Capital in the Twenty-First Century (58 page)

To my mind, the most convincing explanation for the explosion of the very top US incomes
is the following. As noted, the vast majority of top earners are senior managers of
large firms. It is rather naïve to seek an objective basis for their high salaries
in individual “productivity.” When a job is replicable, as in the case of an assembly-line
worker or fast-food server, we can give an approximate estimate of the “marginal product”
that would be realized by adding one additional worker or waiter (albeit with a considerable
margin of error in our estimate). But when an individual’s job functions are unique,
or nearly so, then the margin of error is much greater. Indeed, once we introduce
the hypothesis of imperfect information into standard economic models (eminently justifiable
in this context), the very notion of “individual marginal productivity” becomes hard
to define. In fact, it becomes something close to a pure ideological construct on
the basis of which a justification for higher status can be elaborated.

To put this discussion in more concrete terms, imagine a large multinational corporation
employing 100,000 people and with gross annual revenue of 10 billion euros, or 100,000
euros per worker. Suppose that half of this revenue figure represents purchases of
goods and services by the firm (this is a typical figure for the economy as a whole),
so that the value added by the firm—the value available to pay the labor and capital
that it directly employs—is 5 billion euros, or 50,000 euros per worker. To set the
pay of the firm’s CFO (or his deputies, or of the director of marketing and her staff,
etc.), one would in principle want to estimate his marginal productivity, that is,
his contribution to the firm’s value-added of 5 billion euros: is it 100,000, 500,000,
or 5 million euros per year? A precise, objective answer to this question is clearly
impossible. To be sure, one could in theory experiment by trying out several CFOs,
each for several years, in order to determine what impact the choice has on the firm’s
total revenue of 10 billion euros. Obviously, such an estimate would be highly approximate,
with a margin of error much greater than the maximum salary one would think of paying,
even in a totally stable economic environment.
³⁴
And the whole idea of experimentation looks even more hopeless when one remembers
that the environment is in fact changing constantly, as is the nature of the firm
and the exact definition of each job.

In view of these informational and cognitive difficulties, how are such remunerations
determined in practice? They are generally set by hierarchical superiors, and at the
very highest levels salaries are set by the executives themselves or by corporate
compensation committees whose members usually earn comparable salaries (such as senior
executives of other large corporations). In some companies, stockholders are asked
to vote on compensation for senior executives at annual meetings, but the number of
posts subject to such approval is small, and not all senior managers are covered.
Since it is impossible to give a precise estimate of each manager’s contribution to
the firm’s output, it is inevitable that this process yields decisions that are largely
arbitrary and dependent on hierarchical relationships and on the relative bargaining
power of the individuals involved. It is only reasonable to assume that people in
a position to set their own salaries have a natural incentive to treat themselves
generously, or at the very least to be rather optimistic in gauging their marginal
productivity. To behave in this way is only human, especially since the necessary
information is, in objective terms, highly imperfect. It may be excessive to accuse
senior executives of having their “hands in the till,” but the metaphor is probably
more apt than Adam Smith’s metaphor of the market’s “invisible hand.” In practice,
the invisible hand does not exist, any more than “pure and perfect” competition does,
and the market is always embodied in specific institutions such as corporate hierarchies
and compensation committees.

This does not mean that senior executives and compensation committees can set whatever
salaries they please and always choose the highest possible figure. “Corporate governance”
is subject to certain institutions and rules specific to each country. The rules are
generally ambiguous and flawed, but there are certain checks and balances. Each society
also imposes certain social norms, which affect the views of senior managers and stockholders
(or their proxies, who are often institutional investors such as financial corporations
and pension funds) as well as of the larger society. These social norms reflect beliefs
about the contributions that different individuals make to the firm’s output and to
economic growth in general. Since uncertainty about these issues is great, it is hardly
surprising that perceptions vary from country to country and period to period and
are influenced by each country’s specific history. The important point is that it
is very difficult for any individual firm to go against the prevailing social norms
of the country in which it operates.

Without a theory of this kind, it seems to me quite difficult to explain the very
large differences of executive pay that we observe between on the one hand the United
States (and to a lesser extent in other English-speaking countries) and on the other
continental Europe and Japan. Simply put, wage inequalities increased rapidly in the
United States and Britain because US and British corporations became much more tolerant
of extremely generous pay packages after 1970. Social norms evolved in a similar direction
in European and Japanese firms, but the change came later (in the 1980s or 1990s)
and has thus far not gone as far as in the United States. Executive compensation of
several million euros a year is still more shocking today in Sweden, Germany, France,
Japan, and Italy than in the United States or Britain. It has not always been this
way—far from it: recall that in the 1950s and 1960s the United States was more egalitarian
than France, especially in regard to the wage hierarchy. But it has been this way
since 1980, and all signs are that this change in senior management compensation has
played a key role in the evolution of wage inequalities around the world.

This approach to executive compensation in terms of social norms and acceptability
seems rather plausible a priori, but in fact it only shifts the difficulty to another
level. The problem is now to explain where these social norms come from and how they
evolve, which is obviously a question for sociology, psychology, cultural and political
history, and the study of beliefs and perceptions at least as much as for economics
per se. The problem of inequality is a problem for the social sciences in general,
not for just one of its disciplines. In the case in point, I noted earlier that the
“conservative revolution” that gripped the United States and Great Britain in the
1970s and 1980s, and that led to, among other things, greater tolerance of very high
executive pay, was probably due in part to a feeling that these countries were being
overtaken by others (even though the postwar period of high growth in Europe and Japan
was in reality an almost mechanical consequence of the shocks of the period 1914–1945).
Obviously, however, other factors also played an important role.

To be clear, I am not claiming that all wage inequality is determined by social norms
of fair remuneration. As noted, the theory of marginal productivity and of the race
between technology and education offers a plausible explanation of the long-run evolution
of the wage distribution, at least up to a certain level of pay and within a certain
degree of precision. Technology and skills set limits within which most wages must
be fixed. But to the extent that certain job functions, especially in the upper management
of large firms, become more difficult to replicate, the margin of error in estimating
the productivity of any given job becomes larger. The explanatory power of the skills-technology
logic then diminishes, and that of social norms increases. Only a small minority of
employees are affected, a few percent at most and probably less than 1 percent, depending
on the country and period.

But the key fact, which was by no means evident a priori, is that the top centile’s
share of total wages can vary considerably by country and period, as the disparate
evolutions in the wealthy countries after 1980 demonstrate. The explosion of supermanager
salaries should of course be seen in relation to firm size and to the growing diversity
of functions within the firm. But the objectively complex problem of governance of
large organizations is not the only issue. It is also possible that the explosion
of top incomes can be explained as a form of “meritocratic extremism,” by which I
mean the apparent need of modern societies, and especially US society, to designate
certain individuals as “winners” and to reward them all the more generously if they
seem to have been selected on the basis of their intrinsic merits rather than birth
or background. (I will come back to this point.)

In any case, the extremely generous rewards meted out to top managers can be a powerful
force for divergence of the wealth distribution: if the best paid individuals set
their own salaries, (at least to some extent), the result may be greater and greater
inequality. It is very difficult to say in advance where such a process might end.
Consider again the case of the CFO of a large firm with gross revenue of 10 billion
euros a year. It is hard to imagine that the corporate compensation committee would
suddenly decide that the CFO’s marginal productivity is 1 billion or even 100 million
euros (if only because it would then be difficult to find enough money to pay the
rest of the management team). By contrast, some people might think that a pay package
of 1 million, 10 million, or even 50 million euros a year would be justified (uncertainty
about individual marginal productivity being so large that no obvious limit is apparent).
It is perfectly possible to imagine that the top centile’s share of total wages could
reach 15–20 percent in the United States, or 25–30 percent, or even higher.

The most convincing proof of the failure of corporate governance and of the absence
of a rational productivity justification for extremely high executive pay is that
when we collect data about individual firms (which we can do for publicly owned corporations
in all the rich countries), it is very difficult to explain the observed variations
in terms of firm performance. If we look at various performance indicators, such as
sales growth, profits, and so on, we can break down the observed variance as a sum
of other variances: variance due to causes external to the firm (such as the general
state of the economy, raw material price shocks, variations in the exchange rate,
average performance of other firms in the same sector, etc.) plus other “nonexternal”
variances. Only the latter can be significantly affected by the decisions of the firm’s
managers. If executive pay were determined by marginal productivity, one would expect
its variance to have little to do with external variances and to depend solely or
primarily on nonexternal variances. In fact, we observe just the opposite: it is when
sales and profits increase for external reasons that executive pay rises most rapidly.
This is particularly clear in the case of US corporations: Bertrand and Mullainhatan
refer to this phenomenon as “pay for luck.”
³⁵

I return to this question and generalize this approach in
Part Four
(see
Chapter 14
). The propensity to “pay for luck” varies widely with country and period, and notably
as a function of changes in tax laws, especially the top marginal income tax rate,
which seems to serve either as a protective barrier (when it is high) or an incentive
to mischief (when it is low)—at least up to a certain point. Of course changes in
tax laws are themselves linked to changes in social norms pertaining to inequality,
but once set in motion they proceed according to a logic of their own. Specifically,
the very large decrease in the top marginal income tax rate in the English-speaking
countries after 1980 (despite the fact that Britain and the United States had pioneered
nearly confiscatory taxes on incomes deemed to be indecent in earlier decades) seems
to have totally transformed the way top executive pay is set, since top executives
now had much stronger incentives than in the past to seek large raises. I also analyze
the way this amplifying mechanism can give rise to another force for divergence that
is more political in nature: the decrease in the top marginal income tax rate led
to an explosion of very high incomes, which then increased the political influence
of the beneficiaries of the change in the tax laws, who had an interest in keeping
top tax rates low or even decreasing them further and who could use their windfall
to finance political parties, pressure groups, and think tanks.

{TEN}

Inequality of Capital Ownership

Let me turn now to the question of inequality of wealth and its historical evolution.
The question is important, all the more so because the reduction of this type of inequality,
and of the income derived from it, was the only reason why total income inequality
diminished during the first half of the twentieth century. As noted, inequality of
income from labor did not decrease in a structural sense between 1900–1910 and 1950–1960
in either France or the United States (contrary to the optimistic predictions of Kuznets’s
theory, which was based on the idea of a gradual and mechanical shift of labor from
worse paid to better paid types of work), and the sharp drop in total income inequality
was due essentially to the collapse of high incomes from capital. All the information
at our disposal indicates that the same is true for all the other developed countries.
¹
It is therefore essential to understand how and why this historic compression of
inequality of wealth came about.