Executive Compensation and Capital Markets

There is a substantial discussion these days about the need to reform executive compensation in the financial industry. In particular, recently The Wall Street Journal headlined a story about the Federal Reserve Board's thinking on the subject. I tend to agree that there needs to be restrictions on the composition of executive pay. I don't think that it would be constructive to impose absolute caps on the levels of pay. Don't get me wrong, I feel as much envy and moral outrage at the centi-millionaires created by Wall Street as anyone. It inflames every fiber of my egalitarian soul. However, it is impossible to ignore the fact that incentives matter throughout the economy.

To understand the direction that control of executive pay should go, a brief history lesson is in order. The corporate form of organization, as it exists today is largely a product of the 19th Century. The corporate form permitted investors to pool their capital in large and risky ventures while at the same time insulating them from some of the risks of those ventures. However, as documented by Gardiner Means and Adolph Berle in their classic, The Modern Corporation and Private Property, over the course of time the stockholders (owners) lost effective control of their property to the day to day managers of the corporations. Some, but only some, of these abuses were palliated by the Securities and Exchange Act and subsequent regulation.

Economists who look for incentives the way that the superstitious look for four leaf clover, next suggested that what was needed was to provide executives with incentives that aligned with the interests of the shareholders. This solution had two parts. First, an active market for "corporate control" where malfeasant or non-feasant corporate managements were replaced with more effective managements through hostile takeovers of offending corporations. The other strand of the solution is the creation of equity based compensation for executives. The idea was that executives will want to see increases in stock prices since they benefit directly from them when they are awarded company stock as a share of their compensation. This, of course, benefits shareholders too, since in modern times much more of the return to an equity investment comes in the form of increased stock price than dividend income. (More on this later.)

On the surface these ideas look good. The market triumphs yet again! The problem is that shareholders don't really exercise any direct control over executive compensation. The Boards of Directors of the firms exercise this control. Who sits on board of directors? Three groups, executives of the firm, distinguished business executives from other (non-competing) firms, and other distinguished notables including the odd academic economist. Now the self-interest of the first two of those groups lies a lot more in the area of pumping up executive compensation than it does in taking care of shareholders. The final group is typically a minority and basically intended as window dressing. Since membership in a corporate board is lucrative and not very taxing, they are unlikely to rock the boat, if it means being thrown off the gravy train.

The result is generous stock option programs (and not only for financial firms) tied to goals that are easily achieved. Even if the benchmarks aren't achieved boards are very considerate of the self-esteem of their executive subordinates and often reset the goals to something more achievable. There is an even more egregious feature to stock options. As the exercise dates approach, executives have powerful incentives to juice up the reported performance of the company to make the shares they are about to receive even more valuable. This is a variant of an old stock market scam known as "pump and dump" wherein a group gets control of stock in some obscure firm and proceeds to spread rumors that increase demand for and thus the price of the stock. Thus stock based compensation becomes an exercise in "heads I win, tails you lose." Managers are incentivized to seek out gains which are both risky and likely to pay off in an extremely limited time period. They want and need to raise stock price in the short run, the long run consequences be damned.

In an ideal world, shareholders of corporations could stop this nonsense and tell executives something like this, "We will reward your efforts for our firm with a generous salary that reflects the responsibilities and prestige of your position. Because we want you to have incentives to do the best possible job for us, the shareholders, your bosses, we will provide bonuses to you that reflect your accomplishment in making us wealthier. However, our interest is in long run growth of capital and income from our investments, so your bonus compensation will be deferred until well after you have left our employ." However, as noted above, shareholders have been systematically stripped of their rights vis a vis management, which means to achieve a sensible reform of executive compensation government must be involved.

What are the elements of such a reform? There are two different sorts of reforms required both with executive compensation and in taxation.

In some ways, the the executive compensation reform is the easiest. Bonuses for executives should always be deferred until the executive leaves the labor force. The motive for wealth creation is to provide income for life after active labor market participation, so this should be uncontroversial.

The other principle is that the deferred compensation should be split into two tranches. One tranche would be invested in an index fund tracking the overall composition of world equity markets with dividend reinvestment. This tranche would meet the argument that managers must dispose of some of their stock awards in order to diversify away from excessive concentration of their wealth in their employer. With diversification thus achieved there will be no need for the executives to sell their awards. The other tranche would be divided among the different instruments that the firm uses to acquire its capital. (I.e if the firm had 40% equity capital and 60% debt, the executive would receive awards reflecting that distribution.) This new approach to bonuses limits the incentives for executives to excessively leverage the firm in hopes of generating out-sized returns to equity.

The capital markets and taxation portion of the reform starts with a controversial step. I would propose eliminating the taxation of corporate profits. I can imagine my fellow progressives heads exploding as they read this, but let me explain. There are two benefits to this, the first as noted above is that instead of paying dividends out of profits, corporations retain earnings which leads to higher stock prices. This is encouraged by the favorable treatment of capital gains which are taxed at a lower rate than ordinary income. For this reason, along with elimination of corporate profits tax, there should be a very high tax on any retained earnings. Thus dividends would once again be the principle source of reward for shareholders and subject to regular income taxation. This change would result in improvement in capital markets because firms would have to go to capital markets regularly to raise funds for new projects. Having multiple eyeballs on a firm's projects is likely to lead to better results than the corporate empire building that often lies behind projects funded by retained earnings.

The other benefit of this is that eliminating corporate profits taxation will begin to refute the pernicious idea of corporate personhood. If tax liability attaches, as it should, to the owners of a firm and not to a legal fiction, it becomes more difficult to assert that the corporation is a legal person entitled to the same rights as natural persons.