UK Panel: Executive Compensation Is a “Market Failure“

Rising inequality is in the news. Occupiers from Wall Street to Winnipeg have made rising inequality a cornerstone of their campaign. Labels like “the 1 percent” and “the other 99 percent” are in the news and on politicians' agendas.

This new attention to inequality goes all the way to the top. In his State of the Union address, President Obama warned that America was becoming “a country where a shrinking number of people do really well, while a growing number of Americans barely get by.”

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We expect Democrats to get worked up over inequality, but what about Republicans? In the official GOP reply to the State of the Union address, Indiana Gov. Mitch Daniels called for us to “restore an America of hope and upward mobility and greater equality.”

The day after Obama's and Daniels' remarks, the World Economic Forum opened its 2012 conference in Davos, Switzerland. At the opening debate, Professor Raghuram Rajan of the University of Chicago Booth School of Business told the assembled worthies that rising income inequality was unavoidable.

According to Rajan, rising inequality is not due to outrageous corporate pay practices but to “far deeper forces”: changing technology, globalization and innovation.

“These are not going to be affected by corporate governance,” Rajan said.

The World Economic Forum, held each January at the ski resort of Davos, Switzerland, is an annual invitation-only gathering of top CEOs, politicians and pundits from around the world.

Business executives and business school economists are fond of tracing rising inequality to deep historical trends. If you believe that markets are always rational, then high pay merely reflects a person's true economic value.

Historical trends, so the story goes, are making highly intelligent, highly skilled people more valuable – and thus more highly paid – than ever before. Resistance is futile. Inequality is rising due to deep forces beyond human control.

Economists call this line of reasoning the “skills premium” argument. Economists and executives, of course, tend to be highly intelligent and highly skilled. It's just a coincidence that they believe that their own high salaries are the inevitable result.

The main problem with the skills premium argument is that it is wrong.

The skills premium argument implies that inequality should be rising everywhere in the world. In fact, major increases in income inequality have only occurred in the United States, Canada and the United Kingdom.

It's a strange global historical trend that only shows up in three English-speaking countries and nowhere else.

While business school economists trace rising CEO pay to a skills premium, a blue-ribbon panel in the United Kingdom has reached a very different conclusion.

The UK High Pay Commission concluded that “top pay is a symptom of market failure based on a misunderstanding of how markets work at their best.”

The commission traced rapidly escalating income inequality back to a way of thinking that views “human nature, aspiration and endeavour … through a prism of self interest.”

“It is through looking at executive remuneration that we see the classic problems of corporate governance laid bare,” the commission said. In other words, the commission found that people – not deep historical forces – are responsible for rising income inequality.

British politicians from all shades of the political spectrum have rushed to endorse the report's conclusions. In fact, the Conservative-led British government announced on Monday, January 23, that it would propose legislation to rein in executive pay.

The main focus of this legislation? Corporate governance reform.

The proposed British legislation is similar to the 2010 Dodd-Frank law in the United States, in that it will require British companies to publish details of executive pay and the ratio of executive to median worker pay. The British law will go much further, though. It will give company shareholders a binding annual “say-on-pay” for executive compensation and severance pay. Under the US Dodd-Frank law, shareholder say-on-pay resolutions are nonbinding and only have to be held once every three years.

Remarkably, major industry groups in the United Kingdom have come out in support of these reforms. The Institute of Directors said in a press release that it “welcomes … a binding shareholder vote on executive remuneration,” while the Confederation of British Industry more guardedly affirms that “the proposal that binding votes for shareholders will not be retrospective is welcome” without explicitly endorsing or objecting to the votes themselves.

A shareholder vote on executive pay is unlikely in itself to reverse rising income inequality – certainly not in the United States, where these votes are nonbinding. Broader corporate governance reforms would go further to reduce inequality.For example, the UK High Pay Commission recommended that workers' representatives be given seats on corporate boards. This is already done in countries like Germany, where income inequality is much lower than in the United States, the United Kingdom and Canada.

The British government, however, categorically rejected the possibility of putting workers' representatives on the boards of UK companies as part of its new reform package. The commission also recommended that more company directors be chosen from the public and that the role of compensation consultants in setting executive pay be reduced.

Britain's opposition Labour party, despite having resisted the creation of the High Pay Commission in 2010, has endorsed the commission's report in full.

Meanwhile, American politicians of both parties have vowed to address rising inequalities. The modest Dodd-Frank provisions on executive pay came into force on January 1, but it is unlikely that further action on corporate governance in the United States will be taken before the November elections.