A week ago, I sent to my editor my review of Tyler Cowen’s latest book, Big Business: A Love Letter to an American Anti-Hero. The book is outstanding. There are valuable facts and/or bits of economic reasoning on virtually every page. To give you an idea of how much I liked the book, I titled my review “A Love Letter to Tyler Cowen.” I’m not sure the editor will use that title. 🙂
The consistently great content meant that I had to leave a lot out of my review.
Here’s one part I left out but found striking. It’s on page 50, in the chapter on whether CEOs are paid too much. (Tyler says they’re not.):
Another factor is that, on average, top CEO talent helps larger firms proportionally more than smaller firms, and high salaries can be useful as a means of allocating the best talent to their most important uses. If Mark Zuckerberg had been running a midsized financial services company rather than Facebook, that would have been a waste of his talents, and likely Facebook would not have taken off as it did. A study found that when we take such “matching” factors into account, the optimal highest marginal tax rate on CEOs probably should be in the range of 27 to 34 percent. If the tax is much higher, the returns on making the right CEO-to-firm match will be smaller and productivity will be lower, and some of the star performers will end up at insufficiently important firms.
The study he refers to above is Laurence Ales and Christopher Sleet, “Taxing Top CEO Incomes,” American Economic Review, Vol. 106 (11): 3331-3366.
That reminds me of a point I made in a special seminar for some hand-picked, up-and-coming U.S. Navy and Marine Corps officers about 15 years ago. I had been asked to comment on some of their thoughts. One of their questions was “How can we get the best people into the Navy and Marine Corps?” I said that I thought it would be a mistake to get the best people in the Navy and Marine Corps. I pointed out that if the Navy had managed to persuade Bill Gates to become an officer in the mid-to-late 1970s, the PC revolution would have probably slowed by at least a few months. “Think,” I said, “of the enormous loss of productivity and consumer surplus from even a few months’ loss.”
READER COMMENTS
robc
Apr 16 2019 at 8:36am
I would think the optimal rate would be 0% due to deadweight loss in the income tax.
[Puts on Georgist hat]
Optimal taxes would be those without a deadweight loss, like the Single Land Tax.
[Takes off hat]
Thaomas
Apr 16 2019 at 11:49am
Unclear how this would apply to progressive taxation of consumption rather than income.
Alan Goldhammer
Apr 16 2019 at 2:17pm
It was my experience in the pharma industry that most CEOs were vastly over paid. I may be one of the few who looks at proxy statements every year and will sometimes vote against the recommended compensation package. The whole system is rigged by the consultants who establish the peer groups by which the company’s CEO is evaluated. Of course much of the compensation is based on stock price which can be artificially inflated by share buy backs. About the only CEO I feel that is reasonably compensated is Warren Buffett!
Cliff
Apr 17 2019 at 12:31am
What is artificial about it?
Matthias Görgens
Apr 17 2019 at 1:53am
Especially since share buybacks are mostly equivalent to dividends which no one seems to have much of a problem with.
The main difference between the two is tax treatment (and that you have to write your derivatives contracts very carefully).
Vivian Darkbloom
Apr 18 2019 at 4:05am
No as to the first count and mostly no as to the second.
No as to the first “mostly equivalent to dividends” because the effect of paying a $x dividend versus the same $x amount as a stock buyback is *not* the same on the share price. While stock buybacks don’t tend to increase the share price (“artificially” or otherwise), they also don’t decrease share prices because the number of outstanding shares is reduced and hence the proportionate per share claim to existing assets and future profits is increased. On the other hand, ever wonder why share prices tend to decrease by the amount of a declared dividend distribution when a stock goes ex-dividend? It is certainly in the interest of CEO’s and other option holders to prefer a stock buyback to a cash dividend. Goldhammer is right in the sense that an insider owning options, all else equal, would certainly prefer a stock buyback to a cash dividend. Stated somewhat differently, cash dividends only go to current shareholders and not to option holders. But, option holders benefit from stock buybacks rather than cash dividends because their proportionate claim to future profits is increased. Paying a large extraordinary cash dividend rather than using the same funds for a large stock buyback would be very detrimental to the value of the stock options of insiders. In this context, the question of whether stock buybacks “increase share price” should be viwed when *compared with the alternatives* and not in isolation. Unlike stock splits, reverse stock splits and other corporate events that are deemed “recapitaliations” or “affect corporate structure”, stock option plans generally do not require an adjustment of the exercise price of outstanding options when a company simply repurchases some of its shares in the open market. Since the pharma industry was mentioned, take a look at section 4(c) of the 2004 Pfizer plan. Note that “extraordinary dividends” are explicitly mentioned as an instance in which the Board (“in its sole discretion”) can adjust outstanding exercise prices (presumably because of the negative effect on holders) but open market stock buybacks which affect “corporate structure” to the same magnitude are not even mentioned!
https://www.sec.gov/Archives/edgar/data/78003/000119312512085703/d278590dex102.htm
For a detailed look at the effect of cash dividends on option prices, you might also want to take a look at the Black and Scholes model which is the most commonly used formula for valuing options.
Mostly no as to the second (main difference is tax treatment). While it is true that only those shareholders choosing to sell their shares in a buyback will be (currently) taxed if they sell at a gain, a qualified cash dividend under the current federal tax code is generally taxed at the same (preferable) federal tax rates as a LTCG (only a 60 day holding period necessary for qualified dividend treatment versus 1 year for LTCG).
David Seltzer
Apr 16 2019 at 5:29pm
I was at Barnes and Ignoble , my wife’s pun, today and purchased it. Started to thumb through and wound up reading almost a quarter in the cafe. Love it.
Michael
Apr 17 2019 at 11:04am
Doesn’t it depend what we mean by ‘best people’? Who’s to say Bill Gates would have been a good Marine? And although I agree with the quoted point at an aggregate level, luck matters too. No doubt Zuckerberg’s a genius, but maybe the difference between him and a dozen others who failed is just that he was lucky. Maybe one of the failures was actually an even better CEO with an even better product.
I get the sense that Tyler Cowen wants to elevate CEOs because they are undervalued; culture pays too much attention to luck and not enough to genius. That’s probably right, and I hope the book succeeds. But I also think there’s a sub-culture that gives too much credit to CEO genius and too little to luck, and the contrarian in me wants to challenge gently in the other direction.
Mike
Apr 17 2019 at 1:38pm
In theory this makes sense, however, in practice not so much. Mark Zuckerberg is not a good CEO. His business is based on an idea, a really good one, not on his ability to manage a corporation. Mark had very limited, if none at all, managerial experience. If Mark were a good manager he would have realized his limitations and hired a CEO outside of Silicon Valley.
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