Sunday, August 2, 2009

Limiting Pay

There are a lot of reasons why people want to limit the pay of CEO’s, investment bankers, and money managers. Most of those reasons are bad. Yes, there is an unseemly disparity in income levels between the top and the bottom, and yes, no one needs to make $1,000,000,000 or more per year managing other people’s money. But limiting income disparity artificially and paying people “according to their needs” are bad ideas; they either remove incentives for achievement that create the wealth of the nation, or they delegate to fallible and corruptible bureaucrats decisions that the market can make in a dynamic and self-correcting manner.

But there is a second-order consequence of limiting pay. The current pay regime allegedly creates incentives to risky behavior – behavior of a sort that could bring down the financial system and the economy. If the claim is true – it is just a claim – then one needs to consider effectively limiting those incentives, and if limiting those incentives involves limiting pay, then that’s just how that cookie crumbles. One need not have a socialist bone in one’s body to want to protect our economy from collapse.

So, two questions arise. First, is economy-threatening risk-taking a product of the opportunity to make a ton of money risking other people’s money? And, second, if so, what should we do about it.

I can’t answer the first question. I can only say that I would entertain the possibility, and until I know the answer, I wouldn’t oppose efforts to limit compensation on principle.

As for the second question, how to limit pay, I think the income tax is the only viable approach. The progressive tax structure should add brackets at $1,000,000, $5,000,000, $25,000,000, and $125,000,000 of ordinary (not capital gain) income. And partnership income (e.g., hedge fund contingent management fees) should be treated as ordinary income to the extent the partner does not have a proportional amount at risk.

But that’s only if the case can be made that risk-taking was a but-for cause of the late unpleasantness. And I’m not sure that case can be made.


  1. Larry- Something we agree on. Do you think that any program to limit pay, should be based upon either a longer payout for the incentive pay for any given year, to make sure that the positive gains, and incentive pay are not very short lived. Perhaps a claw back provision. What do you think?

  2. I think that fine tuning is something the bureaucrats too often get wrong. I would trust high income tax rates to discourage swinging for the fences. If the income tax rates are raised, an earn-out provision may lower the effective tax rate by spreading the tax, which would be a good thing. If just raising taxes doesn't work, then we can consider something else. And companies are certainly free to set up any sort of scheme they want to align pay with long-term interest. In the case of executives, that's already the case. Dick Fuld et al. lost fortunes. But for hotshot traders, companies may want to revisit their deals. Not the government's forte, though.

    Clawbacks are a terrible idea and an awful precedent. People and those with whom they do business need to know that the balance sheet is the balance sheet. Non-vested earn-outs are fine, but once the money has been paid and taxed, game over except in the usual cases of fraud and bankruptcy preference.


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