Friday, March 30, 2007
Tweet[IWS] CRS: THE ECONOMICS OF CORPORATE EXECUTIVE PAY [22 March 2007]
IWS Documented News Service
_______________________________
Institute for Workplace Studies----------------- Professor Samuel B. Bacharach
School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies
Cornell University
16 East 34th Street, 4th floor---------------------- Stuart Basefsky
New York, NY 10016 -------------------------------Director, IWS News Bureau
________________________________________________________________________
Congressional Research Service (CRS)
Order Code RL33935
The Economics of Corporate Executive Pay
March 22, 2007
Gary Shorter, Specialist in Business and Government Relations, Government and Finance Division
Marc Labonte, Specialist in Macroeconomics, Government and Finance Division
http://www.opencrs.com/rpts/RL33935_20070322.pdf
[full-text, 40 pages]
Summary
In the past ten years, the pay of chief executive officers (CEOs) has more than
doubled, and the ratio of median CEO to worker pay has risen to 179 to 1. High and
rising executive pay could be an issue of public concern on two different grounds.
First, it is contributing to widening income inequality that may be of concern from
an equity perspective. Second, it could be the result of economically inefficient labor
markets. It is difficult to determine whether executive pay is excessive across the
board since executives' marginal product cannot be directly observed. An upward
trend in pay over time is not sufficient proof that the market is not efficient since
factors determining supply and demand, such as the skills required of the position,
can change over time. To show that pay is excessive from an economic perspective,
one must first demonstrate that there is a market failure that is preventing the market
from functioning efficiently. The market failure could originate in the division in
large modern firms between management and ownership, which is typically dispersed
among millions of shareholders. Shareholders' interests are represented by a board
of directors. Critics of executive pay have argued that boards have all too often been
"captured" by the executive and are no longer negotiating pay packages that are in
the shareholders' best interests. They point to a number of common practices that
they call "stealth compensation" which are inconsistent with arm's length
contracting. These include "golden parachutes," generous severance packages,
company-provided perks, and bonuses that are unrelated to firm performance.
Stock options have been the fastest growing portion of executive pay since the
1990s, and critics believe this pattern can also be explained through the prism of
stealth compensation. Rewarding executives with employee stock options was often
justified in terms of the "pay for performance" mantra, but options are usually
designed to reward absolute, not relative, performance. This means that in the bull
market of the 1990s, when virtually all stock prices were rising, a company could fall
behind its competitors and its executives could still receive handsome options
payouts. Indeed, a sizeable portion of the increase in executive pay in the 1990s was
likely due to options that turned out to be much more valuable than expected because
of the unprecedented price increases of the bull market.
Many of the recent corporate scandals appear consistent with stealth
compensation as well. Stock options backdating, earnings manipulation, and
accounting fraud might have been motivated by attempts to covertly increase
executive pay. If short-term fluctuations in the stock price are not good proxies of
firm performance, then tying compensation to the stock price can create incentives
for executives to engage in activities that are detrimental to shareholders.
Policy proposals mostly focus on improving transparency, increasing board
independence, and strengthening shareholder control rather than attempting to curb
pay directly. H.R. 1257 would give shareholders a nonbinding vote on executive pay.
Another proposal would modify the limit on deductibility of executive pay from
corporate taxation. More broadly, income inequality could be reduced by increasing
the progressivity of the tax system. For current developments and legislation, see
CRS Report RS22604, Excessive CEO Pay: Background and Policy Approaches.
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Data on CEO Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Economics of Executive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
How Executive Compensation Is Set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Executive Pay in the Neo-Classical World . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Principal-Agent Problem and the Free-Rider Problem . . . . . . . . . . . . . . 9
The "Managerial Power" Critique of the Neo-Classical Model . . . . . . . . . 10
Board "Capture" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Stealth Compensation and Outrage Costs . . . . . . . . . . . . . . . . . . . . . . 12
Performance Based Pay: Part of the Solution or Part of the
Problem? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Executive Pay in the 1990s: Being in the Right Place at the Right Time? . 21
Can "Excessive Pay" Be Empirically Measured? . . . . . . . . . . . . . . . . . . . . 23
A Brief History of the Regulation of Executive Pay . . . . . . . . . . . . . . . . . . . . . . 25
The Omnibus Budget Reconciliation Act (OBRA) of 1993's Cap
on the Deductibility of Executive Compensation . . . . . . . . . . . . . . . . 26
The Sarbanes-Oxley Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Requirement that Shareholders Approve Equity-Based Compensation
Plans for NYSE and Nasdaq Listed Firms . . . . . . . . . . . . . . . . . . . . . . 27
Requirement that NYSE-Listed Companies Have Compensation
Committees Solely Composed of Outside Directors . . . . . . . . . . . . . . 27
FASB's Options Accounting Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
SEC Rules on Disclosure of Executive Pay . . . . . . . . . . . . . . . . . . . . . . . . . 28
Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Maintain the Status Quo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Eliminating or Significantly Restricting OBRA . . . . . . . . . . . . . . . . . . . . . 30
A Cap on the Deductibility of Executive Pay When It Exceeds a
Certain Ratio of Non-Managerial Pay . . . . . . . . . . . . . . . . . . . . . . . . . 31
Disclosure of Corporate Services Provided by Firms Affiliated with
Compensation Consultants or a Ban on Such Services . . . . . . . . . . . . 32
Increase Shareholder Roles in the Election of Board Members . . . . . . . . . . 32
Give Shareholders a Non-binding Vote on Executive Pay . . . . . . . . . . . . . 34
Increase the Progressivity of the Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . 34
Appendix. A Primer on Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
List of Figures
Figure 1. Median CEO Pay at the 350 Largest Publicly-Held Companies . . . . . . 5
Figure 2. S&P 500: Actual and Projected Based on Historical Average,
1995-1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
______________________________
This information is provided to subscribers, friends, faculty, students and alumni of the School of Industrial & Labor Relations (ILR). It is a service of the Institute for Workplace Studies (IWS) in New York City. Stuart Basefsky is responsible for the selection of the contents which is intended to keep researchers, companies, workers, and governments aware of the latest information related to ILR disciplines as it becomes available for the purposes of research, understanding and debate. The content does not reflect the opinions or positions of Cornell University, the School of Industrial & Labor Relations, or that of Mr. Basefsky and should not be construed as such. The service is unique in that it provides the original source documentation, via links, behind the news and research of the day. Use of the information provided is unrestricted. However, it is requested that users acknowledge that the information was found via the IWS Documented News Service.
Stuart Basefsky
Director, IWS News Bureau
Institute for Workplace Studies
Cornell/ILR School
16 E. 34th Street, 4th Floor
New York, NY 10016
Telephone: (607) 255-2703
Fax: (607) 255-9641
E-mail: smb6@cornell.edu
****************************************
_______________________________
Institute for Workplace Studies----------------- Professor Samuel B. Bacharach
School of Industrial & Labor Relations-------- Director, Institute for Workplace Studies
Cornell University
16 East 34th Street, 4th floor---------------------- Stuart Basefsky
New York, NY 10016 -------------------------------Director, IWS News Bureau
________________________________________________________________________
Congressional Research Service (CRS)
Order Code RL33935
The Economics of Corporate Executive Pay
March 22, 2007
Gary Shorter, Specialist in Business and Government Relations, Government and Finance Division
Marc Labonte, Specialist in Macroeconomics, Government and Finance Division
http://www.opencrs.com/rpts/RL33935_20070322.pdf
[full-text, 40 pages]
Summary
In the past ten years, the pay of chief executive officers (CEOs) has more than
doubled, and the ratio of median CEO to worker pay has risen to 179 to 1. High and
rising executive pay could be an issue of public concern on two different grounds.
First, it is contributing to widening income inequality that may be of concern from
an equity perspective. Second, it could be the result of economically inefficient labor
markets. It is difficult to determine whether executive pay is excessive across the
board since executives' marginal product cannot be directly observed. An upward
trend in pay over time is not sufficient proof that the market is not efficient since
factors determining supply and demand, such as the skills required of the position,
can change over time. To show that pay is excessive from an economic perspective,
one must first demonstrate that there is a market failure that is preventing the market
from functioning efficiently. The market failure could originate in the division in
large modern firms between management and ownership, which is typically dispersed
among millions of shareholders. Shareholders' interests are represented by a board
of directors. Critics of executive pay have argued that boards have all too often been
"captured" by the executive and are no longer negotiating pay packages that are in
the shareholders' best interests. They point to a number of common practices that
they call "stealth compensation" which are inconsistent with arm's length
contracting. These include "golden parachutes," generous severance packages,
company-provided perks, and bonuses that are unrelated to firm performance.
Stock options have been the fastest growing portion of executive pay since the
1990s, and critics believe this pattern can also be explained through the prism of
stealth compensation. Rewarding executives with employee stock options was often
justified in terms of the "pay for performance" mantra, but options are usually
designed to reward absolute, not relative, performance. This means that in the bull
market of the 1990s, when virtually all stock prices were rising, a company could fall
behind its competitors and its executives could still receive handsome options
payouts. Indeed, a sizeable portion of the increase in executive pay in the 1990s was
likely due to options that turned out to be much more valuable than expected because
of the unprecedented price increases of the bull market.
Many of the recent corporate scandals appear consistent with stealth
compensation as well. Stock options backdating, earnings manipulation, and
accounting fraud might have been motivated by attempts to covertly increase
executive pay. If short-term fluctuations in the stock price are not good proxies of
firm performance, then tying compensation to the stock price can create incentives
for executives to engage in activities that are detrimental to shareholders.
Policy proposals mostly focus on improving transparency, increasing board
independence, and strengthening shareholder control rather than attempting to curb
pay directly. H.R. 1257 would give shareholders a nonbinding vote on executive pay.
Another proposal would modify the limit on deductibility of executive pay from
corporate taxation. More broadly, income inequality could be reduced by increasing
the progressivity of the tax system. For current developments and legislation, see
CRS Report RS22604, Excessive CEO Pay: Background and Policy Approaches.
Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Data on CEO Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Economics of Executive Pay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
How Executive Compensation Is Set . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Executive Pay in the Neo-Classical World . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Principal-Agent Problem and the Free-Rider Problem . . . . . . . . . . . . . . 9
The "Managerial Power" Critique of the Neo-Classical Model . . . . . . . . . 10
Board "Capture" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Stealth Compensation and Outrage Costs . . . . . . . . . . . . . . . . . . . . . . 12
Performance Based Pay: Part of the Solution or Part of the
Problem? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Criticisms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Executive Pay in the 1990s: Being in the Right Place at the Right Time? . 21
Can "Excessive Pay" Be Empirically Measured? . . . . . . . . . . . . . . . . . . . . 23
A Brief History of the Regulation of Executive Pay . . . . . . . . . . . . . . . . . . . . . . 25
The Omnibus Budget Reconciliation Act (OBRA) of 1993's Cap
on the Deductibility of Executive Compensation . . . . . . . . . . . . . . . . 26
The Sarbanes-Oxley Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Requirement that Shareholders Approve Equity-Based Compensation
Plans for NYSE and Nasdaq Listed Firms . . . . . . . . . . . . . . . . . . . . . . 27
Requirement that NYSE-Listed Companies Have Compensation
Committees Solely Composed of Outside Directors . . . . . . . . . . . . . . 27
FASB's Options Accounting Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
SEC Rules on Disclosure of Executive Pay . . . . . . . . . . . . . . . . . . . . . . . . . 28
Policy Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Maintain the Status Quo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Eliminating or Significantly Restricting OBRA . . . . . . . . . . . . . . . . . . . . . 30
A Cap on the Deductibility of Executive Pay When It Exceeds a
Certain Ratio of Non-Managerial Pay . . . . . . . . . . . . . . . . . . . . . . . . . 31
Disclosure of Corporate Services Provided by Firms Affiliated with
Compensation Consultants or a Ban on Such Services . . . . . . . . . . . . 32
Increase Shareholder Roles in the Election of Board Members . . . . . . . . . . 32
Give Shareholders a Non-binding Vote on Executive Pay . . . . . . . . . . . . . 34
Increase the Progressivity of the Tax Code . . . . . . . . . . . . . . . . . . . . . . . . . 34
Appendix. A Primer on Stock Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
List of Figures
Figure 1. Median CEO Pay at the 350 Largest Publicly-Held Companies . . . . . . 5
Figure 2. S&P 500: Actual and Projected Based on Historical Average,
1995-1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
______________________________
This information is provided to subscribers, friends, faculty, students and alumni of the School of Industrial & Labor Relations (ILR). It is a service of the Institute for Workplace Studies (IWS) in New York City. Stuart Basefsky is responsible for the selection of the contents which is intended to keep researchers, companies, workers, and governments aware of the latest information related to ILR disciplines as it becomes available for the purposes of research, understanding and debate. The content does not reflect the opinions or positions of Cornell University, the School of Industrial & Labor Relations, or that of Mr. Basefsky and should not be construed as such. The service is unique in that it provides the original source documentation, via links, behind the news and research of the day. Use of the information provided is unrestricted. However, it is requested that users acknowledge that the information was found via the IWS Documented News Service.
Stuart Basefsky
Director, IWS News Bureau
Institute for Workplace Studies
Cornell/ILR School
16 E. 34th Street, 4th Floor
New York, NY 10016
Telephone: (607) 255-2703
Fax: (607) 255-9641
E-mail: smb6@cornell.edu
****************************************
# posted by SBasefsky : 4:54 PM
