Capping corporate compensation: cathartic, but not efficient

Former Merrill Lynch CEO John Thain probably isn't getting invited to too many parties these days. While his company collapsed and was ultimately bought out by Bank of American a few months ago, Thain contended that he deserved a bonus--a $10 million bonus, that is. Yes, after public outcry he withdrew his request. But his grandiose sense of entitlement has rubbed a recession-addled economy the wrong way.

Executive pay is a hot topic now. With so many people losing their jobs and seeing their savings melt away, the salaries of corporate heads (especially those in the financial industry) seem obscene; so much so, that President Obama has advocated capping executive pay for companies receiving bailout money, and has generally decried the level of corporate compensation.

It's hard to argue with the emotional appeal of corporate salary cuts. Do people really deserve to make tens (or hundreds) of millions of dollars a year? But the economic case for these cuts are not so straight forward. Reed Hastings, CEO of NetFlix, advocates a "tax, not shame policy" towards executive compensation:

"The reality is that the boards of public companies hate overpaying for anything, including executives. But picking the wrong chief executive is an enormous disaster, so boards are willing to pay an arm and a leg for already proven talent. Putting limits on the salaries at public companies, or trying to shame them into coming down, won’t stop this costly competition for talent.

Of course, it’s galling when a chief executive fails and is still handsomely rewarded. But with the concept of “tax, not shame,” a shocking $20 million severance package would generate $10 million for the government. That’s a far better solution than what we have today, not least because it works with the market rather than against it."

Economists generally favor taxes over price caps on the basis of efficiency. Surely some CEO's are worth a lot of money and companies should be allowed to spend extra to attract them. In fact, there is evidence that CEO salaries are tied to improvements in their company's market capitalization, implying that companies (at least sometimes) are getting what they're paying for. This, however, does not explain why US managers do so well relative to their European and Japanese counterparts.

But the larger fallacy in the pay cap argument is that the distribution of gains is between CEOs and shareholders, not CEOs and workers. Capping management salaries will simply put more money in the hands of the corporate board. This may be desierable in and of itself; but it won't do much for the average worker.

The "tax, not shame" policy would certianly do more for the budget deficit than a cap on pay. According to E.J. McMahon, a senior fellow at the (admittedly conservative) Manhattan Institute:

"From a New York perspective, it’s ironic that the Obama administration chose to reveal its bailout compensation cap on the same day that Sheldon Silver, the speaker of our state Assembly, moved closer to endorsing a bigger new “millionaire tax” to help close Albany’s $13 billion budget gap.

If New York’s weakest financial institutions (and who knows what future bailout recipients in other industries) are forced to hold pay to $500,000, Mr. Silver and his colleagues will have fewer million-dollar incomes to tax. This is the sort of unintended consequence that could almost persuade a free-market conservative to embrace the president’s policy. Almost."

As I've written before, the second fundamental welfare theorem says we can use lump-sum transfers (e.g. progressive taxation) to reach a desirable allocation of income. It's a lot less galling to think these gigantic salaries are funding "our soldiers, schools and security".