Executive compensation is about ethics and not regulations. Industry should self-impose reasonable caps on the ratio of executive compensation and average employee salary.

There is justified public outrage at the obscenely large executive compensation. Should the government regulate compensations in the private sector even when there is no government money involved?

Let us first consider a compensation method that exemplifies the best in the capitalistic system. Whole Foods, headquartered in Austin, is an $8 billion company selling natural and organic foods and promoting sustainable agriculture worldwide. They have a self-imposed limit on executive salary and bonuses, which is a maximum of 19 times the average salary of all full-time employees. Additional compensation is tied to stock options. The executives benefit if the average salary of employees goes up. The wealthy CEO and founder, John Mackey, takes a token $1 as salary and all his stock-based compensation is channelled to Whole Food’s not-for-profit foundations that do outstanding work all over the world.

What is interesting is that the CEO, John Mackey, is a well-known libertarian who firmly believes in free market capitalism and that the government should have little role in economic activity. He is strongly against unions and socialised medicine. In fact, his recent article in The Wall Street Journal arguing against government-supported healthcare attracted numerous protests. However, under his leadership Whole Foods governs itself to maximise the benefits of all stakeholders, including employees, suppliers, customers, and community. Ninety per cent of all stock options are awarded to non-executive members. All employees receive generous healthcare benefits. Five per cent of the profits go to non-profit and community organisations. The company believes in the greater role of firms in creating a better environment and opportunities for others. This remarkable company culture is rooted in capitalism and corporate social responsibility (CSR). Mr. Mackey deviates from the popular libertarian view that CSR is unadulterated socialism.

Many executives like Steve Jobs, CEO of Apple, Larry Page and Sergey Brin, co-founders of Google, and Eric Schmidt, CEO of Google, are also in this $1 club and receive compensation only through stock options. Some criticise this, contending that that $1 grandstanding obfuscates real compensation from stock appreciation. But they ignore the fact that these executives could rake in millions in salary any way.

However, the real stinker is the overall executive compensation has grown uncontrollably over the years. In the United States, the ratio of CEO compensation to average employee pay increased from 42:1 in 1980 to 400:1 early this decade. (India’s corresponding numbers were not readily available, but the current compensation of top executives supports such large ratios.)

Steven Kaplan, Professor at the University of Chicago, and others use market equity, firm profitability, and shareholder returns to justify executive compensation. Mr. Kaplan argues that executives are underpaid when a comparison is made with the historical share of adjusted gross income (about 1 per cent). But he fails to explain historical low compensation to average employee salary ratios. His arguments cannot explain why CEOs in oil industries deserve huge bonuses when a large fraction of profits were a result of irrational increase in oil prices.

The arguments cannot explain the differences in compensation of CEOs in the U.S. and those in other developed economies. The CEO compensations of equally powerful global companies in Germany, Japan, and other developed countries range from 10 to 25 times that of average employee salaries.

The rampant increases and somewhat reckless compensation significantly correlate with scandals such as stock option backdating and large severance packages. Managers potentially resort to inflating stock prices through investor expectation management. The short executive tenure adds to the challenge. It breeds short-term focus and potentially drives executives to seek creative accounting methods to show performance. Even worse, executives who inherit mess will seek greater compensation to guard against potential unknown downside creating a vicious cycle. The market equity drives up compensation each time as firms try to out beat peer firms.

The U.S. Congressional report rightly suggests that executive compensation in many sectors, particularly financial services industry, has de-coupled from actual firm performance.

How to rein in executive compensations? It is a non-trivial matter. The government enforcing compensation caps on private firms has unintended consequences. As reported in The Wall Street Journal, since the 1980s the U.S. has tried regulation, legislation, and tax penalties to rein in executive pay, but compensation has skyrocketed. A few executive compensation outliers have become the industry norm after regulations. If one has it, others will want it. The competition to get talent forces firms to match others’ bloated compensation.

Government mandates raise other questions. Should there be a cap on compensation of sport personalities, movie stars, or singers? Should the government put a cap on what proprietary and partnership-based businesses earn? Will the government interfere with how five-star hotels charge their customers? There is no end to this mandate.

Further, what will happen to thousands of non-profit organisations that rely on the wealthy to survive? Will mandates encourage job-creating investments pushed to other countries? Will top talent be poached by other countries with no such restrictions? Will angel investors who support entrepreneurs during high-risk early phase of a start-up disappear? There are numerous unknowns in this debate.

Of course, the government has a responsibility to protect shareholders and the economy from a reckless incentive system. Sensible regulations should give shareholders greater say in executive compensation referred to as “Say on Pay” that companies like Microsoft have adopted. This provides greater transparency and removes the undesirable nexus between the Board of Directors who set the compensation and executives. The clawback provisions to recall bonuses and compensation resulting from incorrect financial reporting or outright fraud need to be strengthened. Corporate fraud must be pursued vigorously. There are ways for the government to make these non-interfering regulations. It can consider tax benefits for firms that voluntarily set reasonable compensation limits.

It is time industry self-regulated proactively to benefit all stakeholders. Otherwise, it opens up for government intrusion since such intrusion may be popular among the public.

Assuming every company replicates or improves Whole Foods’ compensation system, I am confident there is no better economic system than the capitalistic system to create wealth and improved living conditions. There is no need for government intervention and CSR with the right tax incentives can address societal needs.

In the context of India, the above may have greater relevance. There is little evidence that the government can substitute efficient privately run for-profit or non-profit organisations. Since Independence, the government has initiated hundreds of programmes and billions of rupees to improve rural India and socially and economically backward sections of the population. As I heard in one of the talks, considering the amount of money India has spent on various programmes every village should have been a Singapore by now! Obviously, let alone villages, no town or city in India comes close to Singapore on any dimensions.

Unfortunately, there is more tolerance towards corruption than executive compensation in the political establishment. The political establishment should rein in corruption rather than address outrage on executive compensation — it has no impact on the masses who want opportunities to succeed.

In the end, executive compensation is about ethics and vision that is best left for private firms to revisit. John Mackey said in the Harvard Business Review debate on executive compensation — “In my experience, deeper purpose, personal growth, self-actualisation, and caring relationships provide very powerful motivations and are more important than financial compensation for creating both loyalty and a high performing organisation.” This is indeed a powerful statement from a die-hard libertarian.

The media and academia should play a greater role in a meaningful discourse on compensation ethics to inform industry and to bring greater attention. Of course, the government has the right to interfere if the private sector seeks government bail-out or subsidies.

Finally, it is also an ethical issue as to how these wealthy executives spend their fortune. Do they spend it on buying jumbo jets, build massive mansions surrounded by poverty, or plough back part of their fortune for the greater social good? I bet public anger will be non-existent when it is the latter.

(Prabhudev Konana is William H. Seay Centennial Professor and Distinguished Teaching Professor at the University of Texas at Austin, and can be contacted at pkonana@mail.utexas.edu)

RELATED NEWS

The winter of our austerity October 8, 2009

More In: Lead | Opinion