Author’s Note: Amandeep Singh Sandhawalia made an interesting comment to my last post, “Tax Cuts and Employee Compensation.” He also posted the comment on Facebook. Our back and forth there generated many comments. Amandeep’s comments were mostly well reasoned, on point, and well presented. I am posting the conversations here because many interesting points were discussed, and I did not want the followers of this blog to miss them.
Amandeep challenged to what I had said under three main topics: 1) IMMIGRATION AFFECTS COMPENSATION, 2) RISING WAGES ARE ALSO OFTEN INHIBITED BY WHAT CORPORATIONS ARE CHOOSING TO DO WITH THEIR RECORD PROFITS, and 3) CEO WAGES HAVE BEEN GROWING RAPIDLY. Below I have attempted to sort out the various topics of each Facebook post under those heading. Amandeep also made some comments about income inequality and other matters which I consider to be off topic. I have included all of those under the third heading for a want of a better place to put them.
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1) IMMIGRATION AFFECTS COMPENSATION
AMANDEEP: There are some additional factors that go into the formula. The first is immigration. There are obviously many significant positives from encouraging immigration, but one of the negatives is that it does increase the labor pool, and therefore potentially delays reaching the “full employment” tipping point after which wages increase.
HARVEY: Yes! Immigration of workers adds to the supply of workers. That additional supply puts downward pressure on wages. (Conversely, immigration of people/families whose after-tax income is less than the person’s/family’s consumption is a drag on the economy.) Because, however, Americans are not having enough babies to become the workers who will fill the jobs of a growing economy and fund medical care and maintenance of a rising number of elderly (over 65) Americans, immigration is essential to the vitality of the country. Japan, which has miniscule immigration and whose percentage of elderly has grown from 7% to 25% between 1970 and today, has had a stagnant economy for about 30 years and no solutions in sight. Even with America’s robust immigration, the percentage of elderly Americans has risen from 10% to 14.5%. The number of workers per social security recipient in America has fallen from 41.9 in 1945 to 2.9 in 2010 (Every worker must provide for her own family and 1/3 of the benefits of a person on social security!) In addition, immigration of highly skilled individuals is the immigration of “The Ultimate Resource” for any country.
Because America’s economy and wages would stagnate before it collapses without immigration, I did not believe immigration was a pivotal issue with respect to wages in America.
AMANDEEP: The effects of immigration are complex, since even though it is a potential headwind to wage increases, it is also necessary for other reasons as you point out. However, there is a debate over immigration reform … shifting from random (illegal, chain, lottery, etc) to targeted skills. Of course, when industry complains that they need to hire immigrants because there are not enough citizens to fill positions … well that is the same as saying they do not want to give pay raises in order to attract citizen applicants. Therefore, I suspect much of this proposed immigration shift is being pushed by lobbyists for particular industries that will benefit by focused visas in order to keep wages low.
HARVEY: I agree. Nevertheless, some immigration is essential, and some kinds of immigration are far better than other kinds of immigration.
2) “RISING WAGES ARE ALSO OFTEN INHIBITED BY WHAT CORPORATIONS ARE CHOOSING TO DO WITH THEIR RECORD PROFITS.”
AMANDEEP: Rising wages are also often inhibited by what corporations are choosing to do with their record profits. While you ascribe corporate reticence to invest their profits towards growth to ‘animal spirits’ fear surrounding negative expectations of the short term economy or inhibitive government action, large companies are also discouraged from risk taking by the ease with which they can spend their profits on ‘non growth’ expenditures like stock buybacks and dividends. This sort of corporate spending is great for wealthy stockholders as well as corporate executives with their stock based compensations, but it is not growth oriented investment. If the government were to either directly restrict this, or disincentivize it by taxing it, corporations would face greater market pressures to invest their profits towards growth instead.
HARVEY: True, but I take exception to most of your points.
You incorrectly describe my views on “animal spirits.” Contrary to what you said, they are only one of many factors in investment decisions, can affect investment decisions either positively or negatively, and are affected by both short and long term considerations.
I view the causes and effects of stock buybacks very differently than you do. It is in CEO’s best interest to create good returns for the company’s shareholders. If the company does not generate enough investment opportunities that have at least a 50/50 chance of to generate a risk adjusted rate of return greater than the return shareholders could reasonably expect earn on an alternative investment (say a bond), then cash will build up in the company. A company holding in excess of a reasonable working capital level is a waste of wealth that could be put to better uses. Stock buybacks are better for shareholders than dividends for several reasons, and, in theory, and usually in fact they cause stock prices to rise. (Despite such buybacks being a self-evident admission of management failure, management can only make matters worse by sitting on excess unproductively accumulated cash.) More important, for the most part all of the cash received in a stock buyback will be reinvested in companies that are generating profitable investment opportunities. Contrary to what you are suggesting, the relative ease of moving poorly used capital to more positive uses helps the economy grow.
Add to this the fact that taxes, regulations, and corruption turn what could be profitable investments into unprofitable investments. Much less idle cash should be sitting around or used in buybacks if Trump’s administration can lower taxes, regulations, and corruption.
AMANDEEP: I am not understanding why you say that stock buybacks are a productive investment. To me, they seem to be a quintessential anti-investment. Trillions in corporate profits are being spent on essentially a lottery ticket that the stock price will go up (although only shareholders benefit, and only on paper … the corporation does not because the stock bought back is never resold in order to raise money for other investment). As you say, management fails when it just sits on cash. Buybacks basically allow the corporation to metaphorically throw the cash onto the bonfire. Government policies that would disincentivize buybacks (either by outright bans or taxing them excessively) would force companies to apply that cash towards growth instead. I fail to see how this sort of policy would be growth inhibative in any way. See: “How Stock Buybacks Cause Economic Stagnation…”
HARVEY: The studies upon which the Forbes article relied are myopic. They found some interesting trees but missed the forest. Though the facts produced in the studies may be true, the conclusions drawn in the article from those facts are not supported by those facts.
Of course the companies that had such great innovators (inventors, researchers, and developers) that investing in those innovators was a good use of the company’s capital, i.e., the companies grew as a result. Of course companies that did not invest in good innovators fared less well. Those facts are as unsurprising as they are unhelpful in determining whether a company should invest in innovation or buy back stock.
To grow via investments in innovation a company needs to have above average innovators. Average or below average innovators will not win often enough to make it worthwhile to invest in them. Not all companies, however, have above average, much less great innovators. The cited studies did not broach the subject of whether a company’s shareholders would have fared better had the company invested in its average or below innovators, much less reveal whether investing in poor innovators or buying back stock is in the best interest of the shareholders.
Whether you believe that Alta Vista went down the tubes because it failed to invest in its innovators, or that Alta Vista would still be the leading search engine had it invested more in its innovators, the studies on which the Forbes article relies will not support your belief.
“Buybacks basically allow the corporation to metaphorically throw the cash onto the bonfire.”
I couldn’t disagree more. Investing in below average innovators would be equivalent to setting cash on fire, and is certainly not in the best interest of the shareholders. As I mentioned before, buyback are admissions of the failure of management. Those failures include not having hired enough above average innovators and not having an investment decision team with the capacity to get excess cash profitably deployed in a timely manner. Such poor managers should not compound their error by wasting the dollars instead of giving them back to the shareholders.
Stock buybacks are much better than wasting the country’s resources on below average innovators. It is better to release that capital back into the market so as to fund the next Google, Apple….
3) CEO WAGES HAVE BEEN GROWING RAPIDLY
AMANDEEP: Corporate executive wages have been growing, rapidly, even during the high tax high regulation era of Obama. To quote one article I read on this issue, “From 1978 to 2013, CEO compensation, inflation-adjusted, increased 937 percent, a rise more than double stock market growth and substantially greater than the painfully slow 10.2 percent growth in a typical worker’s compensation over the same period.” None of this gets explained by your analysis. It seems clear that what is also going on is that the folks that run these corporations are simply choosing to give themselves massive raises instead of the workers and not earning it based on productivity.
I believe this phenomenon is referred to as “economic rents”, and the appropriate response is to alter the institutional structures that allow for such substantial rents.
HARVEY: True. High and rising CEO compensation was not explained by my analysis. That is because it is irrelevant to the question I was answering. The question was about rank and file compensation. The supply and demand in the CEOs market is vastly different than the supply and demand for rank and file employees. By way of analogy: If I were discussing the wages for non-star professional athletes (including farm team employees), a discussion of the compensation of Kevin Durant and other stars would be a distraction.
“It seems clear that what is also going on is that the folks that run these corporations are simply choosing to give themselves massive raises instead of the workers and not earning it based on productivity.”
It is generally true that people’s compensation is correlated with the value of their production. That each employee is paid a little less than the value of her production is certainly a company goal. While the goal is roughly achieved overall, in reality, other than the bonus portion of compensation, an employee’s compensation is based on the expectation of the value the employee will produce in the future. Employers (e.g., boards of directors and sports team managers) must always guess how productive their employees will be, and, with rare exception, they do not pay more or less than the market dictates they must pay.
Very few people have the combination of skills, personality, and other intangibles that are necessary to be a successful top executive (or athlete). The bigger the company, the more true that becomes. Because so many of those chosen do not meet expectations, it is obvious that there are fewer superstars than there are superstar positions. Nevertheless, all holders of superstar positions are paid superstar compensation because they were expected to produce superstar results. Such is not the case for non-superstar positions. The laws of supply and demand for labor works all the way up and down a company’s organization. The errors in guesses occur throughout the organization, but the top paid people get the most attention because the errors are more consequential and egregious.
There are exceptions. There are situations in which the CEO has so packed the board with cronies (and the cronies so want to hang onto their board status and/or pay) that they kowtow to the whims of the CEO. Such is life.
I submit, however, that the above situations are far less prevalent than your comment suggests. This is because even though a CEO may not be earning her keep, the firm must have a CEO. The issue before the board is not only whether the under-producing CEO should be fired. The issue is whether the company can find and hire a more cost effective CEO. That involves guessing at whether the current CEO or some other CEO (who knows vastly less about the company) would be more cost effective. This creates high risk of a “head I win, tails you lose” situation for boards of directors. (Consider how many football coaches keep their job after losing seasons because the team doesn’t believe they can find someone better. Perhaps more to the point, consider how many such coaches are fired only to be replaced by someone at a higher salary that produces poorer results.) This reality also gives incumbent CEOs inherent advantages. Because lower level employees are so much more plentiful, such is not the case with respect to lower level employees.
It is a sad and sometimes egregious, but unavoidable state of affairs in the market for CEOs. That, contrary to your suggestion, is why most CEO’s make the big bucks!
AMANDEEP: Rising CEO pay specifically, and upper level executive pay generally, is definitely relevant to your analysis. You claim that tax policy acts as a retardant to growth, which is certainly true. However, so does CEO pay. In fact, according to Forbes, CEO compensation actually exceeds taxes. And CEO pay has been increasing insanely rapidly … significantly faster than even college tuition over the decades. Given CEO pay is as much or as large a share of the pie as taxes, it’s effect should be viewed as equally significant.
You seem to treat corporations as close to automatons that simply set wages based on market conditions. However, incorporating behaviorial economics into the mix … it seems much more likely that executives are diverting earnings into non-growth paths based on personal greed divorced from market conditions. Corporations are making record profits, and the actual humans running the companies make the decisions whether to direct those profits towards outlets that benefit them personally as well as major shareholders to whom they are beholden. This is often not the ideal decisions towards growth of the company.
You are proposing a free market for CEO hiring and firing that does not exist. Removing a CEO is a very rare event, they are almost as entrenched as politicians are. There is absolutely no way to judge whether one is underperforming or not, except in the most extreme cases … and even then they often remain in their positions. Maximizing executive compensation and shareholder equity are not directly proportional to growth. The former can be increased even in the absence of growth. And if there is actual growth, it seems more likely that the folks in charge will direct almost all of it towards increasing their pay, not that of the workers … other than nominally as they have been. See: “Study Reveals The Obvious: CEOs Get Paid More Than Uncle Sam.”
HARVEY: Yes. CEO pay has been growing more rapidly than most other factors in business, on average big corporations pay more in CEO compensation than in income taxes (why is that a meaningful benchmark I do not know), CEOs are self-interested, most CEOs can influence what they are paid to some degree, and government doesn’t do much to prevent any of this. None of this is inconsistent with my other comments. (Therefore, I am not arguing that the market for CEOs is a completely free market. As I said, the aspects of CEO compensation that are not free market are “are far less prevalent than your comment suggests.”)
That CEOs are self-interested and have some influence over their compensation has been true of big corporations everywhere and always. There are, however, some important differences between today and yesteryear:
a) Some corporations today are so large and profitable (in absolute terms) that the difference in the profitability (in absolute terms) of the firm between one CEO and a 20% better CEO is so large that the incremental compensation between the two CEO is often a small fraction of the value the CEO brings to the corporation. This fact gives CEOs tremendous bargaining power is their compensation requests are for less than the value they bring to the corporation. That can be a very large number. (Just Kevin Durant will get $108 million over the next two years because Golden State believes his presence on the team will enable the team to earn more than that.)
b) Government is granting favors to large corporation at a record pace in a record amount (in large part because of the desire of politicians to have their campaign coffers filled). Only large corporations can afford to lobby and their scale gives them a competitive advantage of potential competition with respect to regulatory compliance. Government favors and regulations cause there to be much larger companies than would otherwise exist. This largeness is the source of the problem described in a). (Kevin Durant would make much less if government did not so heavily subsidize basketball.)
c) The most egregious CEO pay is in the financial industry. Because they are routinely bailed out when their wildly risky investments, CEOs in that industry make tons of money during the good times (before the crashes their riskiness induced) and rarely bear the costs of the losses they inflict in their own industry and everywhere else. This government induced situation causes there to be much more short term thinking that would otherwise be the case. (Because governments do not bailout bad basketball team decisions, Kevin will not make $54 million a year two seasons from now if he does not generate more than $54 million a year for the team.)
d) “Experts” have advised companies, and shareholders have demanded, that CEO’s compensation be more aligned with stock performance. While there merits of that approach to compensation are obvious, the fact that it has focused CEOs on short term stock gains has been an inevitable result.
I too do not like the fact that so many CEOs focus on short term gain because some or all of their compensation is based on short term gain. Those that send their companies down the river for their own gain are contemptible. The CEOs that lobby government for and gain favors from government are as contemptible as the politicians who grant them.
More government involvement will exacerbate these problems, less would ameliorate them.
AMANDEEP: Corporate executives decide to direct corporate revenue to, broadly, four outlets. 1) Pay themselves. 2) Invest in growth. 3) Pay the government. 4) Pay the workers. Nothing wrong with this. And if things worked exactly as you described in your blog, increased growth would lead to proportionally increased wages as well. The flaw here though is that the relative ratios of these four have been changing over time … and dramatically in favor of #1. There is little reason to think that more growth will do anything other than continue to exacerbate this phenomenon (since there are no policies in place to prevent it) despite some nominal wage growth.
HARVEY: I have no problem with the “four outlets” analysis of the situation. The gist of this comment, however, appears to be saying that greater income inequality is likely to be a consequence of the tax bill and regulation cuts. That very well may be, but it does not undercut my claim that lower taxes and regulations working together could cause there to be many more jobs than would otherwise be the case and that more jobs means scarcer labor. Scarcer labor means higher compensation and lower welfare costs.
As you know, I have written extensively about income inequality.[i] As you also know, my focus is making life better for the non-rich, especially the poor. To me, if the cuts in taxes and regulations improve the finances of those people it is a good thing. However bad income inequality is, it is a different topic. People are not poor because others are super-rich (but poor people are economically better off than they would be if there were no super-rich people).
You are also correct that the compensation increases I have been talking about are “nominal.” That does not mean that much could not have been said about real compensation increases. I was trying to keep the discussion focused. The way to improve real compensation is by increasing human capital and giving workers tools with which to be more productive. There are many reasons to believe that employers will invest more in employees if there is more profit to be made by investing in them than there was before the tax cuts. So if the cuts work, we should anticipate both nominal and real compensation increases.
AMANDEEP: Thank you for the detailed reply. It gives me a lot to think about.
Abstractly, corporations with superior innovators in charge will succeed more. But this is virtually always a post hoc determination. At the time of hiring, it is or should be the opinion of the board that they have hired the best person for the job. You say stock buybacks are better than wasting the money on below average innovators … but at the time they are approved, the board is always under the assumption that its corporation is being led by an above average innovator. What it really is is an active decision by the folks in charge to divert corporate profits to their own pockets instead of investing it. If a board feels they have an inferior CEO, they should simply fire him or her and hire a superior one.
I brought up the comparison between CEO pay and taxes paid to emphasize that the former can be just as significant a factor in corporate decision making as tax policy. While I have no disagreements with your description of CEO value, that analysis has applied for as long as there have been corporations but the rapid escalation in CEO pay (as well as top tier management) over the recent decades is a new phenomenon that is not justified by market forces.
Rising income inequality is a real problem. Not merely for the social dissatisfaction, but also because it eventually creates monopolies. And while monopolies may temporarily be acceptable, the more common outcome is inefficiency, higher prices, inferior products, and a loss of incentive to innovate. It is a major headwind to achieving your focus on making life better for the non-rich.
Eventually, monopolists, even those that began as above average innovators, become fat and lazy. Human nature after all. And the temptation to divert profits into their own pockets instead of investing gets stronger and stronger. And once a corporation becomes too big to fail, it no longer matters if an above or below average innovator is in charge. Market forces become insufficient to force change as opposed to inequality. IBM is a perfect example.
Much like the corporate board that never knows if their new CEO will be a dud or not, none of us know how successful this tax bill will actually be. But it’s definitely structured in a way that will increase inequality which will further us along towards the dystopian future. I guess one could defend it because there will be some nominal gains for the masses as well, but it could definitely have been crafted in a different way too. Once you restrict buybacks and corral CEO pay, market forces will demand that corporations put the best innovators in charge to a significantly stronger degree than currently.
HARVEY: Your last two posts have little to do with the topic of this thread: the relationship between tax and regulation cuts and jobs. Your comments are mostly about self-serving management and income inequality. As interesting as those subjects may be, they are not the subject of this thread. I’ll nevertheless make a few closing comments. Perhaps we can discuss those subjects in future posts having to do with those things.
I already conceded that there is some CEO self-dealing with respect to their own compensation. Repeating the claim does not refute what I said on that subject earlier in the thread. Additionally, agency problems are ubiquitous and largely unsolvable. Empowering more agents to address the agency problems of CEOs will merely move the agency problem (and opportunity for corruption) to the new agents. To make tax and regulation cuts dependent on solving agency problems would be folly.
As I have also conceded (see my blog post, “Non Sequiturs on Parade – PART IV”) that inequality creates some problems. Most of those problems, however, have nothing to do with the inequality itself. They have to do with some people’s feelings about the existence of significant inequality. Moreover, income inequality itself is in many ways a very good thing. (See my blog post, “Income Inequality Is More Than It’s Cracked Up To Be.”)
You state that income inequality causes monopolies. I think you have the causality arrow pointing in the wrong direction. Monopolies can cause there to be more inequality. Moreover, getting government more involved with achieve the opposite result from the one you suggest. With few exceptions, enduring monopolies are made possible only by government. Government already has the power to break up monopolies, but rarely do. If the goal is to eliminate monopolies, we cannot reasonably expect government to help you achieve that. History instructs that politicians like big, protected companies. (Remember the “solution” to “too big to fail” was to make banks bigger.) If we were to give government the power to directly manage company expenditures, we should expect even more corporate money finding its way to the coffers of politicians.
Your discussion of the differences between NBA and “most industries” suggests that I have said that higher profits leads to higher wages. I have said no such thing. I have said it is scarcity of labor relative to jobs that causes wages to rise. (Plus there is that productivity thing.) I have also said that tax cuts in the midst of excessive business regulations will not create enough jobs to change significantly the current scarcity of jobs relative to suitable laborers.
“Professional sports are the rare industry in which escalating wealth for the owners has coincided with rapid wage growth.” True. It is also true that without the NBA’s rise in revenue, such rapid wage growth would not have happened. Contrary to what you are suggesting, however, it is the scarcity of people who can play well enough to draw the fan base they do that has caused all of that to happen. It is folly to believe that unions played a major role in Durant being guaranteed $25 million this season and Kevon Looney, who plays the same position, being guaranteed $1.5 million this season. (Unions are typically into equal pay for equal jobs.) The difference in pay is mostly because the owners believe that Durant will produce at least 17 times as much revenue for the team as Looney will.
“[Stock buybacks]… is in no way superior to having that money returned as wages.” I find this to be nonsensical. “Returning” money to employees (as wages)? Somehow the company took money from employees that needs to be returned to them? That’s as bad as saying that extracting less wealth from high income earners in the form of taxes is a “giveaway” to the rich. It makes no sense to me.
[i] “Investment Income and Universal Basic Income Are Not ‘Basically The Same’,” “Income Inequality Is More Than It’s Cracked Up To Be”, and “You will always have the poor among you. . . .”
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