Viewpoint

How to Fix Oversize Executive Compensation


From the mid-1970s until at least the mid-2000s, the earnings of American workers did not keep pace with U.S. productivity growth. The earnings of corporate executives, however, increased dramatically. The total annual incentive compensation, not including base salaries, of the top five executives of U.S. public companies increased from $4.9 billion in 1992 to $29.3 billion in 2006.

Among the top five percent of these companies' income earners, the value of the exercised stock options alone increased from $10.8 billion to $65.1 billion, a total of $806.7 billion for the 15-year period—and that does not include earnings from cash incentives and restricted stock plans. Moreover, companies can deduct large payouts from their income before they pay their taxes, large sums shielded from government coffers as a cost of doing business.

The defenders of executive compensation argue that senior executives make the most significant contribution to a company's success; ergo, outsize compensation is justified. But the NBER Shared Capitalism Research Project has shown the opposite: Distributing rewards across the corporation—sharing them with workers—is the most efficient way of making businesses more successful. Motivated employees are more productive and spur innovation in products and processes.

Sharing the Booty

The Shared Capitalism Project, originally funded by the Russell Sage and Rockefeller foundations, has been in progress for a decade. Harvard economist Richard Freeman, Rutgers sociologist Joseph Blasi, and Rutgers economist Douglas Kruse analyzed data from surveys of 41,206 employees at 323 work sites. They note that almost half the employees of American corporations participate in some form of profit-sharing or stock-option plans, what they call "shared capitalism." The researchers found that shared capitalism:

• Improves company performance. It is associated with greater attachment, loyalty, and willingness to work hard; lower turnover; workers reporting more commonly that co-workers work hard and are involved in company issues; and workers suggesting innovations.

• Improves worker well-being. It is associated with workers' greater participation in decision-making; higher pay, benefits, and wealth; greater job security; satisfaction with influence at work; trust in the company; positive assessments of managers; and better labor–management relations.

• Complements other policies. Such companies are more likely to have other worker-friendly labor policies and practices.

It is no surprise that when workers share in the rewards, they are more likely to be committed to a company's success. You would also expect workers to be happier when they have more responsibility and less supervision, as the researchers found. One expects to find these practices at leading technology companies. But shared capitalism works just as effectively at such companies as Wegmans Food Markets, Procter & Gamble (PG), and John Lewis in the U.K.

Gaming the System

Many argue that the present system of top-heavy compensation works fine. Yet there is zero evidence that awarding huge executive incentives has caused the U.S. economy to perform better. Instead, as we have seen with the demise of Enron and other companies—and the near collapse of our economic system—enormous payouts encourage risky behavior and lead managers to game the system. Unethical management teams manipulate news about the company, rewrite options when the company performs poorly, and in some cases misreport or misrepresent performance so that their options are in the money.

Freeman, Blasi, and Kruse propose a simple way to encourage companies to follow the Googles and Wegmans of the world: Allow them to deduct incentive pay as a cost of business only if they offer the same incentive program to all workers. In other words, don't give tax breaks to companies that provide stock options and bonuses to only a few executives. This would correct a major loophole in the tax system with which corporate executives have been enriching themselves at the expense of their stockholders and taxpayers. (The U.S. Tax Code does not allow the deduction of salaries beyond $1 million as a business expense, but it does allow companies to deduct as a cost of business any amounts paid as incentive compensation.)

This proposal is not as radical as it may seem. It is, rather, American capitalism at its best, the extension of a system that has engendered the success of such major companies as Google (GOOG), Apple (AAPL), and Procter & Gamble. The same principles already apply to pension and health-care plans—these are deductible as a cost of business only when they cover every employee. Compensation should be subject to the same rules, which will encourage more companies to extend incentive pay to all workers. And most importantly this change would make U.S. businesses more productive while benefiting workers.

Economic performance depends on the work of all Americans, not just that of a few. All-inclusive incentive systems work. It is one way to restore the historic pattern in which all boats, not just fancy yachts, rise when the economic tide of prosperity returns to the country. The proposal to use the tax system to encourage incentive pay for all workers will not, by itself, restore the American middle class. But it is a positive step for which business and labor, conservatives and liberals alike can rally. In fact, only executives who pay themselves with tax-deductible money on the grounds that they alone bear responsibility for a company's success may find reason to balk.

Vivek_wadhwa
Vivek Wadhwa is vice president of Academics and Innovation at Singularity University, Fellow at Stanford Law School and Director of Research at Pratt School of Engineering at Duke University. You can follow him on Twitter (@wadhwa) and find his research at wadhwa.com.

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