Top Pay under fire again

The Prime Minister says that the government intends to act on what it sees as excessive executive pay. Apparently we “can’t tell people what they should be paid but (should act) where you’ve got market failure”.

This may have been a slip of the tongue. The concept of market failure is anyway highly debatable and Austrians would deny its validity, but even in mainstream economics it has a specific meaning which Mr Cameron, who has probably not opened an economics textbook in many years, has clearly forgotten.  A-level students will know that “market failure” relates either to limited information, the abuse of market power or technical issues associated with external costs and benefits. None of these apply to executive pay. What we have here is a market outcome which some people don’t like, a very different matter.

I’m sure that there are many market outcomes which individual readers dislike on moral or aesthetic grounds. But we cannot legislate to remove them all or economic and personal freedom would disappear.

Mr Cameron and Business Secretary Vince Cable follow the self-selected High Pay Commission and the IPPR in claiming that executive pay bears little or no relation to performance. A particularly shoddy press release by the IPPR shows a scatter diagram which shows only a weak correlation.  From this, a need for intervention is inferred.

This is a persistent error in the pay debate. The determination of any prices, including salaries, will be affected by many supply and demand factors. In the case of top executive pay it will inevitably be associated with the alternative opportunities available to individual executives, the size of the firm, the type of market in which it operates, tax regimes and so on. In fact careful studies show that there is a relationship between pay and performance when other factors are held constant.

The coalition is reacting to what they perceive to be a public mood of hostility to high pay. But it is being highly selective in this reaction. FTSE executives, and especially the anathematized “greedy bankers”, are only a tiny proportion of the very rich, which includes pop stars, actors, footballers, Russian oligarchs and, more importantly, private equity capitalists, entrepreneurs, property dealers and consultants. Many senior FTSE executives can – and do – transmogrify into these latter categories, which are not in the politicians’ line of sight. Many more must be tempted to do so when they hear our current crop of politicians mouthing off. Why put up with the awful pressure of being a top FTSE executive when you can quietly make more money in other fields?

The IEA has provided a response to the BIS’s recent consultation paper on executive remuneration. A number of its comments are pertinent to measures which the Prime Minister says he supports.

For example, the proposal that shareholders should have a binding, rather than advisory, vote on remuneration. The IEA response was that “a binding vote could plunge a company into crisis and would inevitably lead to a considerable diversion of time and energy into activity which may be peripheral to the company’s prospects. It would impact on executive morale and might be difficult to square with contractual obligations”.

Or take his proposal that membership of remuneration committees should be widened: “the argument that this would lead to lower executive pay levels, different pay schemes and ‘innovation in the structure of remuneration’ is debatable, as is the belief that such changes would be desirable. Bringing in people with very different backgrounds and little or no experience of board-level activity could lead to clashes of expectations and disruption”.

In any case, “little evidence is cited of companies gaining from such changes. A company that broke from market norms in isolation would be taking a gamble. The benefits from this would surely be small. If top pay at a large company like Tesco or BP was halved, say, this would lead to only a tiny direct increase in company profits (because less would be paid out in pay) and it is difficult to see that there would be other significant benefits in eg employee morale or reputation with investors or customers. The downside risks, however, are considerable if it leads to discontent amongst executives and making them more likely to quit the job”.

What about employee representatives on these committees, something which Vince Cable is said to favour? There are legal issues here which would require considerable changes to company law. More importantly, “employee representatives would be under considerable pressure from unions and activists to take a negative line on any pay increases for executives. If they were elected in some way then this pressure would be exacerbated. The efforts of management and of remuneration committees should be directed to the interests of shareholders rather than to winning popularity competitions with employees. Business should not be politicised in this way”.

The IEA response also took issue with the Cameron/Cable belief that shareholders are at fault in some way in not pursuing “fairer” pay more actively, pointing out that dispersed shareholders, many based abroad, rightly form the view that there are more important matters to a company’s prospects than whether executive pay meets the approval of a fickle and badly-informed public.

Finally, the IEA disputes the belief that steps must be taken to prevent executives being rewarded for businesses performing poorly – for instance having “clawbacks” and shareholder votes on exit packages. “Failure is by no means always easy to define, particularly when a company’s prospects worsen for reasons which cannot sensibly be attributed to the efforts of top executives. This is implicit in the BIS discussion paper’s account of the difficulty of defining performance measures, though the authors of the paper seem to have ignored this.

“If failure is not crystal-clear, but nevertheless it is felt that the CEO or other leading executives should go, it is foolish to tie the hands of companies, and prevent them paying people off. Just to dismiss executives with little compensation will invite litigation – which is not desirable as it can delay action and cause reputational damage.

“In practice, companies would inevitably have to fudge this, with people ‘resigning’ through ill-health etc. Self-righteous lobbyists on this issue do not understand the realities of the corporate world”.

Sadly, it would appear that Messrs Cameron and Cable also fall in this category.

Len Shackleton is an Editorial and Research Fellow at the IEA and Professor of Economics at the University of Buckingham. He was previously Dean of the Royal Docks Business School at the University of East London and prior to that was Dean of the Westminster Business School. He has also taught at Queen Mary, University of London and worked as an economist in the Civil Service. His research interests are primarily in the economics of labour markets. He has worked with many think tanks, most closely with the Institute of Economic Affairs, where he is an Economics Fellow. He edits the journal Economic Affairs, which is co-published by the IEA and the University of Buckingham.

3 thoughts on “Top Pay under fire again”

  1. Posted 09/01/2012 at 15:33 | Permalink

    Liberal Democrat Ministers should be particularly sensitive to the problem expressed in the penultimate paragraph as their last-but-one Chief Executive resigned on ‘ill health grounds’ remarkably soon after being criticised in the national media for the level of his remuneration from the public purse, and whether or not it pertained to genuine performance…

    I don’t recall any current Lib Dem Minister or MP joining in the public outrage over that matter…

    Perhaps their silence relates to the shocking problem of politicians sitting on each other’s committees and setting their own pay… and perhaps, to be consistent, the solution is for Matthew Elliot of the Tax Payers Alliance to sit on the Parliamentary pay committees as a ‘shareholder representative’?

  2. Posted 10/01/2012 at 08:24 | Permalink

    If being bailed out by the taxpayer counts as ‘failure’, what does that imply for excecutive pay?

  3. Posted 10/01/2012 at 11:40 | Permalink

    Michael, if the taxpayer bails out a bank the government presumably becomes the major shareholder and it could legitimately use this power to influence pay within the bank – although it would be wise to bear in mind some of the points made above..Mr Cameron’s proposals however cover all major public companies, including those like Tesco or Marks and Spencer which have never gone cap in hand to government and should be free to set pay however they wish .

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