Tuesday, 17 March 2015

Competition at the top: is managerial compensation really increasing economic inequality?


Bank bonuses have, since the financial crisis, been at the center of the debate on economic inequality. The public has grown tired of such generous compensation, which is seen as underserved, because of the direct role that the banking sector played in the recent—and in many places—still ongoing crisis. The scandals about Libor rate manipulation and the very recent reports on HSBC hidden Swiss accounts are exemplar about the type of behavior that people take—and rightly so—as unacceptable and as incompatible with huge bonuses.

However, finding such behavior reprehensible may turn the conversation towards a question of professional ethics and morality that are context specific and, therefore, cannot be swiftly use to make any assertions of economic inequality, as an issue that goes beyond individual or sectorial behavior.  The real question must be one that takes into account managerial compensation at large (throughout all sectors): should we see super-salaries as equally outrageous across all industries? And, more concretely, are super-salaries really a contributing factor to rising economic inequality?

Are super-salaries really a contributing factor to rising economic inequality?

The French economist Thomas Piketty takes a close look at the actual evidence in his acclaimed work, Capital in the Twenty-First Century. He explores the changes that the highest incomes from labor have had in recent decades and in particular since the 1980s. What he finds is highly insightful and provides persuasive arguments, based on hard evidence, about the true role that exuberant managerial compensations are really playing.


The figures

Piketty provides clarifying figures, from which a detailed image of the labor inequality landscape emerges. It is important to keep in mind that the following figures focus only on the income that results from people’s work, that is, their salaries and other related compensation, such as bonuses. This distinction is key, because income can also be the result of investments, savings and an array of financial instruments—and taking a close look at this second source of income provides impactful conclusions, without a doubt, but not conclusions on how labor income is contributing to economic inequality.

So,

The upper 10% of the labor income distribution (the best-paid 10%) in developed nations, says Piketty, generally receives between 25–30 percent of total labor income. This means that the best-paid 10% of the population takes home around 25% of all the income that results from salaries, bonuses, etc., within a country.

Is the richest 10%—in the US or the UK—made out of the same people that are in the best-paid 10%?

Not exactly, and this is where it gets interesting. The richest 10% is not made out of the same people as the best-paid 10%, because the richest 10% receives most of its income not from their salaries (their work in any shape or form), but from the capital they owe (from income generated mainly in the financial and real estate markets). To understand this difference in income sources and the role it plays in economic inequality Piketty divides that wealthiest 10% even further, between the richest 1% and the rest (the 9% left). What he finds out is that,

The top 1% receives a much lower proportion of their income through their salary and other forms of work-related compensation, than the rest—than the missing 9%.

In fact the higher up you go—so from the richest 1% to the richest 0,1% and then even higher up to the 0,01%—the less important income from labor becomes.

Now, you may be thinking at this point, ‘so the super-rich don’t earn their money like most people, so why is this important?’

I will tell you that it is important for three reasons:

1.    People, who make most or all of their income, through financial instruments alone (capital income alone), are people who inherited their wealth in the first place (Piketty, 2013). Hence, when we are talking about the richest 1% we are not mainly talking about moguls of innovation like Steve Jobs or Richard Branson, but actually of heirs like the Hiltons or the Kennedys, just to name a couple of exemplar cases.

2.    Capital income, in addition, has been increasing as a percentage of GDP in most developed countries, between 1975-2010, from
  • 22% of GDP to 27% in the US
  • 19% of GDP to 20% in Germany
  • 17% of GDP to 30% in the UK

(Piketty, 2013, p. 222)

This means that capital income has become more and more important in our time, than it has been for the past seventy years, and is set to become even more important in the future. This is important because it means that wealth inheritance has likewise become in the recent decades more and more important.

40-year trend in capital income for developed countries


Source: Piketty, Capital in the Twenty-First Century, p. 222

3. The bottom 50% of wage earners is becoming poorer in comparison to the rest.

·      While they make up 50% of the labor force, they get to keep only 30% of the total income generated from labor—they take virtually nothing of the income generated from capital.
·      When we look at general wealth, the bottom 50% owes less than 5% of a country’s total wealth (US figures).

This is a very worrying trend, because it means that the bottom 50% can never expect to earn any income from capital, because their savings are insignificant—plus they have no inheritance at all—and their income from labor does not allow them to be able to buy into even the less-profitable types of financial instruments; too many in the workforce are stuck with at most a savings account, offering a rate of return that is barely above inflation, and is probably lower than inflation today.

Western societies proudly boast that ancient hierarchies, where last names mattered more than personal ability, have been long left behind: if you work hard and persist, society will compensate you in turn, was the mantra that most of us were born repeating. Believing that hard work is the underpinning of economic success motivates many to study, to want to excel at their jobs, to want to become entrepreneurs, etc., as well as to be trustful of corporations and firms at large.

In a word, living in a society that rewards smart, hard working people, is, for the most part, something that defines our identities and our sense of freedom, and a social virtue that provides the kind of political stability and freedom that is but a myth in too many countries around the globe. It is the increasing difficulty to reach this desirable outcome in the West that makes Piketty’s findings especially worrisome: are we set to return to the old-times, where inheritance determined our place in society? Will our kids be talking about dowries again?


Written by Daniel Vargas Gómez



If you like this article read more about economic inequality and Piketty’s ideas on The factish: The Thomas Piketty series.