Bonus Culture

The comments I received on my post about a maximum wage were interesting for many reasons. In this post I just want to focus on one common misperception. This is that a maximum wage, because it interferes with the market, must be distortionary and therefore something that should tend to be avoided. This in turn assumes that the actual economy approximates the competitive efficient allocation students learn about in Econ 101, which is what neoliberals would like people to believe.

To see why this might well not be true when it comes to high pay, I want to briefly discuss a paper (NBER version here) by Roland Bénabou and Jean Tirole, which has the title of this post. I will try and make my discussion as non-technical as possible.

The basic idea is as follows. Jobs involve two types of activity or output, one of which is measurable and one is not. To reflect this, pay involves two components: a fixed component, which the worker always gets, and a performance element (the bonus) which depends on the worker’s measured output. The firm wants the worker to undertake both types of activity, so it sets the appropriate relationship between the two elements of pay to make sure the worker puts the right amount of effort into each type of activity. I will talk about what these two types of activity might be in practice below.

So far, so good. But now we add an information problem. There are two types of workers: the ordinary and the talented. The talented worker is much better at producing the measurable output. The firm cannot tell the two types apart, but it would naturally like to attract some of the more talented workers. One way it can do this is to offer two types of remuneration package: a ‘low bonus’ type and a ‘high bonus’ type. Talented workers will be attracted to the high bonus package, because their talent means that they can achieve high measured output (and therefore high pay) with relatively little effort.

This is useful for the firm, but it creates a problem. The bonus payment is now doing two jobs: allocating worker effort between activities, and attracting talented workers. In these circumstances, the bonus payment can depart from its efficient level. In particular the paper shows (p13) that in a competitive labour market, bonus payments designed for talented workers will be too high, in the sense that they lead to these workers putting too much effort into the measured activity, and too little into the other activity.

So what might these two activities (one measurable, one not) be in practice. The paper suggests, for measurable activities, things like sales, output, trading profits, and billable medical procedures, and for immeasurable activities things like intangible investments affecting long run value, financial or legal risk-taking, and cooperation among individuals or divisions. So the problem is that, in an effort to attract talented workers, the firm over incentivises effort on achieving tangible short term goals at the expense of work on intangible, longer term objectives.

The relationship to my discussion of a maximum wage should now be clear. To quote from the paper: “Turning to policy implications, we show that a cap on bonuses can restore balance in agents’ incentives, and even re-establish the first best, as long as it does not induce employers to switch to some alternative “currency” to screen employees.”

If you want to think about how this idea relates to alternative models of executive pay and competition for talent, I would encourage you to read section 1.1 of the paper, which is not too technical. The paper also contains a lot more that will be of interest to economists.

The general point I want to make is this. We can think about the minimum wage as an unfortunate interference in the market which can nevertheless be justified on equity grounds, or as a means of reducing poverty. However we can also see it as a way of increasing the efficiency of the economy, because many employers of low paid workers can exploit their monopoly power to pay wages that are below the efficient level (monopsony). Exactly the same may be true of the maximum wage. It could be that top pay is inefficiently high because executives have monopoly power, or it could be as this paper suggests because the firm wants to attract unobservable talent. I see no reason to presume that the dramatic increase in top pay reflects increases in the productivity of those workers.

  

If minimum wages, why not maximum wages?

I was in a gathering of academics the other day, and we were discussing minimum wages. The debate moved on to increasing inequality, and the difficulty of doing anything about it. I said why not have a maximum wage? To say that the idea was greeted with incredulity would be an understatement. So you want to bring back price controls was once response. How could you possibly decide on what a maximum wage should be was another.

So why the asymmetry? Why is the idea of setting a maximum wage considered outlandish among economists?

The problem is clear enough. All the evidence, in the US and UK, points to the income of the top 1% rising much faster than the average. Although the share of income going to the top 1% in the UK fell sharply in 2010, the more up to date evidence from the US suggests this may be a temporary blip caused by the recession. The latest report from the High Pay Centre in the UK says:

“Typical annual pay for a FTSE 100 CEO has risen from around £100-£200,000 in the early 1980s to just over £1 million at the turn of the 21st century to £4.3 million in 2012. This represented a leap from around 20 times the pay of the average UK worker in the 1980s to 60 times in 1998, to 160 times in 2012 (the most recent year for which full figures are available).”

I find the attempts of some economists and journalists to divert attention away from this problem very revealing. The most common tactic is to talk about some other measure of inequality, whereas what is really extraordinary and what worries many people is the rise in incomes at the very top. The suggestion that we should not worry about national inequality because global inequality has fallen is even more bizarre. 

What lies behind this huge increase in inequality at the top? The problem with the argument that it just represents higher productivity of CEOs and the like is that this increase in inequality is much more noticeable in the UK and US than in other countries, yet there is no evidence that CEOs in UK and US based firms have been substantially outperforming their overseas rivals. I discussed in this post a paper by Piketty, Saez and Stantcheva which set out a bargaining model, where the CEO can put more or less effort into exploiting their monopoly power within a company. According to this model, CEOs in the UK and US have since 1980 been putting more bargaining effort than their overseas counterparts. Why? According to Piketty et al, one answer may be that top tax rates fell in the 1980s in both countries, making the returns to effort much greater.

If you believe this particular story, then one solution is to put top tax rates back up again. Even if you do not buy this story, the suspicion must be that this increase in inequality represents some form of market failure. Even David Cameron agrees. The solution the UK government has tried is to give more power to the shareholders of the firm. The High Pay Centre notes that: “Thus far, shareholders have not used their new powers to vote down executive pay proposals at a single FTSE 100 company.”, although as the FT report shareholder ‘revolts’ are becoming more common. My colleague Brian Bell and John Van Reenen do note in a recent study “that firms with a large institutional investor base provide a symmetric pay-performance schedule while those with weak institutional ownership protect pay on the downside.” However they also note that “a specific group of workers that account for the majority of the gains at the top over the last decade [are] financial sector workers .. [and] .. the financial crisis and Great Recession have left bankers largely unaffected.”

So increasing shareholder power may only have a small effect on the problem. So why not consider a maximum wage? One possibility is to cap top pay as some multiple of the lowest paid, as a recent Swiss referendum proposed. That referendum was quite draconian, suggesting a multiple of 12, yet it received a large measure of popular support (35% in favour, 65% against). The Swiss did vote to ban ‘golden hellos and goodbyes’. One neat idea is to link the maximum wage to the minimum wage, which would give CEOs an incentive to argue for higher minimum wages! Note that these proposals would have no disincentive effect on the self-employed entrepreneur. 

If economists have examined these various possibilities, I have missed it. One possible reason why many economists seem to baulk at this idea is that it reminds them too much of the ‘bad old days’ of incomes policies and attempts by governments to fix ‘fair wages’. But this is an overreaction, as a maximum wage would just be the counterpart to the minimum wage. I would be interested in any other thoughts about why the idea of a maximum wage seems not to be part of economists’ Overton window.