Noah Roberts
In movies and TV shows depicting corporate America, CEO’s and business executives are usually portrayed in the same way. What comes to mind for me is the show “Suits” where top executives in the law firm wear their expensive suits, drive their expensive cars, and have the nicest and largest office in a huge office building. But, why do we have these stereotypical depictions of business executives? Why were they ever paid so much and are their salaries still growing exponentially today?
In Planet Money’s podcast “When CEO Pay Exploded”, they review the events in the 1990’s that resulted in a boom in CEO pay. Before 1990 CEO pay was consistently increasing by a little each year. No matter the performance of the company, the CEO would continually have an increase in salary. During the 1990 recession, where executives were being paid more and more while employees were being laid off, the economist Kevin Murphy wrote a paper on changing the way CEO’s were paid. This launched campaigns for people like Bill Clinton who proposed a new Tax Code that would change the pay of CEO’s. This ultimately resulted in a use of Stock options as payment, which did not work out the way the government intended. However, in the early 2000’s, companies realized the effect on their companies by issuing stock options to executives and have changed pay scales.
The overarching idea throughout this podcast is Business, State, and Society. After Kevin Murphy’s paper on the principal that CEO’s should be based on company performance and not given a base salary, Bill Clinton proposed a new tax code. This tax code would prevent big companies from writing off more than a million dollars of their CEO’s salary. This was to discourage a high base pay. However, they did add in section 4C of the tax code saying that if companies paid based on company performance, they could write off all of the salary. This encouraged stock options to be offered to executives as a form of pay. Where if an executive performed well, they could possess a stock at a certain price and sell it for a gain if the company improved, or a loss if the company did not perform well. Ultimately, this did motivate CEO’s to try to advance their company.
However, this held both Unacknowledged Assumptions and Unintended Consequences. Economists like Kevin Murphy assumed that companies would lower base pay because they were offering stock options as a way for CEO’s to make more money. The reality, though, was quite different. If you were a CEO, you wouldn’t want to lower your own salary, and if you were on the board of executives and liked the CEO, you wouldn’t want to risk losing him or her to another company that would offer more money. This resulted in a same base pay with the addition of a 40% growth in stock options. Consequently, the average CEO salary for Fortune 500 companies dramatically increased from $4 million to $8 million between 1992 and 1996.
Although, this increase in stock primarily happened due to another Unacknowledged Assumption made by corporations. Due to a weird accounting rule, stock options could be expensed at zero cost, and in result, businesses genuinely thought they were issuing stock to their workers with a zero cost. All they had to do when an employee cashed in was create a stock and give it to them to sell. This led to greater effects on everyone associated with the company. Employees that had their retirement based in stock, or citizens that had many shares of stock were being greatly affected. Their stocks were now worth significantly less because of how many shares the companies were creating out of thin air to pay salaries with.
Eventually, the companies did realize the affects of issuing a lot of stock and stopped giving it out so freely. This has actually resulted in a decrease in average CEO salary over the past few years, going against what most may think. Although one could make a fair argument that executives are still overpaid, we do know that the salaries aren’t going anywhere but down for now.
Call me cynical, but I wonder if this was less “unintended consequences” than “CEOs and their accountants sneaking a provision into law that would make them ridiculously wealthy.” Somebody had to know ahead of time how this would play out.