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Unintended Consequences on Executive Pay II: Pay Caps

Posted By Andrew M. Grossman On February 4, 2009 @ 5:02 pm In Economics | Comments Disabled

Policies premised more on class-warfare than sound economics, are not going to get us out of this recession. They may actually delay recovery.

In my last post [1], I discussed the example of a ban on “golden parachutes” for top executives. Now, another item from the Treasury’s pay rules [2]for companies receiving “extraordinary assistance” that may soon be foisted on the broader market: executive pay caps.

The rule is short and sour: Senior executives can receive no more than $500,000 in total annual compensation. They can also receive restricted stock that has no value until after the government loans have been repaid.

The result: once again, unintended and counterproductive consequences that will sap incentives for economic growth.

First, let’s get something out of the way here: $500,000 per year, while a large amount, is hardly extravagant. Think: Is someone like Steve Jobs at Apple worth that much? The market seems to think he’s worth billions to the company. Annual compensation of $500,000 or more is not outrageous in every case. It depends on the situation.

And it’s not far-fetched at all that some executives bring much more than $500,000 in value to their companies—and now, especially, when we’re desperate for economic growth, hopefully much, much more!

But the government’s rule brooks no exception.

Thus firms subject to the rules won’t be able to pay for big talent—those exceptional individuals who really are worth the big bucks. Law professor Larry Ribstein suggests [3]that the cap could “hasten the flight of talent” out of Wall Street firms and into private equity partnerships, where the earnings are limited only by results. The first to leave, of course, will be those worth the most money—that is, the most talented. That’s not good news, especially for the corporations that have needed “extraordinary assistance” and now need extraordinary performance. As Ribstein puts it, “These are the executives and companies for which incentive pay is most important.”

And even if the brilliant types stay on at lower pay, they may not put their all into their work. After all, once you’ve maxed out compensation for the year, why bother putting in 12-hour days and working weekends?

One way to get around these problems is to get around the rules. In other words, provide perks, lots of them, so that effective compensation is far higher than reported compensation. Executive jets, for now, are off the table, but personal assistants, cars and drivers, and many other luxury trappings are still game. But all these things are less efficient than just paying compensation, so they will cost companies and their shareholders more. Even worse, perks aren’t a perfect substitute for a carefully crafted compensation agreement that aligns an executives incentives with shareholders’. So if the caps don’t strictly hold, the net result could be higher expenses and, yet again, poor performance.

Finally, John Carney points out [4]one additional consequence for the financial industry (though it may be more broadly applicable): the end of job-exit as a signal. In economics, “signaling” is how individuals convey information to others, often through their actions. For example, a college degree signals to employers that you’re likely to be a good worker. On Wall Street, talent walking out the door signals that your firm is in big trouble. But with pay caps, there’s little reason to exit so swiftly. Some corporations might take advantage of this state of affairs to take big risky bets. And when a business really is in dire straits, there will be a longer lag before it comes to light, making it harder for investors to judge that business’s health. That won’t help the investment markets one bit.

Again, class warfare is no substitute for good economic policy—indeed, the two are often precisely opposed.


Article printed from The Foundry: Conservative Policy News from The Heritage Foundation: http://blog.heritage.org

URL to article: http://blog.heritage.org/2009/02/04/unintended-consequences-on-executive-pay-ii-pay-caps/

URLs in this post:

[1] my last post: http://www.foundry.org/2009/02/04/unintended-consequences-on-executive-pay-i-golden-parachutes/

[2] the Treasury’s pay rules : http://clusterstock.alleyinsider.com/2009/2/the-fives-the-limit-treasury-departments-statement-on-pay-caps

[3] suggests : http://busmovie.typepad.com/ideoblog/2009/02/the-stupid-bailout-pay-caps.html

[4] points out : http://clusterstock.alleyinsider.com/2009/2/paycaps-as-a-bailout-why-capping-pay-hurts-the-recovery

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