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Micro and Macro Effects of an Executive Pay Cap (Labour Markets)

Level:
A-Level
Board:
Edexcel

Last updated 10 Dec 2018

Here is a revision video working through a draft answer to this question: "Evaluate the micro and macro effects of a policy that caps the level of executive pay."

  • Executive pay refers to the total remuneration of executives in businesses.
  • Earnings include basic salaries, bonuses and other rewards such as share options
  • The level of executive pay has become a major issue in the UK and many other countries
  • Median CEO pay in the UK in 2015 was £4 million, which works out at £1,009 an hour
  • The median pay for FTSE 100 CEOs is around 144 times that of the national average pay
  • Labour is proposing a 20:1 limit on the gap between the lowest and highest paid workers in companies given government contracts
  • What micro and macro economic effects might come from a legally enforced limit on the scale of executive pay?
Micro and Macro Effects of an Executive Pay Cap (EdExcel Paper 3 - Essay Question)

Micro point 1

A cap on executive pay might lead to a brain drain effect as top executives leave the UK labour market in search of higher pay in other countries.

If the rewards to CEOs are limited, then executives may decide to take jobs at companies in other countries. This will create a scarcity of talented leaders in industries and might lead to a loss of dynamic efficiency in the long run

A counter argument is that companies should focus instead more on nurturing upcoming talent in their businesses as well as just seeking to outbid others for ‘top talent. The argument of rock-star CEOs is a largely a myth, most innovation comes from within a business.

Micro point 2

High executive pay is an an example of market failure because of inadequate scrutiny of pay awards by shareholders and huge managerial power in businesses

Capping executive pay will help to bring more equity into the labour market and might improve productivity. A huge gap between top and bottom pay within an organisation harms performance by building resentment

Top rewards for executives are needed as an incentive for people to work hard and build careers. The pay of CEOs can be linked more closely to the long-term performance of a business for example by varying according to profitability and innovation achievements

Macro point 1

One macroeconomic effect of capping executive pay might be to reduce foreign investment into the UK because firms find the UK less attractive to do business.

High executive pay is a price worth paying for having some of the world’s most successful multinationals based in the UK investing here, creating jobs and contributing to exports of goods and services.

Foreign investment depends on many factors not just taxes on the incomes of executives. Many MNCs are aware of the wider stakeholder effects of a big pay gap for example health problems of people with lower wages who often have to resort to expensive debt.

Macro point 2

Anther argument is that an executive pay cap is justified on the grounds of fairness. Studies have found that persistently high income inequality can damage growth.

Several businesses such as John Lewis have successfully used share-ownership schemes throughout their workforce to spread more widely the profits made. This sustain more consumption and aggregate demand.

Much depends on where a pay cap might be set. 30 years ago, average pay of a CEO was 45 times the median wage, enforcing a cap would be difficult as tax advisors would find ways around it. A pay cap might be almost impossible to enforce and costly to do so if tried.

Broader evaluation points

Executive pay relative to median wages has soared in recent years. But the average FTSE-100 boss is not 129 times more productive than their workers. And nor is super-high pay justified by enormous differences in corporate profitability.

However, top earners pay a large percentage of income tax. A pay cap might actually reduce total tax revenues

Consider in your evaluation some of the alternatives to an executive pay cap:

  1. Increasing the marginal tax rate on CEO pay/bonuses
  2. Legislate to require companies to publish their pay ratios E.g. ratio of CEO pay to wages at the bottom of the pay scale or the median wage of employees
  3. Only award government spending contracts to companies that have signed up to some form of pay limit for CEOs
Prof. Alex Edmans dissects the controversy surrounding CEO pay

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