Arguably the most convincing “smoking gun” evidence that CEO pay is excessive is how it’s risen much faster than median worker pay. In the U.S., CEO pay was $10 million, 350 times that of the average worker in 2013, compared to 40 times in 1980. This seems to debunk any argument that CEOs deserve their high pay because of their talent. CEOs in 2013 were not suddenly any more talented (compared to the average worker) than in 1980, so why is the multiple nearly 9 times higher? Instead, the argument is that the CEO has the board in his pocket, and so dictates an outrageous level of pay to the board.
One of the most influential finance papers written this millennium answers this question. It’s by Professors Xavier Gabaix and Augustin Landier*, then at NYU Stern, now at Harvard and Toulouse respectively. It was published in the 2008 Quarterly Journal of Economics; while I typically write about new papers, this paper is extremely relevant to the current debate on pay ratios yet seems to be largely absent from it. The one advantage of writing about an older paper is that we can see that it’s stood the test of time – it has 1,400 Google scholar citations (one measure of impact), and was cited as a major reason for Xavier winning the Fischer Black award for the person under 40 who has contributed most to finance (similar to the Fields Medal in maths).
Their argument is as follows. High pay is justified, not because CEOs have become more talented, but because talent has become more important. It’s helpful to start with an analogy from football (soccer). Most people would agree that Wayne Rooney is not more talented than Pele. Yet, Rooney gets paid far more than Pele ever did, even adjusting for inflation. This high pay is clearly not due to Rooney having Sir Alex Ferguson (who signed him) in his pocket. Instead, it’s because talent has become more important. Football is now a multi-billion dollar industry, due to TV advertising and a global marketplace, unlike in Pele’s time. Even if Rooney is only a tiny bit better than the next-best striker (and, most ordinary people couldn’t tell the difference in a training session), these tiny differences in talent can have a huge effect on Man United’s profits. If Rooney’s goals get Man United into the Champions League, that’s worth many millions. So, it’s worth it paying top dollar for top talent.
Now, let’s translate this from the football pitch to the boardroom. Just as the football industry has got much bigger, so have firms. Firms also now compete in a global marketplace, and technology changes so rapidly that the inability to change with the times can render firms virtually extinct (compare Blackberry with Apple). Thus, just like in football, it’s worth paying top dollar for top talent. Average firm size in the Fortune 500 is $20 billion. Thus, even if a CEO is only a tiny bit more talented than the next best alternative, and contributes only 1% more to firm value, that’s $200 million. Suddenly, his $10 million salary doesn’t seem so outrageous. Moreover, the Gabaix-Landier hypothesis isn’t just an abstract theory; you can test it. Unlike many models that are qualitative, they make quantitative predictions for how much pay should rise when firm size rises. They show that the increase in pay between 1980 and 2003 can be fully explained by the rise in firm size over that time. An update studying 2004-11 shows that subsequent changes were also linked to firm size – in 2007-9, firm size fell by 17%, and CEO pay by 28%.
But, why doesn’t this argument apply to employees? Because the CEO typically has a multiplicative effect on firm value. Their actions are scalable. For example, if the CEO implements a new production technology, or improves corporate culture, this can be rolled out firm-wide, and thus has a larger effect in a larger firm. 1% is $20 million in a $2 billion firm, but $200 million in a $20 billion firm. In contrast, most employees have an additive effect on firm value. Their actions are less scalable. An engineer who has the capacity to service 10 machines creates $50,000 of value regardless of whether the firm has 100 or 1,000 machines. In short, CEOs and employees compete in totally different markets, one which scales with firm size and the other which scales less so. “Fair” CEO pay is determined by comparing a CEO to other CEOs, just like a manager decides how much to pay an international footballer by comparing to another international footballer, not a reserve-team player at the same club (due to notions of “fairness”), or even to the CEO of Man United, as they compete in different markets.
Of course, this all assumes that CEOs actually create value in the first place. We can see Rooney score goals, and how the Man United team is weaker when he’s injured. He’s one of only two strikers. But, the CEO is one of thousands of employees; surely he has only a tiny impact on firm value? But, this can be studied as well. I already wrote here and here how the CEO’s contract has significant effects on firm value, suggesting that the CEO matters. Various papers (e.g. here, here, and here) have shown that CEO departures and deaths have a significantly negative effect on firm value and performance, and that the effect is stronger for well-paid CEOs, suggesting that pay is indeed reward for talent. You might be skeptical, because correlation doesn’t imply causation. Perhaps the firm was going to do badly anyway, and that’s why the CEO left (he deserted a sinking ship) or died (due to the stress). So, another paper looks at the effect of CEO family deaths, which are likely not caused by expectations of firm performance. If the CEO’s spouse, parents, children, or siblings die, this distracts the CEO. If the CEO didn’t matter (since there are so many other executives), this bereavement would be unimportant. But, they show that it has significant negative effects on profitability. The exception is that, if the CEO’s mother-in-law dies, profits go up (although the effect is statistically insignificant).
In short, looking at pay ratios is misleading, as CEOs and workers compete in different markets. What matters is welfare rather than equality. However, constraining CEO pay can drive top talent to other countries (or to private firms, or to other professions such as hedge funds), reducing firm performance and hurting everyone. Welfare is best achieved not by bringing the CEO down, but hiring a talented CEO who can bring everyone else up (and good CEOs do, as shown here). Good CEOs increase the size of the pie; they will naturally capture a large slice of the increase, due to the scalability of their talent, but other employees and society still get a larger slice than if the CEO were not hired, or not incentivized. Bad CEOs shrink the pie for everyone; this increases equality, but only by making everyone equally poor.
* Full disclosure: I have coauthored one paper with Xavier and Augustin (which provides evidence that CEOs have a multiplicative effect on firm value), and have written several more papers with Xavier. However, the impact that the paper has had illustrates the esteem the paper is held in by the academic profession more generally.