CEO pay, equity and efficiency

The Associated Press and the executive compensation data analysis firm Equilar on May 27 released new data showing a new high for executive pay. The median Chief Executive Officer, or the CEO exactly in the middle of the income distribution, made $10.5 million in 2013, an almost 9 percent increase from the year before according to their data.

For most Americans that level of pay and such a sizeable increase in annual pay is outside the realm of everyday comprehension.  But is this rising pay for executives a major contributor to rising inequality? And if so, is it necessary for a well-functioning company?

The level of CEO pay reported by the AP and Equilar would certainly put most CEOs in the top 0.1 percent of earners. Looking at 2012, the most recent year for which comparable data are available, we can compare CEO pay to the overall income distribution compiled by economists Emmanuel Saez at the University of California-Berkeley and Thomas Piketty of the Paris School of Economics. The median CEO pay of $9.6 million a year would have put these top earners well above the threshold for the top 0.01 percent, $7.2 million.

CEO pay may put them among the ranks of the top 0.1 percent, but are they a significant share of that group? Research by economists Jon Bakija of Williams College, Adam Cole of the tax analysis division of the U.S. Treasury Department, and Bradley Heim of Indiana University uses tax data to map out the occupations of the top 1 percent and the top 0.1 percent of earners. They find that executives are a large portion of these top groups. In 2005, the most recent year they analyze, executives, managers, and supervisors were 30 percent of the top 1 percent and 42.5 percent of the top 0.1 percent. That occupation group doesn’t include managers from the financial sector. Professions from the financial sector, including managers, were another 13.2 percent of the 1 percent and 18 percent of the top 0.1 percent.

The data are quite clear that executives are highly paid, but how much of this pay reflects superior talent and skills? If CEOs, for lack of a better word, deserve this pay then the high salaries are the results of an efficient system. Saying how much a CEO is worth, however, is a tricky business. There is evidence that CEOs as a class are overpaid in one particular industry. Economists Marianne Bertrand of the University of Chicago and Sendhil Mullainathan of Harvard University show that CEO pay in the oil-and-gas industry is just as responsive to upticks in business fortunes due to luck or to random rises in oil prices, as to upticks in fortunes due to skill.

If CEOs are being rewarded for events they are not responsible for, then there must be a process outside of rewards for productivity going on. Betrand and Mullainathan argue that their result is evidence of the capture of the pay-setting process by CEOs.

If CEO pay is indeed the result of an inefficient captured-compensation system then a more open system could be more efficient. Calls for reforming executive compensation may be grounded in concerns about equity but they may end up boosting the efficiency of our economy as well.