At a glance
As told to Susan Muldowney
Question: “At our company’s recent annual general meeting, there were a few questions about executive compensation, including comments about inflated compensation packages. What are the ethical considerations when reviewing our compensation packages, which are closely tied to business performance? How do we communicate this to shareholders?”
Answer: When it comes to executive pay, the two dominant ethical principles are those put forward by American philosophers John Rawls and Robert Nozick.
Rawls proposed what he calls the “difference principle”. If everyone is paid the same, no matter what choices they make, no one will be bothered to work hard. People are incentivised to work hard only if this comes with a reward. There is therefore going to be some level of income difference in society.
However, Rawls noted that we should also recognise that a just society is one in which we tolerate only whatever income inequality is necessary to make the worst-off as well-off as they can be.
In a liberal market economy, the difference principle provides the ethical basis for letting labour markets determine pay differentials. Pay is the price of labour, and markets will determine the right price or the “just wage”, to use a medieval philosophical term.
When it comes to senior executive pay, however, there is a problem. An efficient market requires many buyers and sellers, homogenous products (or at least good substitutes), free market entry and exit, plentiful information and little economic friction.
In the market for top executives, practically none of these conditions hold. Labour markets for highly experienced top managers are very inefficient. Accordingly, there is a significant risk of market failure — rewards may be far higher than the market clearing wage, which is necessary to obtain the services of appropriately qualified executives.
Nozick proposes an alternative to the difference principle: “entitlement theory”. According to Nozick, a just society is one in which individuals are free to engage in whatever transactions they voluntarily choose.
If some become inordinately wealthy because of free distribution from an equitable starting point, who is to say that this is unjust? Any forced redistribution from some to others is, according to Nozick, equivalent to theft.
If some become inordinately wealthy because of free distribution from an equitable starting point, who is to say that this is unjust? Any forced redistribution from some to others is, according to Nozick, equivalent to theft.
While entitlement theory potentially justifies strong incentives, in a publicly listed company with dispersed shareholders, who is to determine the limits on what directors, acting as “economic agents” of shareholders, can legitimately choose to pay executives?
Economists propose that, to motivate executives (agents) to carry out actions and select effort levels that are in the best interests of shareholders (principals), boards of directors must design incentive contracts, which makes an agent’s compensation contingent on measurable performance outcomes.
Most economists accept that the strongest empirical correlation is between executive pay and firm size, not financial performance. The relationship is a power function — top pay increases at a much faster rate than the increase in firm size.
Big companies are presumably more complex and difficult to run than smaller companies. The biggest companies must therefore attract the best management talent to run efficiently and should therefore provide the highest pay.
From a business ethics perspective, there is something deeply unsatisfactory about this line of argument. To accept that a correlation between CEO pay and company size is an acceptable outcome, when aiming for a causal connection between CEO pay and firm performance, would appear to be entirely illogical.
Where does this leave us? There appears to be evidence that, in many countries, top executives are paid more than is necessary to secure their service and motivation. There is no good ethical justification for this.
The judgement that non-executive directors on remuneration committees must make is this: what is the necessary amount to pay to secure the services of a particular executive and to ensure, as far as possible, that they are incentivised to give maximum effort? That is surely what is meant by a “just wage”.
