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Why Obama, Congress must curb CEO pay

/ Source: Business Week

Confronted with the daunting array of economic failures confronting the nation, it may seem improbable for me to say that excessive executive compensation is one of the issues needing the early attention of President-elect Barack Obama and the next Congress. Yet this particular cancer — which has been growing exponentially for almost two decades — is at the core of many of our nation's economic ills.

And it is a cancer that the average worker finally understands. During the worst days of the recent stock-market, bank and credit-market upheaval, a raw nerve was struck on Main Street when workers generally became aware, many for the first time, of the huge salaries being earned on Wall Street and on other streets far removed from Main Street.

Wherever earned, excessive executive and CEO compensation, simply by being "excessive," belies the principles of a meritocracy, which is what corporations should be. Managers rise to something akin to royalty when their compensation is at unjustified levels and when the rewards of employment are not more commonly and fairly shared with the general employee base.

Primacy of profits
Way back on Sept. 13, 1970, just as I was starting my second year at Stanford Business School, Milton Friedman authored his seminal opinion piece in The New York Times titled "The Social Responsibility of Business is to Increase Its Profits." But unlike many of Friedman's other writings, this particular opinion piece was only modestly embraced, and was embraced by almost no one credible.

In fact, from the end of World War II until the mid-1990s, prominent public and private company CEOs almost universally viewed their responsibilities as being equally split among shareholders, employees, customers and the nation. This broad sense of corporate responsibility was actually so widely and comfortably held that in 1981, the Business Roundtable, which is the key public policy arm of the nation's largest public companies and their CEOs, officially endorsed a policy that said that shareholder returns had to be balanced against other considerations.

However, just as the Business Roundtable was making its policy statement, the deregulation and laissez-faire era that was born in the Reagan administration was starting to chip away at the statement's core contention. And by 2004 — even after many of the myriad scandals and outright thefts that have hallmarked the last decade of American business had already come to light — the Roundtable amended its position. It said, just as Friedman did in 1970, that the job of business is only to maximize the wealth of shareholders. And at that point, because of the prevalence of stock option and restricted stock grants, shareholders included many if not most senior managers at a large number of publicly traded companies.

And this narrow single-mindedness has taken corporate America down a very bad path that has resulted in executive compensation that is truly excessive.

For most of the past century, CEOs earned roughly 20 times as much as the average employee, according to the Economic Policy Institute, as quoted in The New York Times on Dec. 18, 2005, and again on Jan. 1, 2006. And also for much of the past century, there was nothing like the excesses within the financial industry that we see today, which enable its managers to earn almost obscene levels of compensation — and then get favorable income tax treatment to boot.

Frothy trough
Today, however, average public company CEO compensation is 400 times that of the average employee. And thousands of senior managers in addition to CEOs are drinking at the same frothy trough, especially, as we have all just seen, senior managers in the financial services industry. (By contrast, the ratio of CEO pay to that of the average employee has remained around 22 in Britain, 20 in Canada and 11 in Japan.) And with such U.S. exalted compensation, management has so elevated itself above average employees as to have become, in my opinion, a constituency unto itself — and one that, to compound the inequity, largely sets its own compensation.

(Incidentally, in 1971 my first boss out of business school, who was then easily one of the nation's top half-dozen public company CEOs, made 10 times my starting salary of $15,600 and about 15 times the salary of our average employee. And throughout the remainder of his exceptional career, I don't think that ratio ever exceeded 20 times, which was a great example to me as I started my own career. Although I have started several companies and engineered several major mergers that have rewarded me generously, my own compensation since I started my career has, with the exception of two and a half years when I received share-price increase-based bonuses, always stayed in that same range.)

The disparity in compensation today is an ethical embarrassment to our country, and it is certainly an affront to workers and to shareholders. When polled, 90 percent of institutional investors said they thought corporate executives were dramatically overpaid, and 85 percent of them said the prevalent executive compensation system hurts corporate America's image, according to a Watson Wyatt Survey published on June 20, 2006.

With the ills of our broken executive compensation system rippling through so many of the critical economy-related issues that Obama and Congress need to address, Congress should step forward early in 2009 to play a proactive role in fixing the system and reestablishing its fairness.

First, Congress should immediately grant public shareholders the rights, on their own, to call a shareholders' meeting to vote out the current board and to render an advisory vote on executive compensation — rights that they don't currently have. Much better than any other similar measures contemplated or previously adopted, these three rights, which are already in place and working well in Britain, would align shareholder and management interests as to both governance and executive compensation.

Second, Congress should establish a ceiling for individual executive compensation as a reasonable multiple of average employee compensation, and penalize through the corporate income tax code and/or otherwise those companies that elect to pay in excess of that multiple.

Third, Congress should close the loopholes that currently allow the wealthiest Americans to use offshore tax schemes that cost our Treasury $70 billion in taxes each year, and it should aggressively step up tax enforcement to capture the 30 percent or so of earnings from selling investments that currently goes unreported each year.

Fourth, Congress should tax the "carried interest" now being earned by private equity and hedge fund managers at the ordinary-income tax rate of around 35 percent, rather than at the much lower capital gains tax rate of 15 percent. Carried interest is just a form of performance fee, and like every other performance fee or bonus it should be taxed as ordinary income — otherwise it is just another example of excessive and unfair executive compensation.

And fifth, Congress should continue to oversee the compensation practices of any entity that has or relies on federal government guarantees. To this point, particular compliments should go already to those in Congress and to the New York state attorney general for their efforts to recover the excess compensation that recently went or is still scheduled to go to AIG executives.

If Congress enacts these five measures, then many of the oppressive breakdowns in our economy will be mitigated — from the grossly un-progressive tax outcomes to the insensitive employee practices to the larger than necessary trade and federal deficits. And the fairer and more balanced sense of corporate responsibility which so honorably distinguished our country for most of the 20th century will be restored.