Executive pay: what worked?

• Author: Bank, Steven A.

1. INTRODUCTION II. The Facts of Executive Pay: The 1930s to Today III. Executive Pay Reform--More Misses Than Hits IV. Taxation and Executive Pay A. Higher Tax Rates as a Potential Cure for Executives Being Paid "Too Much" B. Tax and Executive Pay Levels During the Middle of the 20th Century C. How Much Did Tax Matter? V. IF Not Tax, Then What "Worked?" A. Internal Variables 1. Boards of Directors 2. Shareholders B. External Variables 1. Direct Regulation 2. Disclosure Regulation 3. Unions 4. The Market for Managerial Talent 5. Norms VI. Conclusion I. INTRODUCTION

   There is a substantial consensus that something is seriously amiss with executive pay, as the compensation of top executives of U.S. public companies is widely perceived as scandalously generous. (1) Critics of executive pay can be found even amongst stout defenders of free markets. (2) For instance, Richard Posner, a law and economics pioneer before he became a federal appellate judge, said in 2010 that the proposition that executive pay was excessive was "accepted not only by many leading scholars but by almost the entire nation, including many chief executive officers." (3)

   Critics of executive pay often draw upon history for support, noting that the chief executive officers (CEOs) of today are much better paid than their counterparts of a half-century ago. (4) Being a chief executive may be challenging. Still, when the job is basically the same one it was during the mid-20th century, how can it be that CEO pay has increased substantially quicker than gross domestic product (GDP) per capita, total shareholder returns, corporate earnings, and the wages of ordinary employees? (5)

   The dramatic growth in executive pay has not occurred in a vacuum. Managerial compensation has generated substantial controversy and criticism for at least a quarter-century, (6) and various reforms have periodically been introduced in response, seemingly to little avail. As the Wall Street Journal observed in 2006, "critics tried to slow skyrocketing pay through regulations, legislation and shareholder pressure. Few of their tactics worked. Many backfired." (7) For those perplexed or frustrated that efforts at reform have failed to reverse dramatic increases in executive pay, history may provide valuable lessons. American business enjoyed unparalleled success from the mid-1940s to 1970. (8) Nevertheless, during the middle decades of the 20th century, CEOs of U.S. public companies not only were paid less along various measures than their present-day counterparts, but inflation-adjusted executive compensation remained static and executives lost ground as compared to rank-and-file employees. What "worked" to constrain executive pay? This is the topic we explore in this Article.

   Others have identified the shift from (relatively) modest mid-20th century executive compensation to stratospheric CEO pay by the century's closing stages as a topic worth investigating. Paul Krugman said nearly 15 years ago, "[t]he explosion in C.E.O. pay over the past 30 years is an amazing story in its own right, and an important one." (9) Michael DORFF wrote similarly in 2014 that, "[t]his major shift provides an opportunity to probe the inner workings of CEO pay." (10) Research on point nevertheless is just beginning. Carola Frydman, who has empirically analyzed 20th century executive pay trends in considerable detail, (11) observed in a 2010 survey of CEO pay "the causes of the apparent regime change in CEO compensation ... remain largely unknown." (12)

   Explaining the "regime change" that disrupted mid-20th century CEO pay has important present-day policy ramifications. Thomas Piketty, in his much publicized 2013 tome Capital in the Twenty-First Century, detailed historical changes in the concentration of income and wealth and offered policy prescriptions designed to reverse growing inequality on both fronts. (13) In so doing, he argued that imposing high individual marginal income tax rates may be "the only way to stem the observed increase in very high salaries." (14) He suggested that the optimal top marginal tax rate would be above 80%, (15) a policy recommendation that became increasingly contentious as the popularity of his Capital book grew. (16) Piketty bolstered his argument with historical evidence, attributing a late 20th century surge in the income of top earners in the United States, including CEOs, to substantial cuts to income tax rates that began in the 1970s and were pronounced in the 1980s. (17) He argued that if the intention is to stop the "stratospheric pay of supermanagers," then "only dissuasive taxation of the sort applied in the United States and Britain before 1980 can do the job." (18)

   Piketty's argument is certainly plausible. If, due to high marginal income tax rates, executives keep very little of what they earn, executives might well be prepared to leave substantial money "on the table" because they know that they will only be able to retain a small fraction of what they have earned. This should in turn dampen pressure public companies might otherwise feel to pay management generously. Still, is Piketty's invocation of history appropriate?

   We argue no. Tax did not "do the job" with executive pay during the middle decades of the 20th century in the way Piketty implies. Instead, other factors were equally or more important. Powerful unions exerted downward pressure on executive pay. Managerial bargaining power was muted by limited job mobility and by a perception that the managerial function was bureaucratic in orientation and correspondingly undeserving of exceptional rewards. Perhaps most crucially, there were norms militating against "moneygrubbing" by top executives that functioned as a potent check on executive pay.

   What are the policy implications of our findings? We are not seeking to identify in the past some sort of ideal executive pay model. Instead, our study provides insights regarding tools that could be deployed to restructure executive compensation should the political will develop to limit CEO pay substantially. One might wonder, for instance, if it would be possible to revise perceptions of top management to accord with those prevalent in the 1940s, 1950s, and 1960s or resurrect norms within companies strongly biased against greedy, grasping executives.

   Simply turning back the clock, however, is impossible. For instance, to the extent that mid-20th century norms constrained executive pay, these norms were shaped by the economic chaos of the Depression and the challenges of World War II, neither of which we would like to experience again. Moreover, top executives are perceived differently now than they were in the mid-20th century, in the sense that their contribution to corporate success is thought of as being more critical. That means mid-20th century remuneration packages where performance-related pay was largely an afterthought are unlikely to be acceptable today. This in turn has important implications for the level of executive pay because a logical trade-off with a managerial compensation scheme where much of the pay is "at risk" is a highly lucrative upside if all goes well.

   This Article is organized as follows. Part II provides an overview of the history of executive pay since the 1930s. It focuses primarily on a mid-20th century era of comparatively modest managerial compensation that began to unravel in the 1970s and was displaced fully in the 1980s in a way that set the scene for dramatic increases in executive pay occurring in the 1990s. Part III describes how efforts to respond to executive pay controversies arising over the past quarter century have failed to "work" in the sense that CEO compensation has remained high and criticism of executive pay remains vocal.

   The remainder of this Article deals primarily with the middle decades of the 20th century, with the objective being to explain what "did the job" during this era of executive pay moderation. Part IV considers the contribution that tax policy made to managerial compensation trends, focusing particularly on the question of whether the relatively modest executive pay arrangements in place during the mid-20th century were chiefly a product of high marginal tax rates on income in place at that time. Part V analyzes other plausible explanations of what "worked" with executive pay. Some, such as board structure, shareholder intervention, and federal wage controls, had at best a minor role to play. Others--including union power, the market for managerial talent, and corporate culture ("norms")--do help to account for the configuration of executive pay during the middle decades of the 20th century, with the latter two factors being of particular importance. Part VI concludes.

2. THE FACTS OF EXECUTIVE PAY: THE 1930S TO TODAY

   To set the scene for analysis of what "worked" with executive pay during the middle decades of the 20th century, we consider now the evolution of executive compensation since the 1930s and do so with particular reference to the period from 1940 to the 1990s. We focus primarily on identifying trends governing overall executive pay, though we also consider how pay was structured. Our summary is not exhaustive; it seeks merely to provide sufficient detail to put our subsequent analysis into proper context.

   Railways aside, prior to the 20th century, corporations were almost always run either by individuals with large ownership stakes or by their representatives. (19) After a merger wave at the turn of the 20th century started to disperse ownership in major industrial corporations, (20) salaried executives lacking a meaningful ownership interest began taking up top managerial posts with great frequency. (21) Executive pay became a public issue as the 1930s began due to revelations that cast a harsh light on compensation practices during difficult economic times. Lawsuits and congressional hearings revealed that top executives at three major firms...