Related link(s): http://www.richmondfed.org/publications/research/region_focus/2009/spring/policy_update_weblinks.cfmExecutives - Salaries

David Van Den Berg

English

Research Papers in Economics

12 Region Focus • Spring 2009 Spring 2009 • Region Focus 13
I
n June, President Obama announced the appointment
of a Washington attorney as the administration’s new
“special master” for executive compensation. Kenneth
Feinberg, the appointee, will oversee pay packages of
company executives whose firms are receiving government
assistance. 
Feinberg will review and approve any compensation for
the senior executives and the next 20 highest-paid employ-
ees at seven firms who received money through the Federal
Government's TARP program. Those companies include
Bank of America, Citigroup, AIG, General Motors, GMAC,
Chrysler, and Chrysler Financial, according to the Treasury
Department. Feinberg’s duties also include advising 80 more
financial companies that received government money about
executive pay.
Part of the debate in Washington about executive pay has
centered on the question of whether CEOs are overpaid 
relative to their contribution to firm value. Another ques-
tion has revolved around whether their compensation
packages create incentives for them to take excessive risks. 
Across the corporate sector, the size of executive com-
pensation packages has soared. The gap between the salaries
of the workers and the CEO of a corporation has widened
considerably. In 1994, the ratio of median CEO pay to 
median production worker pay was 90 to 1, according to a
Congressional Research Service report. In 2005, that ratio
had increased to 179 to 1. 
Executive compensation packages often contain multiple
elements. CEOs can receive company stock, stock options,
deferred compensation, long-term bonuses, and nonmone-
tary perks. Not all of these are new. Stock options have been
an important element of CEO pay since the 1950s, although
executives receive those more frequently now.
In a 2008 paper, New York University economists Xavier
Gabaix and Augustin Landier write: “[T]he sixfold increase
of U.S. CEO pay between 1980 and 2003 can be fully attrib-
uted to the sixfold increase in market capitalization of large
companies during that period.” Gabaix says that this sug-
gests the market for CEOs works well and there are only a
few egregious examples of executives getting paid more than
you would expect based on their contributions to a compa-
ny’s success. 
CEOs may operate in a kind of superstar market, which
the late University of Chicago labor economist Sherwin
Rosen describes as one in which “relatively small numbers of
people earn enormous amounts of money and dominate the
activities in which they engage.” The differences in talent
levels among top executives is quite small, Gabaix and
Landier argue. However, those small differences can lead to
big gaps in compensation and are magnified by firm size. In
their paper, they note that the first CEO on the list earns
over 500 percent more than the 250th ranked executive. 
The more-talented CEOs seem to add more value to
their companies than the less-talented ones. Marko Tervio
of the University of California at Berkeley tried to deter-
mine what would happen if the managers of the 1,000
largest U.S companies in 2004 had been replaced by less-
skilled executives, such as the CEO of the company at the
bottom of the list. The combined market value of the top
firms would have been perhaps $25 billion lower. Tervio’s cal-
culations imply talented CEOs contributed $17 million to
$21 million, or 15 percent of the total market value, of the
largest 1,000 firms, writes Arantxa Jarque in a 2008 paper for
the Richmond Fed’s Economic Quarterly.
Economists differ on how closely the executive’s pay
should be linked to the company’s performance. For
instance, stock options may prove problematic in CEO
compensation packages, Gabaix says, by encouraging exces-
sive risk taking that only temporarily bolsters a firm’s share
price. In addition, a large decline in share price can render
the stock options worthless and granting new options or 
re-pricing existing ones may seem to reward an executive for
failure.
Part of the CEO’s compensation should not be subject to
risk, providing some insurance against bad performance due
to factors outside of his control, Jarque writes. Failure to
provide that assurance would make it difficult to recruit
executives.  
In a May 2009 paper, Gabaix and three co-authors 
propose one possible solution for improving incentive struc-
tures. They suggest awarding executive pay through
“dynamic incentive accounts.” Under the plan, CEOs would
see their pay escrowed each year and would have no imme-
diate access to most of it. A constant percentage of the
executive’s pay would be invested in company stock and the
remainder in cash. The portfolio would be continuously
rebalanced so that the portion of company stock is sufficient
to induce effort at minimum risk to the executive. The exec-
utive would receive small portions of the account gradually,
and that gradual vesting would continue even after an exec-
utive’s departure. This could discourage an executive from
behaving badly, such as using accounting tricks to inflate the
company’s short-run stock price before cashing out and 
leaving the firm in shambles. 
In the end, structuring executive compensation in a way
that aligns the incentives of the CEO with those of the 
company and its shareholders can be a tricky task — but one
crucial to well-functioning markets.  RF
POLICYUPDATE
Are CEOs Paid Too Much?
BY DAVID VAN DEN BERG
“Capital Taxation During the U.S. Great Depression.” Ellen
R. McGrattan, Federal Reserve Bank of Minneapolis
Working Paper 670, April 2009.
W
hile most economists would argue that the main
cause of the Great Depression was unwise mone-
tary policies, such policies alone cannot adequately explain
the severity and duration of the crisis. In this paper Ellen
McGrattan of the Minneapolis Fed seeks to prove that
some fiscal policies during the period had more than a
small impact. One key insight of the paper is that prior
studies on this topic have assumed that the only sort of
capital taxed during this period was profit. Yet the big
change in policy was actually a substantial increase in the
taxation of dividends in the Revenue Act of 1932. 
As McGrattan suggests, even the anticipation of divi-
dend taxation — a proposal publicly suggested by President
Herbert Hoover as early as 1930 — could have had an effect
on investment in that period. In addition, the studies that
suggest tax increases had little or no effect note that few
people actually paid income taxes during this period.
McGrattan notes that while this is true, the taxpayers who
did pay those taxes earned almost all of their income
through dividends.    
Adding dividend taxation to the standard growth model
on which the majority of research on this topic is based,
McGrattan discovers that a large fraction of the observed
declines in real GDP between 1929 and 1933 is explained by
her tax-inclusive model. Additionally, the decline in produc-
tion hours per capita during this period also can be
explained by her model. 
“The Olympic Effect.” Andrew K. Rose and Mark M. Spiegel,
Federal Reserve Bank of San Francisco Working Paper 2009-
06, March 2009.
T
he right to host a mega-event such as the Olympics
or the World Cup is seen as an honor to the nation
chosen, but economists are skeptical about the economic
benefits. In practice, these events usually end up impos-
ing large costs on their hosts that are not often fully 
recovered through revenue during the event or from the
structures that are left over afterward.
While it is commonly asserted that hosting the Olympics
will promote a nation’s exports, economists Andrew Rose of
the University of California at Berkeley and Mark Spiegel of
the San Francisco Fed examine the empirical evidence. They
find a large positive effect of the Summer Olympics on both
exports and overall trade. (The Winter Olympics are not
studied due to the fact that fewer countries are able to host
that event.) The authors also found a strong positive effect
on trade from other mega-events such as the World Cup.
The research shows that Olympic host countries have seen
up to a 30 percent increase in exports. Yet the authors 
also find an almost equal increase in trade in the nations that
vied for the right to host the event but were not chosen. 
This implies that the effect on trade comes not from 
actually hosting the games but from bidding for them in the
first place.  
The authors speculate that this increase results from the
signal that bidding to host the event sends to the world. This
“signaling strategy” conveys the country’s interest in trade
liberalization. This idea is illustrated by the fact that just two
months after being awarded the right to host the 2008
Summer Games in July 2001, China successfully concluded
negations with the WTO, thus formalizing its commitment
to trade liberalization.
“Subprime Mortgage Pricing: The Impact of Race, Ethnicity,
and Gender on the Cost of Borrowing.” Andrew Haughwout,
Christopher Mayer, and Joseph Tracy, Federal Reserve Bank
of New York Staff Report 368, April 2009. 
S
ome have argued that during the peak period for sub-
prime lending (2004 to 2006) minority borrowers were
saddled with higher interest rates than nonminority 
borrowers. The authors of this study test that claim using a
new sample that merges data on more than 75,000
adjustable rate mortgages with information on the race, 
ethnicity, and gender of the borrowers. This dataset allows
them to examine the differences in mortgage lending while
controlling for both the risk profile of the mortgage and the
characteristics of the neighborhood in which the property
was located.  
In contrast to some previous findings, their results 
show that there is no evidence of adverse pricing for most
minority demographics. If anything, many minority 
borrowers actually received slightly lower rates. Black and
Hispanic borrowers paid a slightly lower initial mortgage
rate than other borrowers, although Asian borrowers paid a
slightly higher rate. No appreciable differences were found
in lending terms based on gender. Finally, the adjustable
rates on the mortgages did not “reset” at higher levels for
minority borrowers relative to nonminority borrowers when
one controls for risk and location. The authors conclude
that these results suggest the possibility that subprime lend-
ing was a credit innovation that did serve as a positive credit
supply shock in locations with more minority residents.   RF
AROUNDTHEFED
What Prolonged the Great Depression?
BY MATTHEW CONNER 
 

Policy update: Are CEOs paid too much?

http://www.richmondfed.org/publications/research/region_focus/2009/spring/pdf/policy_update.pdf

Policy update: Are CEOs paid too much?

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