More Less
More Less
September 19, 2019

Is CEO pay economically justified?

Opinion image

Uproar over high levels of CEO (chief executive officer) pay often accompanies economic downturns—when the disparity in pay between top executives and struggling workers is most unsettling. Researchers have taken positions on both sides of the debate over whether or not the level of CEO pay is economically justified. Because CEO pay is growing in relation to both firm profitability and the pay of regular workers, the attention paid to CEO pay is unlikely to subside. 

The trend in the ratio of average CEO pay to the pay of workers in the firm’s industry for the largest 350 US firms is detailed in Figure 1 of “Efficent markets, managerial power, and CEO compensation.” Over the period from 1965 to 2012, average CEO pay including the value of stock options exercised increased over 16-fold, while the typical worker’s pay increased by just 30%. 

The US case is broadly relevant because evidence suggests that CEO pay is converging internationally. A comparison of 14 developed countries found that, although US CEOs earned about twice as much as their foreign counterparts, after statistically controlling for factors including firm size, industry stock price volatility and performance, growth opportunities, and ownership and board structure, the excess over CEO pay elsewhere fell to 26% in 2006 and to 14% in 2008.

A primary economic rationale for high CEO pay is that the market for executive talent is competitive, and high pay levels result from bidding by firms for scarce talent. The higher pay of the CEOs in large firms directs the most talented executives to the larger firms where the value of their talent is magnified by the larger scale of the enterprise. The six-fold increase in CEO pay at large US companies from 1980 to 2003 matches the six-fold increase in the market capitalization of the companies during the period. The increase in CEO pay may also reflect the increase in externally hired CEOs and increases in the awards of stock and stock options.

The other side of this debate argues that CEOs are overpaid because of their influence over the composition of the board of directors, the compensation committee determining CEO pay, and the selection of the compensation consultant advising the compensation committee. It is argued that CEO pay is not the product of arm’s-length negotiation between two parties with opposing interests because the CEO does not bargain against the owner of the firm. The corporate board sets CEO compensation and has little desire to oppose the CEO in doing so. 

Supporting contentions regarding CEO influence over pay determination is evidence that CEO pay is higher in firms with a weak board of directors, more outside board members appointed by the CEO, more board members serving on three or more boards, no dominant outside shareholder, CEOs holding larger ownership stakes, and CEOs also serving as chairman of the board. 

Measures regulating US CEO pay have thus far largely been ineffective in restraining it. The US adopted legal measures during the 1990s and 2000s to increase board independence, and board independence has increased since the mid-1980s. But these regulatory measures did not reduce CEO pay. 

Regardless of the economic arguments surrounding CEO pay, the spotlight is intensifying. Income inequality and the pay levels of CEOs in industries under fire have drawn condemnation in political debate, especially in the US. In the current climate, an increase in the progressivity of the tax code or new regulatory measures may be on the horizon. 

© Michael Bognanno

Read Michael Bognanno’s IZA World of Labor article “Efficent markets, managerial power, and CEO compensation.

Please note:
We recognize that IZA World of Labor articles may prompt discussion and possibly controversy. Opinion pieces, such as the one above, capture ideas and debates concisely, and anchor them with real-world examples. Opinions stated here do not necessarily reflect those of the IZA.