Monday, October 10, 2011

Don’t tax it: fix it! Executive pay in a bubble.

You meddle with price at your peril.

This is a wisdom that we have learned from centuries of economic experience. Price is a critical factor in moving resources to where they are most needed. It is an inexorable natural law which not only balances supply and demand but also reflects fundamental imbalances between them. Economic history is full of examples where price meddling did not correct imbalances, but indeed exacerbated them to the point of crises. You do not fiddle with the thermometer if you do not like the reading.

It is not surprising then that when debating what is one of the most critical issues of our time – pay disparities – the market purists predict all kinds of dire consequences if executive pay is tampered with through interventions such as a wealth tax. But what if the price mechanism itself is broken?

I have consistently argued that the labour “market” is one of the most dysfunctional of all. There are just too many glib assumptions, interferences, impediments and even emotional factors that frustrate conventional market scrutiny at all levels, particularly at the lowest skilled and at the “executive” level.

The pay disparity debate is rife with incongruities that have to be clarified first before it can become remotely coherent. There are so many on both sides that I can only deal with some and then briefly. I have also previously dealt with others in this column.

For starters, the “real gap” has to be better defined. As important a social issue as it is, the pay gap hysteria is based on some shaky assumptions. Gross income comparisons are used and that gap will be considerably reduced by different personal tax rates at the opposite ends of the scale. The much vaunted Gini wealth gap “shame” organised labour loves to bleat about, suffers from the same inaptness – plus some others that space and complexity discourage me from dealing with here.

Cosatu goes a giant leap further into absurdity by presenting the Gini indicator as proof that South African workers are underpaid. Our nearest comparable Gini neighbour Brazil has a maximum tax rate of only 27.5% compared with our 40%, --

implying a much higher “after tax” gap between rich and poor than in South Africa.

The biggest shortcoming in the “market-driven-pay” argument is that it lacks sound empirical research. To be sure, there are vast volumes of research and statistics on pay levels themselves, their impact and how they have been constituted, but little on benchmark drivers. For example, the Association of British Assurers questions “peer level” benchmarking as being valid at all.

Comprehensive data on poaching, resignations because of better pay offers, etc. is sparse. Also nothing tangible exists for the most important evidence such as quantified shortages and surpluses and the crucial but unquantifiable motivators and de-motivators. What really counts here cannot be counted: as Einstein would have put it.

The “market-driven-pay” argument that current levels prevent a flight of executive skills is based on a false assumption that “price” is the only or even major influence on human effort. There are many other motivators or detractors, including passion for the task, family and other ties, living conditions, tax rates, and different living costs.

Some argue that this is indeed recognised in geographical differentiation. Impossible! You cannot adjust measurements with factors that cannot be measured, particularly when the latter are highly personal and for many could be far more important than pay itself.

Another obvious flaw is the assumption that there is a single category of executive skill or talent that can be benchmarked against others of the same species and then globally. In turn, the argument goes, they come at a specific price according to supply and demand – like neurosurgeons or pilots, or tomatoes and potatoes.

There is a vast difference not only between different “executives” but also between groups. The three I identified in an earlier article are creators (who develop an innovative idea into a major business), builders (who construct big corporates from underlying and organically growing ventures) and professional managers (who are appointed by shareholders to promote their interest and mostly to enhance shareholder value.)

Creators and builders are the true entrepreneurs, often starting at a modest level and taking substantial personal risks along the way. They should be allowed maximum room to go about their legitimate business, even if it implies huge rewards.

Professional managers are an entirely different matter. They have become nothing less than a clearly identifiable separate “stakeholder” in business since the mid-seventies: a “4th estate” next to labour, capital and government. I would argue that their “price” was broken by a bizarre distortion which coincided at that time with a giant leap in short-termism, speculation, derivatives, debt and a disconnect between tangible wealth and “froth”. Today we are paying the price for 40 years of excesses and executive pay is one of them.

In the pursuit of shareholder value and applying the agency theory, shareholders have futilely tried to replicate the attributes and behaviour of creators and builders, and constructed a price on four pillars: base pay, bonuses, stock options and longer term incentives. But the premise itself was a myth and unavoidably caused a vacuum between supply and demand. Once established this price increased horizontally and vertically.

clip_image002This graph by the Washington Post shows that inflation adjusted executive compensation has quadrupled in 20 years to early 2000. Average worker pay over the same period has been static if not in a small decline. The supreme irony is that according to author Roger Martin total returns on the S&P 500 were 7.5 percent (compound annual) from the end of the Great Depression (1933) to the end of 1976, the beginning of the shareholder-value era. From 1977 to the end of 2010, they were 6.5 percent -- suggesting that shareholders have little to celebrate, despite having been made the clear priority.

Executive compensation is clearly distorted and in a bubble. It seems to have survived the global financial bubble burst, but burst it must, either through government intervention or through investor reaction. Warren Buffet and many of America’s wealthiest are NOT averse to a super-rich tax. At the very least this seems to confirm that Americans do not share fears of an exodus of executive skills if their take home pay were to be reduced.

Still, I would caution against using tax as a method of correcting pay disparity in South Africa. Economist Azar Jammine has mooted that it could be on Finance Minister Pravin Gordhan’s mind when he delivers his medium term budget policy later this month. The wealth tax debate is still far from coherent. For one thing, there’s little point in moving more resources to an environment that is rife with inefficiencies, waste, non-service delivery and corruption.

Proper cost benefit research has to be done with comprehensive data on how that money is being deployed by the rich at present – for example into charities, investments, saving and perhaps other productive pursuits. Certainly not all of it will be on toys and ostentatious lifestyles. Tax is a very blunt and seldom successful instrument in correcting supply and demand imbalances. A wealth tax may do little in the long run to uplift the poor or close the pay gap. An unintended consequence is that it validates and entrenches the faults in this market. Best the imbalance is corrected by those who created it in the first place – the shareholder body.

Any price distortion is unhealthy for an economy. This one is particularly onerous. It is arguably creating little value for those who introduced it, and is far too heavy a price to pay in social discontent.

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