CEO compensations are again a motive of discussion, as inequality rises:
Chief Executive Officers’ (CEO) compensations are once again the topic of the moment, with several news coverages reporting increases in the earnings of the ultimate day-to-day firm managers, in the last year of 2022.
For example, Dara Khosrowshahi, Uber Technologies Inc.’s CEO saw a total increase in compensation of 22% in the last year alone, culminating in a total payment of $24.3 million. According to the report issued by the Securities and Exchange Commission, his payment was composed of a $1 million base salary, stock awards of around $14.3 million, $5.9 million in options, a $2.9 million bonus and a “symbolic” $170 thousand compensation for personal travel and security costs. James Gorman’s salary, CEO of Morgan Stanley, rose 13% to $39.4 million, of which $1.5 million in base salary, $7.5 million in a cash bonus and stock awards of $30.4 million. According to Reuters, these numbers reflect a ratio of 274 to 1 when comparing Gorman’s pay to the median pay of an employee in 2022, an increase from the previous year’s ratio of 255 to 1. American CEOs of oil companies experienced a large growth in their pay checks as well, as their record profits were driven by the increase in energy prices, with ExxonMobil’s CEO, Darren Woods, having a 52% raise in his payment of $35.9 million. However, the same cannot be said for the median oil company worker, who saw a decline in the average salary, with those of Exxon seeing a decrease of 9% to a total yearly salary of $171,582. Moreover, just this week, Alphabet and Google’s CEO, Sundar Pichai, was reported to earn $226 million, which included stock awards of $218 million. This represents more than 800 times the annual pay of a median employee and it is subject to controversy and outrage as the company has been cost-cutting with their employees through layoffs that have already started, following Google´s plan to cut 12,000 jobs, representing around 6% of its total workforce.
These numbers express a growing concern in today’s society, with the rising disparity between CEO’s average salary and the median worker. In fact, in June 2022, the Institute for Policy Studies released a study including the top 300 publicly traded US firms, in which it was concluded that the average pay gap between CEO and median worker jumped to 670 to 1, an increase of 31%, from 2020’s 604 to 1. In total, 49 firms had ratios higher than 1,000 to 1, signalling that, for each dollar the median employee received, the company’s CEO would earn more than $1,000. Furthermore, in more than a third of surveyed companies, the median worker salary did not keep up with inflation.
Figure 1: Aggregated CEO-to-worker compensation ratio for the 350 largest publicly owned companies in the U.S. from 1995 to 2021
Figure 2: Ratio between CEO and average worker pay in 2018, by country
However, such large differences in pay do not occur in every country. There are cross-national differences which relate to the culture of the country in question. Indeed, the average US executive compensation is significantly higher than that experienced in Europe or Asia. This relates to the fact that Asian countries, like Japan, favour group rewards while others, such as China, value other aspects more highly, namely promotions or potential political careers. Nevertheless, for the sake of exemplification, in this article, the US will be used as a case study.
The agency problem as a potential explanation:
To truly comprehend where these differences arise from, one must start by understanding what an agency is. An agency is a contract by which one party, the principal, grants authority to another party, the agent, to act on his behalf in a particular matter. Consequently, the agent – which may be a CEO – is expected to act in the best interests of the principal – in this case, the shareholders – and, normally, is not held liable for his actions as long as he acts under his fiduciary duty. However, an agency problem occurs due to the separation that exists between the management and shareholders, such that both parties’ interests are not aligned, with CEOs potentially acting in their self-interest due to several reasons, like imperfect contractability or the fact that actions are not perfectly observable. In order to mitigate this problem, many times CEOs are attributed compensation that is related to their firm’s performance, such as stock options or golden parachutes to align incentives.
The medium-class lifestyle seems more and more distant:
To say that things are not going well in the United States and many other advanced countries is an understatement. Discontent is widespread in these parts of the world, namely in the US, displaying the world’s most severe corporate inequality, in which the gap between a company’s highest and median pay – known as its pay ratio – should not be as sky high.
Income inequality has resulted in a substantial gap in society, making it more challenging for individuals to attain a middle-class standard of living. This divide not only demoralizes the workforce but also shrinks the chances for billions of people to earn a liveable wage. Moreover, income inequality is a deterrent to economic growth, as it is estimated to reduce demand by 2-4%. Adding to that, the accelerated inflation rate, which will have the most significant impact on low-wage earners, emphasizes the necessity for businesses to prioritize policies that elevate the average worker.
A significant majority of Americans (close to 75%) view the economic disparity between the wealthy and the less affluent as a critical issue, and their concerns are well-founded: income inequality ratios between the highest and lowest percentiles have been steadily rising over the past five decades. Americans have thus an informed sense that there is a misalignment in the proportion of exorbitant CEO pay vis-à-vis lower-wage workers. Relatedly, a majority of Americans (66%) recognize wage stagnation as a significant issue, and slightly over half (51%) feel that there are not sufficient prospects to improve their financial status. Roughly half of Americans also recognize wage discrimination against Black individuals and women as significant problems.
Figure 3: Assessment of the inequality and discrimination as problems in the U.S.
What can be done?:
The CEO compensation issue needs to be addressed, and companies should consider limiting the pay of their top executives to prevent it from growing excessively. Such a cap could have positive effects on the workforce if the excess compensation is redistributed among them. A recent study by the Financial Times revealed that capping CEO pay could help alleviate financial insecurity among low-wage workers. For instance, if the top 110 publicly traded US companies were to set a $1 million limit on their CEO pay, workers in these companies could potentially receive an additional $400 per month.
Lawmakers in seven US States are collaborating to propose higher taxes for wealthy individuals and corporations in their respective state legislatures. Many of the new proposals suggest taxing the overall wealth of the rich, not just their annual income. In 2021, ProPublica released a report based on leaked tax documents from wealthy individuals, revealing how they evade paying income tax. The report showed that, in some instances, the wealthiest billionaires avoid income tax altogether by accumulating wealth through stock and property ownership, which are taxed at lower rates than income. As part of his budget proposal last spring, US president Joe Biden introduced a 20% “wealth tax” at the federal level, which would apply to an individual’s total income, including growth in assets, such as stocks.
According to Sarah Anderson of the Institute for Policy Studies, companies should not view measures to reduce income inequality as punitive, but rather as potentially beneficial for them. Anderson believes that narrowing income gaps can actually improve a company’s bottom line by motivating employees and ensuring they feel fairly rewarded. She suggests a fair ratio of 25:1, where the median pay at a company should be $200,000 if the CEO earns $5 million. Companies have the option to reduce CEO pay, increase worker pay, or pay higher taxes, which can then be used to address inequality in other ways.
All in all:
The message from the public is clear: corporate leaders, including CEOs, have a responsibility to address income inequality in America by prioritizing worker wages and financial sustainability. Nobel prize winner Joseph E. Stiglitz emphasizes that paying taxes is the first element of corporate social responsibility.
To build fairer economies, it is crucial to ensure that the lowest-paid workers can meet their basic living costs. Americans believe that companies can contribute to this by raising their minimum wages to a decent pay.
Sources: MarketWatch, Reuters, The West Australian, The Guardian, CNN Business, BBC, Financial Times, Institute for Policy Studies, ProPublica, Grenness, Tor; “The Impact of National Culture on CEO Compensation and Salary Gaps Between CEOs and Manufacturing Workers” in ResearchGate