Freeman

ARTICLE

Executive Salaries

JULY 01, 1958 by HANS SENNHOLZ

Dr. Sennholz is Professor of Economics at Grove City College, Pennsylvania.

A favorite point of attack against capitalism is the im­pressive height of the salaries of top business executives. Labor un­ion leaders especially tend to be critical of executive salaries and bonuses amounting to a hundred thousand dollars or more. People unfamiliar with the principles that determine wage and salary rates are apt to become envious and re­ceptive to ideas that are hostile to our free economy.

The selection of corporate man­agement confronts stockholders with choices similar to those we all must face in our daily purchase decisions. Should they look for management at bargain rates? Should they shop for medium-priced management, or search for the best possible men who demand top salaries? As in everyday life, the best is often the cheapest in the long run.

The stockholder must hire the men who do the actual work for him. He is aware that the mistakes of corporate executives can con­sume a large percentage of net in­come or even eliminate it alto­gether. On the other hand, the right men may earn large profits and greatly enhance the value of the corporation. Depending on the size of the business, the selection of management may mean a differ­ence of millions of dollars in prof­its or losses, which emphasizes the importance of the right management.

In the history of the automobile industry the stockholders of doz­ens of independent companies had this choice to make. Many of them chose management at bargain rates — and lost their investments when the companies fell by the wayside. The managerial salaries in those cases, no matter how low, proved to be no bargains after all. At the same time, the obscure and failing Maxwell-Chalmers Corpo­ration hired Walter P. Chrysler who built it into one of the big three of the industry. His com­pensation, no matter how high, constituted a real bargain to the corporate owners.

Not only the owners but also the workers gain from superior man­agement. Contrary to much union propaganda, the workers’ interests are served best under superior management. Wages tend to be higher in a profitable and expand­ing enterprise than in a failing one. Fringe benefits are higher and jobs more secure. Rejoicing about cheap management can be very shortsighted — and short lived.

Finally, there are the consumers who, indirectly at least, demand efficient management. Production efficiency makes for better and cheaper products which can meet the pressures of competition.

 

Corporations Must Compete for Management

The important problem of ex­ecutive remuneration is to attract and hold the best men. The value of a company is determined by the men who run it and work for it.

The corporation need not neces­sarily pay the total amount which good management adds to net worth. What must be paid to at­tract and hold the men may con­stitute merely a fraction of the amount they actually earn for the corporation.

In bidding for managerial serv­ices in the executive labor market, each corporation acts in competi­tion not only with all other exist­ing corporations but also with the opportunities for the manager to organize a business of his own. Of course, this competition is re­flected not only in salaries but also in pensions, bonuses, and other benefits. And the calculations are in terms of net salaries and net benefits after taxes.

In order to attract a man from other employment a corporation usually must outbid its corporate competitors. And in order to hold its man the corporation must pay him at least as much as he could earn in other employment.

To move from one employment to another involves a serious deci­sion. It often entails a change of residence which is both incon­venient and costly. The home may have to be sold, perhaps at a loss. Children may have to change schools, and many other problems arise through resettlement. It is obvious that the net inducement in the form of higher salary or advancement must be great enough to exceed the disadvantages of such a move.

 

Confiscatory Taxes Have Leverage Effect

Let us assume that a net salary improvement of $5,000 annually will induce an executive to move to a different community to work for a different company. And assume further that the man is in the 80 per cent income tax bracket. Therefore, his $5,000 net raise will cost the company $25,000, with $20,000 going to the government and $5,000 to the executive. If he should be in the 90 per cent tax bracket, the corporation would have to boost his gross salary by $50,000 in order to attract him. The question is whether or not the new executive will add at least the gross amount of his remuneration to the company output. A skilled executive who adds millions to the net worth of his company un­doubtedly meets this condition.

The large salary figures often criticized by labor union leaders are the inevitable result of the pro­gressive taxation of large incomes. Without this taxation the net salary that suffices to attract and hold the executive would consti­tute the total salary. The govern­ment share in the executive salary would remain in the company as profit. Of course, such an economy without income taxes would allow rapid capital accumulation and business expansion which in turn would intensify corporate bidding for executives and thus raise their remunerations. But it is doubtful that salaries soon would reach the present figures which are so large­ly conditioned by progressive tax­ation.

We are assuming here that cap­able executives who are the entre­preneurs in a corporation add far more to the output of the business than their own employment costs. This assumption seems justified in the light of corporate experience. Walter P. Chrysler’s salary, for in­stance, undoubtedly was merely a fraction of the net worth he added to the company.

As we have said, competition largely determines how much the corporation has to pay for a good manager. When an executive is hired, his future contribution can merely be estimated. Economic prudence therefore requires that he be paid merely the amount that suffices to induce him to accept employment. This minimum is determined by competition in the ex­ecutive labor market. Once he proves to be a capable entrepre­neur who adds profits to the com­pany, his remuneration tends to go up. For the corporation now must increase his remuneration lest he accept employment with a competitor who also recognizes his ability to create profits.

To avoid the leverage effect of confiscatory taxation on executive salaries, often involving tax rates higher than the corporation other­wise would have to pay on profits, many companies resort to forms of remuneration that are taxed at lower rates. For instance, they may grant purchase options that give executives the right to buy from the company a certain num­ber of shares of stock at prices that are lower than the market price. Besides the tax advantage, this method has an additional at­traction. The executive becomes co-owner, giving him new incentives for doing his utmost in the serv­ice of the company.

 

Company Profits Set Salary Ceilings

The upper limit of an executive salary ultimately is determined by the profits which his employment yields to the company. The execu­tive’s productive contribution minus his employment costs constitute this profit on his employment. This explains why an executive is apt to be replaced as soon as another executive can be found whose pro­ductive contribution minus his em­ployment costs yields a larger profit to the company. The new man may be more productive for the same money, or equally productive for less money, or in some other way afford the company the maximum profits on his employment, which is the major factor that deter­mines the executive selection.

Of course, these economic prin­ciples of the determination of ex­ecutive salaries are moderated and may be frustrated by personal fac­tors, such as ignorance, inertia, friendship, hopes and illusions, and other feelings.

 

The Case of Poor Management

We have been discussing supe­rior management and its compen­sation, but must not neglect the cases of poor management which undoubtedly exist. Inferior management is apt to make costly mis­takes and inadvertently inflict losses on the company. It is ob­vious that the services of such executives are not worth the sala­ries they are paid. In other words, their productive contributions are worth less than their costs. Pru­dent corporate owners will dismiss them without delay.

To unseat an inefficient manage­ment of a huge corporation is dif­ficult when hundreds of thousands of stockholders are involved. It may be that no one man or group owns enough shares to exert work­ing control. In this case, stock­holders seem to have only the choice of selling their securities. Such selling or shunning of shares may result for the time being in lower price-earnings ratios and higher yields on the stock. But in that event, various promoters and speculators may see an opportunity for unseating the inefficient execu­tives through soliciting the sup­port of dissatisfied stockholders. They wage costly proxy fights and occasionally succeed in obtaining working control.

But modern interventionism with its confiscatory taxation even hampers this last safeguard for efficient management. Proxy fights are very costly. Without assurance of success they may consume hun­dreds of thousands of dollars of a man’s own funds. Few men still can dare to lose these sums for the sake of corporate control, the eventual fruits of which they must again share with the government. Therefore, proxy fights have be­come relatively infrequent, and in­efficient management may stay in office indefinitely. Thus does inter­ventionist government encourage and perpetuate inefficient manage­ment.

Executive salaries ultimately are determined and paid by the con­sumers. Through buying or absten­tion from buying, consumers de­termine which corporations are to earn profits or suffer losses. They determine the remuneration of Frank Sinatra, Marilyn Monroe, and Rocky Marciano. And they also determine and pay the workers’ wages as well as the ex­ecutive salaries at General Motors and U.S. Steel.

 

***

 

 

Ideas On Liberty
The Search for Profits

It is the search for profits which governs the whole delicate fabric of capitalist society. In a capitalist economy if mines are sunk and ores and minerals worked, if trains run along the rail­ways and ships plough their way across the ocean, if iron is beaten at the forge and steel rolled at the mills, if fibers are spun and textiles woven at the loom, it is in order that some person or group of persons may make a profit. It is true that they can make a profit only by satisfying a demand; and the search for profits has in the course of centuries wonderfully enriched and widened the life of men.

Ivor Thomas, Socialism and Communism

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July 1958

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