High CEO Pay Isn’t Making Anyone Poor

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While most American are still following the final vote counts in the 2020 presidential election, many lower-profile, but still important, issues have been decided at the state and local level. San Francisco voters have approved Proposition L, called the “Overpaid Executive Tax,” which will levy an additional layer of taxation on the CEO of any corporation that does business in the city and who earns more than 100 times more than a “typical local worker.”

Cyrus Farivar of NBC News describes the implementation:

Companies with top executives who fall into this category must pay a 0.1 percent surcharge on their annual business taxes. The surcharge increases by 0.1 percent per factor of 100, topping out at 0.6 percent. So top earners making 200 times more than the average worker pay a 0.2 percent tax and so on. […]

The latest ruling applies to a breadth of companies. While Portland, Oregon, has a similar measure, which passed in 2018, that tax applies only to publicly held companies. This measure affects both privately and publicly held companies. This tax not only affects large, local firms like Salesforce, but also large corporations that do business in the city, like Visa and J.P. Morgan.

This new law has successfully exploited the envy and resentment of class warriors, but is unlikely to do anything to improve the living conditions or long-term job prospects of anyone living in San Francisco. NBC’s Farivar quotes local political commentator Richie Greenberg, for example, who points out that since this measurement comes in two parts, firms are far more likely to simply cut back on hiring low-wage local employees than they are to lower their CEO’s compensation.

More importantly, the idea that CEOs, in general, are “overpaid” is a canard. Average CEO pay is linked closely to firm size, meaning that the rising observed value of many compensation packages has more to do with firms merging and growing than top executive taking a bigger share of the pie. Speaking of which, Professor Alex Edmans of London Business School took a sledgehammer to the rickety case for limiting CEO pay in his recent book Grow the Pie: How Great Companies Deliver Both Purpose and Profit. As he wrote back in 2017 for Harvard Business Review, “we need to stop obsessing over CEO pay ratios.”

If compensation is tied to firm performance (mostly through stock options rather than cash salary, for example), a CEO’s pay comes entirely as a result of creating market value—no one loses. Indeed, a company that has become more profitable is in a much better position to do things like increase pay and benefits all around. Edmans asks us to consider this scenario:

If an enterprise generates £8 billion of value, the CEO gets £4 million and the average worker earns £32,000, the ratio is 125:1. If the CEO innovates so that the enterprise generates £12 billion of value, she gets £6 million and workers earn £40,000—everyone benefits—but the ratio increases to 150:1.

The ratio, in and of itself, tells us nothing about the actual prosperity of workers. And it’s an unfair yardstick for companies that, because of their industry, naturally employ fewer low-skilled people. A boutique investment firm will have mostly highly paid employees, so the top executive-to-average worker ratios will be lower than, say, Walmart, which has a CEO that earned $46 million last year, but also many low-wage hourly workers. But which firm is better for low-skilled Americans, the one that employs no one without a college degree or the one that employs a million and a half sales associates in the U.S. alone? 

Moreover, contrary to what many class warriors would suggest, there is copious research showing that high pay ratios are associated with more valuable, better performing firms. Edmans tells us that “high ratios are associated with higher valuations, operating performance, long-run stock returns and earnings surprises.” That research has also showed that firms with pay ratios in the highest third outperform those in the bottom third by around 10 percent a year, after controlling for several other potential causes of stock performance.

Big CEO paydays may stagger the minds of a person with a normal salary, but the same is true of the pay earned by Hollywood celebrities and sports stars. The important thing to remember is that because successful enterprises can create wealth rather than merely redistribute it, those big bonuses are not coming out of someone else’s pocket. CEOs do not get rich by making other people poor, and making them poorer won’t magically make workers better off.