Should Executive Compensation Limits Be Repealed?

The Financial Economists Roundtable, certainly thinks so. They have released this paper to make their argument.

The Roundtable provides a number of recommendations that we believe will mitigate the potentially harmful effects of some executive compensation plans and should ensure a better alignment of managerial and shareholder-owner interests. Among these recommendations are (a) treating the granting of stock options as an expense in company financial statements, (b) repealing section 162 (m) of the U.S. Internal Revenue Code, (c) more disclosure of financial transactions by executives that affect the sensitivity of their pay to shareholder wealth, and (d) various corporate governance changes that will enhance the independence and responsibilities of corporate boards and their compensation committees, and give shareholders the power to monitor and control executive compensation.

Price ceilings do not work because they are anti-market. Tax laws enacted in 1993 were:

the product of a highly politicized effort to "reel in" CEO Pay. Before the enactment of �162(m), members of both the Senate and the House of Representatives had sponsored various bills intended to curb CEO pay. 4 In addition, there was frequent criticism of CEO pay by candidates during the 1992 political campaigns.

Actually, they contributed to the complex pay packages that forced CEOs to focus on stock price instead of other measures of performance, which led to the accounting shenanigans that companies used to manipulate share prices. Those of you whose knee jerk reaction to every business conundrum is "the government should pass a law…" need to realize that it was a stupid, poorly though out law that helped lead to the scandals of recent years. The government can regulate all day and bury corporations in a tomb of bureacracy, and people will still find a way to look out for their own best interest. That is human nature and you can never eradicate it, you can only try to channel it into positive use (by rewarding cooperation, honesty, transparency, etc. such that those things become in one's self-interest).

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Laws frequently have unintended consequences, which is why I favor more indirect government intervention. For instance, I am a big fan of laws that force more information out into public view, since a better distribution of information leads to more effective markets. I also support laws/taxes that force companies to deal with negative externalities (like pollution) that are spread out in such a way that the cost is not reflected in the market price. What I don't support are laws that directly contradict capitalist principles. They are doomed to fail.

One final thing I would like to point out from the paper is the examination of whether or not compensation has become excessive.

What is "excessive"? In theory, compensation is excessive if it is more than that required to minimize the principal-agent (shareholder-manager) costs due to the separation of ownership and management, or, alternatively, is more than that required to maximize shareholder wealth. Put another way, it is higher pay than the executive could command in a competitive labor market. It is difficult, however, to provide an operational measure that is consistent with these definitions. Thus, while it is probably safe to say that there have been incidences of excessive executive pay, we are not able to generalize from these cases about whether the average level of executive compensation is excessive.

Certainly there are executives (and people at all levels in all companies – for that matter) who are grossly overpaid for their performance. But keep in mind that some business leaders are truly remarkable, and deserve every penny of their multimillion dollar pay packages.