Three myths about income inequality when it comes to executive pay

Salary is held in high regard in this society as an indicator of the value and worth of carrying out a role an in any given profession. The free distribution of salary payments also provides a foundation for economic growth and higher levels of productivity. One form of salary at the top end of the pay scale is the ever-controversial executive pay. The common economic approach of executive pay – known as the optimal contracting model – suggests that firms propose the most efficient compensation salaries possible to attract, retain and motivate executives.

Now, when income inequality crops up it’s usually being subject to the easy line of criticism about income inequality that executive pay is so used to receiving. Indeed, executive pay can be substantially larger than the average salary, but constantly comparing CEOs and the average worker seems like a manifestation of the old untruth that ‘the rich get richer and the poor get poorer’. What’s more, firms are consistently forced to retaliate by warning boards from large shareholders, as the public that seem to want to punish those in top executive positions. Reporting on these alleged trends only heightens public fear of ‘corporate greed’ and income inequality.

We must be recognise that in the current globalised economy the role of the executive has become increasingly important, with the successes and failures of a company heavily dependent upon their actions. Executive pay therefore not only compensates for the time and effort required of upper management to run their company, but effectively allows companies to compete globally for the best talent. Unfortunately, the intense criticisms from the public have generated common myths that are dangerously misleading and thus distorting the benefits of executive pay in society.

1) “CEO pay is accelerating as the economy is more globalised”

Whilst pointing out the eye-popping CEO salaries, many claim that CEO pay is on the rise. A recent study by Steven Kaplan found that changes in the global economy saw wages stagnate. In fact, the average estimated CEO’s pay, whilst still accounting for inflation, has declined since 2000. CEOs have actually been out-earned by venture capitalists, private equity executives, and hedge fund managers. The 25 hedge fund managers as a group regularly earn more than all 500 CEOs in the S&P 500.

2) “The wastage of executive pay is contributing to ‘corporate greed’”

Contrary to whatever narrative is implied by the ‘CEO pay is out of control’ charge, executive pay has not been at the expense of the typical worker. It’s wholly disingenuous to suggest to workers that if a CEO were paid less, the money would be automatically redirected towards their own salaries. The high salaries are designed, not only to compensate the executives, but to maintain a large pool of talent within the country. If CEOs in the UK were under-paid, we would have seen our top CEOs going overseas and taking leadership of larger, better firms. It is not productive when we end up pushing talented CEOs out of a country because they’re receiving such a great volume of scrutiny over how much they are paid.

3) “CEOs are held less accountable in comparison to the average worker”

CEOs are in fact subject to severe consequences of poor performance as opposed to their counterparts. In fact, boards fire CEOs at a much greater rate than they used to, and the duration of executive positions are shorter. When boards have larger percentages of equity and independence, bad performance is even more likely to be punished, and the onus of poor performance falls on executives, not the average workers.

It is understandable that people are concerned about economic inequality, but executive pay has not been the driver of that inequality. Policymakers who want to diminish the salary gaps by intervening in corporations are likely to create unintended damage by harnessing the ability of top companies, who are significant players in the global economy, to attract and retain the best people.

Ilma Amin is an IEA intern and studied Accounting and Management at the University of Western Australia

As with all IEA publications, the views expressed are those of the authors and not those of the Institute (which has no corporate view), its managing trustees, Academic Advisory Council or senior staff