a footballer is overpaid by comparing his pay to his performance, and other footballers with similar ability. Similarly, an executive’s pay should be closely scrutinised – but against his or her performance and the pay of other executives.

So should we just give up on helping the average worker? No. Because executives themselves have incentives to treat staff well. A firm that mistreats its workers, through low wages or poor working conditions, will see them walk out the door. Reports of mistreatment will tarnish its reputation, deterring customers. In contrast, my 2011 paper Employee Satisfaction and Equity Prices showed that the 100 Best Companies to Work For in America beat their peers by 2 to 3 per cent over a 26-year period. I also showed that treating workers well leads to superior performance rather than the other way round.

But here’s the snag. I found that the effect of employee welfare takes several years to show up in the stock price. An executive pressured to meet next month’s earnings target may cut wages and employee training. Even though there will be long-run damage, the executive may have moved on and sold his or her shares by then. Thus, the better way to reform pay would be to increase the vesting period of stock and options (e.g. to five years). With a long-term perspective, executives will treat workers like long-term assets. Politicians like to rant about the level of pay, and promising to cap pay at ten times the average salary is much more alluring to voters than increasing its horizon to five years. But it’s the structure of pay that will have the biggest impact on society.

Alex Edmans is a finance professor at London Business School and Wharton. He authors the blog Access to Finance, which aims to make complex finance issues accessible to a general audience. Twitter: @aedmans.