A CEO Pay Cap Would Cap The Welfare Of All

Dani Bolt September 5, 2016 1
A CEO Pay Cap Would Cap The Welfare Of All

The share of national income going to top CEOs is going up and up. Government intervention to restrict this commits twin errors of assuming that rising pay at the top is an unwarranted endemic and assuming that intervention seeking to constrain pay at the top will necessarily improve the labour market opportunities of those at the bottom. Neither of these assumptions holds true. Governments trying to restrain CEO pay will hamper economic growth whilst simultaneously doing much damage to the living standards of those at the bottom of the earnings distribution.

A recent Institute of Economic Affairs publication by Ryan Bourne and Professor Len Shackleton reviewed a series of damaging changes proposed by those across the political spectrum. This included Jeremy Corbyn’s plan to “institutionalise fairness” by setting a maximum pay ratio between CEOs and the lowest paid worker and a proposal from the High Pay Centre that publicly listed firms in the United Kingdom should be forced to publish data on the ratio of CEO pay to median earnings. It concluded that concern over inequality at the top end of the pay distribution would be better dealt with by “a fundamental simplification of income tax to eliminate exemptions, loopholes and tax shelters” which would also work to affect other high–earning individuals such as private equity investors, business owners and celebrities.

Before exploring the potential harm that the proposed regulations could inflict, it is first interesting to challenge the idea that rising CEO pay necessitates regulation at all. Many politicians argue that extreme income inequality at the top is a symptom of some terrible corrosion of societal morals, holding back growth and damaging the life chances of those at the bottom. These claims are simply unfounded. The OECD found no evidence that “those with high incomes pulling away from the rest of the population harms growth”.

Conversely, rising CEO pay is actually associated with increasing firm value. When former Prudential Chief Executive Tidjane Thiam announced his move to Credit Suisse, the total value of their shares rose by £2 billion. The high pay earned by Thiam was clearly deemed worth it by shareholders. Increasing pay at the top is a reflection of an increase in the (perceived) value added. It has not caused those at the bottom to get any poorer. Why should the government intervene?

Attempts to regulate or cap CEO pay could seriously damage economic growth. Switzerland dodged a bullet by voting overwhelmingly against a reform that would see CEO pay capped to twelve times that of the lowest paid worker in the firm. Jeremy Corbyn’s proposal that the UK should adopt similar regulation is a plan to shoot oneself in the foot. There are three obvious ways that businesses can reduce the pay ratio between their cheapest worker and CEO: slashing CEO pay, grossly augmenting the pay of the lowest–paid, and cutting low–paid workers altogether. None benefit the economy.

FTSE–100 CEOs are currently paid almost two hundred times the pay of the average worker. To bring this ratio down via a reduction in CEO pay down to any so–called “sensible” level would require extreme cuts. Since few countries have regulations requiring the publication or capping of such a ratio, in an increasingly globalised market CEOs would simply jump ship.

Top CEOs bring much value to their organisations – such a loss of talent could seriously harm companies. Many businesses would be forced to either relocate to regain access to top executives or shut down altogether. Both responses damage economic growth and result in unemployment, particularly amongst immobile lower–paid employees.

Since a slashing of CEO pay appears unviable, firms might instead reduce their ratio by increasing the pay of the employees at the bottom of the pay scale. Since labour expenses often account for a large portion of business costs, this would be hugely damaging to a business’s profits. Furthermore, for competitive companies with large numbers of employees, the extent of wage augmentation needed would simply be unfeasible. Increasing the wages of those at the bottom of the wage ladder would lead to increases right up it to ensure some extent of differential pay based on value. This would be extremely expensive.

To add to this, a cap on the ratio would severely restrict the size of these value–based differentials, crushing incentives for workers to add to their human capital or encouraging higher–value workers to move abroad where regulations would less stringent, enabling them to earn fairer wages. Regardless, in the long–run, workers cannot be paid significantly above the value they add to a business. If firms are forced to pay some workers more than their value it is likely that other workers will pay the price: unemployment.

It would clearly be difficult for businesses to artificially manipulate their ratios by cutting CEO pay or increasing the wages of the lowest–paid workers. This means that many companies would likely be forced to take the uncomfortable step of making workers redundant. There is already a huge shift towards the mechanisation of work; the laws and requirements proposed above would unnecessarily and inefficiently speed up this process. Low–paid jobs would be outsourced or removed altogether. This would increase unemployment, with the bulk of displaced workers being the less–educated. Such a policy would not help the low–paid or the well–paid. It would help noone.

Bourne and Shackleton conclude that a war against high CEO pay would both be unsuccessful and highly detrimental, causing “collateral damage” across the economy. Basic populist rhetoric on the topic skates over many of the important issues and so should not form the foundations for effective policy design. They state that the government should not extend requirements on firms to publish data on executive pay. If, despite the overwhelming evidence suggesting otherwise, high pay is felt to be a problem, “it should be dealt with through simplifying the tax system and eliminating loopholes” not through rules and regulation which leave everybody worse off.

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