executive compensation: excessive or equitable?

ABSTRACT. The eighties and nineties have seenmuch debate about CEO compensation. Criticsof CEO compensation support their contentionof excessive and inequitable CEO pay based on anumber of factors and premises. This paper examinesthe validity of these arguments. We show why manyof these arguments fail to persuade, in part, becausethey attempt to determine propriety of CEO paywithout having a definitive standard for comparison.Arguments based on comparisons between CEO payand the pay of other individuals or jobs or betweenCEO pay and firm performance are shown to be aninsufficient mechanism to determine the appropri-ateness of CEO compensation.

Is executive compensation excessive or equitable?Many persons argue that executives of companiesare overpaid and that their compensationamounts are excessive and inequitable. Executivecompensation has become an increasingly heatedtopic in the 1990’s. The controversy exists notonly in the academic journals in management,accounting, finance and economics, but it spillsover to the popular press.

Because the chief executive officer (CEO) of

a company is usually the highest paid and themost visible executive, the spotlight has tendedto focus on CEO compensation.1 The argumentsrelating to CEO pay generally take one of twoforms. The first concerns the relationshipbetween executive compensation and ownershipinterests which is identified in the literature asthe agency problem. In the agency problem,managers may take actions that increase theirpersonal well-being rather than the well-being ofthe business or the owners. One of the trends ofthe 1990’s has been attempts by the board ofdirectors to reduce agency problems by con-structing executive compensation packages thatpresumably better align the interests of share-holders and executives by making ownershipinterests a significant part of these packages.Critics question the effectiveness of these com-pensation contracts in reducing agency problems.The second issue raised by many is the size ofthe CEO pay. The business press is replete witharticles suggesting that CEOs are overpaid andtheir pay inequitable.

This paper examines arguments related to thesecond controversy; i.e., arguments for andagainst the proposition that CEOs are overpaid.In addition, the paper briefly examines otherpotential aspects of CEO pay that may cloudthe arguments and some problems of changingthe structure of CEO pay if it is felt to beinequitable. We show that failure to resolve thecontroversy may be primarily due to a lack of adefinitive basis for determining the appropriatelevel of pay. Most arguments that CEO pay is toohigh are based on comparisons between CEOpay and pay for other individuals or jobs orbetween CEO pay and company performance,but as will be discussed, the uniqueness of the

Executive Compensation: Excessive or Equitable?

Journal of Business Ethics

29: 339–351, 2001.© 2001 Kluwer Academic Publishers. Printed in the Netherlands.

Donald NicholsChandra Subramaniam

Donald Nichols is professor of accounting in the M.J. Neeley School of Business at Texas ChristianUniversity. His publications have appeared in Journalof Accounting Research, The Accounting Review,Journal of Accounting Economics and otheraccounting journals.

Chandra Subramaniam is an assistant professor ofaccounting in the M.J. Neeley School of Business atTexas Christian University. His publications includepapers in the Journal of Accounting, Auditingand Finance, Journal of Business Finance andAccounting and other accounting journals.

job the CEO performs makes such comparisonsan insufficient basis for conclusions.

Background

Executive compensation has been the subject ofmuch discussion and controversy in the popular,business and academic media. Most persons whoexpress an opinion seem to believe that execu-tive compensation has become excessive based onequity or fairness arguments. These argumentsoften are either (1) that the amounts are unfairrelative to other worker’s pay or (2) that theamounts are unjustified when compared to thefirm’s or the CEO’s performance. Primaryreasons for these arguments are that the amountspaid to executives are extremely large comparedto other workers and appear to have very littlerelation to company performance. In addition,the percentage and total amounts of raises toexecutives have tended to be much larger thanthose for rank and file workers or increasesin company performance in recent years.Exacerbating the problem is a recent trend to addlarge amounts of noncash compensation, espe-cially stock options grants, to the cash compen-sation paid to executives.

Concern over executive compensation hasspurred action on the part of several regulatorygroups. Congress, claiming concern over theexcessive amounts of CEO cash compensation,passed a law in 1993 limiting the amount ofCEO cash compensation that could be deductedby the firm for income tax purposes to $1 millionunless a larger amount could be justified byunusually good performance. Another regulatoryorganization, the Financial Accounting StandardsBoard (FASB) recently proposed that compensa-tion expense include the estimated market valueof stock options that are granted to executives.2

The protests from the business community andthe accounting profession were unprecedented.In addition, Congress threatened to intervene ifthe proposal was passed and implemented by theFASB. Because of the intense pressure, the FASBwithdrew the proposal in spite of its strongopinion that the proposed accounting treatmentwas preferable and appropriate.

Magnitude of executive compensation

There is no question that CEOs of many com-panies receive large amounts of compensation.According to a recent Business Week survey, thehighest paid executives in 1996 were LawrenceCoss of Green Tree Financial who received$102.45 million, Anthony Grove of Intel whoreceived $97.59 million, and Sanford Weill ofTravelers Group who received $94.16 million.These were the largest individual amounts, butaccording to the survey, the average total com-pensation for CEOs of the 500 largest companiesmeasured by market value was $5.8 million in1996. This represents a 54 percent increase from1995. Excluding stock options, CEOs of the 500largest firms received cash and bonus compensa-tion of $2.3 million in 1996, a healthy 39 percentincrease from the previous year. In comparisonthe average worker received a meager 3 percentincrease in 1996 (Reingold, 1997).

For the highest paid CEOs, much of the com-pensation amount is in the form of long-termcompensation, usually stock options, rather thansalary and bonus, with salary and bonus often lessthan ten percent of the total compensation. Forexample, of the $97.59 million reported forGrove, only $3.00 million was salary and of the$94.16 million reported for Weill, only $6.33million was salary. The proxy statement for WaltDisney for 1995 reported that its CEO, MichaelEisner, received only about $8 million in salaryand bonus for the year, but he was granted stockoptions that appeared to be conservatively valuedat over $200 million.3

The highest paid executives generally managecompanies that are successful in one respector another, and many persons agree that largeamounts should be paid to CEOs who have beenand will continue to be very important to thesuccess of the company. In general, companiesdid well during the 1990’s, and undoubtedlyCEOs should be rewarded for this good perfor-mance. However, the 54 percent average CEOpay increase for 1996 is difficult to justify evenif firm performance is the basis, given that cor-porate profits rose only 11 percent and stockprice of the S&P 500 increased just 23 percent.In addition, it is much more difficult to justify

340 Donald Nichols and Chandra Subramaniam

the huge amounts that have been paid tomanagers who left companies that have per-formed poorly. Michael Ovitz was given apackage worth about $90 million when he leftWalt Disney after a disappointing performanceduring his year there. Other CEOs who werewell paid on leaving their positions include FrankBiondi, Jr. of Viacom, Michael Schulhof of SonyCorp. of America, Michael Fuchs of the musicand Home Box Office operations of TimeWarner, and Douglas Morris of Warner MusicU.S. unit of Time Warner, all of whom receivedpackages estimated to be worth $20 to 50 million(WSJ 12/16/96).

It is possible that these compensation packageswere especially large because the executiveswere leaving the company and the large com-pensation was part of a contractual or voluntaryseverance package. But large amounts of com-pensation are often paid to continuing CEOswhose company or shareholders have not doneparticularly well. Stephen Case of AmericaOnline was paid $33.46 million over the threeyear period ending in 1996 while the averagereturn on equity for the company was –413percent. Similarly, Robert Palmer of DigitalEquipment received $3.84 million while theaverage return on equity for his company was–25 percent (Reingold, 1997).

Many persons who have reviewed this andsimilar data conclude that executives, especiallyCEOs, are overpaid. Conclusions that executivecompensation is too high are often based onarguments of fairness or ethics. The validity ofthese comparisons and conclusions based onthem are the focus of this paper. However,evaluations of fairness or equity must involvecomparisons with standards or criteria that woulddefine or determine what is fair or equitable.Several criteria have been used, usually the rela-tionship between the manager’s pay and otherworkers’ pay or the relationship between themanager’s pay and firm performance.

Arguments about overpayment

This section presents discussion and analysis ofsome of the common arguments put forth in the

literature on the perceived overpayment inexecutive compensation. The objective of thediscussion is to clarify the nature of some thesearguments and to focus on some of the difficul-ties in reaching definitive conclusions aboutwhether CEO compensation is excessive or equi-table based on these arguments. We start withthe arguments by critics of CEO compensationand show that some of these arguments aretoo simplistic and do not stand up to rigorousexamination. We next examine arguments byproponents that CEO pay is equitable eitherbecause a free market has set the price or due toan existence of a relationship between pay andperformance. We show that even if both argu-ments are true, it may still not imply that CEOpay is equitable. We take each position in turn.

Arguments that executive compensationis excessive

The relation between executive and averageemployee’s compensation

Some studies point to the large disparity betweenthe average employee’s salary and CEO com-pensation as evidence of overpayment of theCEO. According to the Business Week survey,CEO compensation is 209 times that of theaverage factory worker (Reingold, 1997).However, even such a large difference may notbe conclusive evidence of overpayment.

Persons in different positions or levels of anorganization often earn different salaries. Aworker on a production line in a plant usually ispaid less than the plant manager, who in turn isusually paid less than a manager of the overallcompany. These differences in compensationbetween levels of an organization are likely tobe justified based on arguments of increasedresponsibility and perhaps increased abilityrequirements at the higher levels, and differencesare often not viewed as inappropriate. Inaddition, compensation differences may arise, inpart, because of differences in the complexityof jobs. There is evidence that complexity ofduties is an important determinant of CEO com-pensation (Henderson and Fredrickson, 1996).

Executive Compensation: Excessive or Equitable? 341

Furthermore, most would argue that a CEO hasmore responsibility and job complexity than theaverage worker.

However, even if a concept of differencesin compensation because of differences in jobcomplexity and responsibility is reasonable, themagnitudes of the resulting differences thatwould be appropriate are not immediately clear.For example, if there were agreement that somedifferential because of responsibility or com-plexity is appropriate, how would the appropriateamount of the differential be determined? In thiscase, how much more than the average workershould a CEO make?

A related argument is that compensationshould be based on the relative contributionof the employee to the company. Again, mostwould argue that the CEO’s contribution to acompany’s success is greater than that of theaverage worker. Based on this line of reasoning,observing that the average CEO’s salary is 200times the average employee’s salary would notbe conclusive evidence that CEOs are overpaidrelative to the average employee. It is possible thatthe value of the contribution of the average CEOto the success of the company is 500 times theaverage employee’s contribution, and if so, itcould be argued that CEOs are underpaid relativeto their contributions. Little prior research hasattempted to measure the absolute or relativecontribution of the CEO and the average workerto the company, and such measurement wouldbe difficult, if not impossible. Furthermore, evenif relative contributions were measurable, theamounts of compensation appropriate to therelative contributions are not obvious.

Thus, looking at the magnitude of compen-sation differences between the average CEO andthe average worker does not appear to provide adefinitive way of concluding whether magnitudesof the differences are appropriate or inappro-priate.

Widening gap between executive and average workercompensation

Some critics of executive pay point to thewidening gap between the average employee’s

compensation and the compensation of CEOsas evidence of overpayment of CEOs. As statedearlier, the average increase in total compensa-tion for CEOs was 54 percent compared to about3 percent for the average worker in 1996. Theaverage raise for CEOs in 1995 was 30 percentcompared to another 3 percent for the averageworker in 1995. Because of the large disparityin the percentage and dollar amount of raises, theratio of CEO pay to average worker pay hasincreased dramatically over the past several years.As mentioned previously, the CEO average payis about 200 times the average factory worker’spay, while in the not-too-distant past, a ratio of50 times was argued by some to be excessive. Infact, Martin Sabo, a Minnesota Congressman, hasintroduced a bill in Congress every year since1991, so far unsuccessfully, that would disallowa tax deduction for executive salaries in excessof 25 times the salary of the lowest paid employeein the same organization. Sabo argues that com-pensation differentials greater than this ratio arearbitrary and excessive.

Again, the widening gap between the pay ofthe average executive and that of the averageworker is not definitive evidence of overpaymentfor at least two possible reasons. First, it ispossible that CEOs were previously underpaidrelative to the average worker and the largeincreases are intended to rectify that underpay-ment. Second, even if CEOs were not previouslyunderpaid, another possible rationale for thewidening gap is that the large increases in CEOcompensation are a response to changing condi-tions and increasingly difficult challenges that theCEO confronts. The CEO often operates in aglobal and an increasingly technologically basedand competitive environment, and it is possiblethat the talent required and demands on thesuccessful CEO have increased more that of theaverage worker. If true, these conditions mightsuggest increasing differentials in compensationlevels are appropriate.

A world of rapidly changing technology, withincreasingly global operations, is likely to makerunning a company successfully a more complextask than it was previously. In addition, today’sintense domestic and often global competitionmay produce a much more difficult environment


in which to operate a company successfully thanthe environment even ten years ago.

Research by Gaver and Gaver (1995) supportsthis premise. They found that both total and thetype of compensation are related to the type offirm, suggesting a relationship between compen-sation and type of duties. In addition, CEOs ofhigh growth firms tended to be more likely toreceive not only larger total compensation butalso larger amounts of equity as compensationthan CEOs of lower growth companies. Thus,it is possible that the increasing ratios betweenCEO and average worker salary may be influ-enced by increasing demands on the CEOrelative to those of the average worker. If thecomplexities of businesses and their environmentsare increasing rapidly, these conditions mightexplain why successful CEOs have much largerincreases in compensation relative to the averageworker.

However, again, even if changes in relativedemands of duties were measurable, the amountof compensation differential appropriate to thechanges in differences in relative demands is notimmediately clear. Thus, looking at the magni-tude of changes in compensation differencesbetween the average CEO and the averageworker does not provide a definitive way of con-cluding whether the magnitude of these changesis appropriate or inappropriate.

Gap between domestic and foreign executive compensation

Some critics point out that CEOs of U.S. com-panies make considerably more than CEOs ofmany foreign companies (Neff, 1993). Again, theargument is not conclusive, this time due toseveral factors including differences in culture,tax laws, and difficulty in properly valuing pay.Walter et al. (1995) point out that decisionmaking in Japan is typically more team-orientedthan in the U.S., and hence responsibilities,decisions, and rewards may be shared by severalindividuals rather than a single CEO. Parker-Pope (1996) states that German workers place apremium on security and stability, preferring setsalaries and bonuses to the ambiguity of more

lucrative incentive-based packages. Furthermore,in many countries like Germany and Italy,government restrictions through high tax ratesand requirements that employees who receivestock bonuses have to hold the stock for at leastsix years, reduces the value of incentive pay.

In addition, the amount of premium paid toU.S. executives compared to foreign executives isdifficult to calculate. As Liebtag (1991) pointsout, Japanese executives benefit from extensiveperquisites and expectation of lifetime jobsecurity. These perquisites and security ofemployment and pay are valuable, but they arenot included in typical measures of compensa-tion. Consequently, computation of the value offoreign CEO’s total compensation is generallyunderstated.

Parker-Pope (1996) also finds that Europeanexecutives place far greater value on pensionpackages than do their U.S. counterparts. Usinga simplified example of an American executiveearning $2 million and a U.K. counterpartearning half as much, she points out thatassuming the most generous pension benefits forthe American and conservative assumptions forthe Briton, the Briton would actually draw apension 5% higher than the American. If thisscenario is representative then the lower pay forforeign CEOs may be partially justified.

Further, it is possible that differences in thebusiness environment, such as the system ofinterrelated operations and ownerships in manyforeign countries, make managing a companysuccessfully in the U.S. more difficult and thusmore valuable than managing one overseas.Finally, CEOs seem to be held more responsiblefor the success or failure of companies in the U.S.compared to CEOs in many foreign companies.For example, termination of a CEO in the U.S.when a company is performing poorly is notuncommon, as evidenced by cases, such as AppleComputer, General Motors, Kodak and IBM.By contrast, termination of a head of a poorlyperforming company does not seem to be acommon practice in foreign countries such asJapan. Hence, CEOs in the U.S. may be paid apremium for this increased responsibility and riskof termination. The issue of deciding whetherCEO pay is excessive by comparing compensa-


tion across different environments and culturesis difficult, if not impossible.

Compensation equity vs work equity

Some argue that CEOs are overpaid based onarguments of equity for the nature of the workperformed. This issue was considered somewhatin the discussion of different levels of pay forworkers in different levels in the organization,but it is more complicated. Although compen-sation appropriate to the work done may seemto be a desirable objective, determination ofequitable amounts of compensation amongvarious types of work are likely to be difficult.

For example, what are equitable pay levels foran experienced nurse in a trauma center and anentry level person who works on a waste recy-cling truck? On the one hand, it might be arguedthat the nurse should make more money, perhapsbecause of the relative level of educationrequired, the nature of special skills utilized, therelative level of responsibility, or the value of thecontribution of one’s work to individuals and tosociety. But, on the other hand, the person whoworks on the waste recycling truck may actuallywork harder physically in a harsher physical envi-ronment for longer hours, and the contributionof a clean environment is also valuable.

Even if it is concluded that differences in treat-ment seem equitable, the proper amount of dif-ference is not clear. For example, if a differenceis appropriate, what is an equitable differencebetween the nurse and the person working onthe waste recycling truck? Should the differen-tial be 30 percent, 80 percent, 150 percent, or300 percent? So relative work equity in evenseemingly simple situations may be unclear,making work equity an extremely difficult basisfor discussion about appropriate compensationlevels of various types of workers.

Distributive equity

Perhaps, the most troubling basis for argumentabout CEO compensation could be described asa distributive equity among workers. Basically,

the argument suggests that workers for an orga-nization should share somewhat equitably inrewards when the organization is successful andin penalties when the organization is not. Personswho argue that CEOs are overpaid sometimesmake that argument on the basis of a lack ofdistributive equity.

On one dimension, there is evidence of somedistributive equity in the sharing of penalties inthe unsuccessful organization. The usual ratio-nale that is used to justify laying off workers isto make the company more profitable or com-petitive. This downsizing has been somewhategalitarian, in that not only lower paid workersare laid off, but often higher paid managers oftenlose their jobs in this process. In addition, oftenif a CEO’s actions are not as successful as hopedfor, the CEO steps down or is terminated. Oneof the more recent and more highly publicizedexamples is the termination of Al Dunlap ofSunbeam Corp. Mr. Dunlap was sometimesreferred to as “Chainsaw Al” because of hisapproach to turning companies around bylaying off significant percentages of employees,including management level persons. When hisstrategy did not appear to be working forSunbeam, his services were terminated by theBoard of Directors. Thus, on this dimension,CEOs often share the same fate as otherterminated workers if the CEO is not entirelysuccessful.

There is a second form of distributive equitythat appears to be more troublesome. When acompany attempts to improve profitability andcompetitiveness, there is often an attempt to limitincreases in salaries and benefits of lower levelemployees to reduce or restrain costs. At the sametime, CEOs and higher level employees may bereceiving large amounts of salaries and raises,explicitly for having succeeded in reducingemployee pay. In this case, whether there is dis-tributive equity in the pool of money availableto pay salaries does become a question. The issueis why should one group of workers suffer tobenefit the company when another group doesnot share in the suffering. This does not seemequitable.

However, distributive equity is a potentiallytroublesome issue in a number of labor areas in


addition to the market for CEOs. For example,in the National Basketball Association, althoughthe average salary of players is relatively high, theaverage is highly skewed by the salary of ahandful of superstars, while the vast majority ofthe players receives much less than the average.Certainly, the NBA has been a prime example ofan industry that has made great economic stridesover the past decade or two. However, the wealthsharing among the employees has been extremelyunequal, with the superstars obtaining muchhigher increases in salaries than other players.Thus, the escalation in the pay of persons at thetop of many fields, such as the NBA, has beenextremely rapid over the past decade, dramati-cally outpacing the “average person in the field.This is not only a CEO phenomenon, eventhough the issue in other fields has receivedalmost no attention or outcry.

In addition, it may not be appropriate toconclude that CEO compensation is unfair froma distributive equity perspective based on anassumption that any amount paid to the CEOcannot be paid to other employees. This viewsthe salary pool as a fixed amount in a staticsituation. Suppose that a particular CEO’s effortsadd much more incremental income to thecompany than the CEO’s salary. In that case thesalary levels of the remaining workers may bemuch higher because of the CEO and even afterthe CEO is paid a large amount of money, thanwould be the case if the CEO’s services werenot available to the company. Viewed from thisperspective, the CEO’s salary does not come outof the other employees’ salaries, but rather itcauses their salaries to be higher than they wouldbe otherwise. Thus, it is not clear that the CEO’ssalary comes out of other employees’ paychecks.4

This distributive equity issue is a subset of thequestion about how much various individualsshould be compensated for their contributions tothe company. This more general question waspreviously considered and was concluded to bea very difficult issue to resolve on the basis ofequity or fairness.

A complicating issue is that it is possible thatexecutive compensation may have purposes otherthan compensation for the CEO as a reward forCEO performance or contribution, further

clouding the arguments. This possibility is dis-cussed in the following section.

Other purposes of executive compensation

It is possible that compensation related to otherpurposes may make comparisons with otherworkers or performance difficult if not entirelyinvalid as a basis for arguing the propriety of aparticular level of CEO compensation. Oneprimary purpose is the attempt to reduce theagency problem. Much of the recent increase inCEO compensation has been in the form ofstock grants and stock options. This form ofcompensation would be consistent with attemptsby the company to alleviate agency problems. Itis argued that having a significant amount ofCEO compensation that increases or decreases invalue with increases and decreases in stock priceencourages alignment of owners’ and the man-ager’s interests, reducing agency problems. Onealternative to such an alignment of intereststhrough compensation would be significant mon-itoring of the manager’s activities which wouldbe expensive and perhaps somewhat ineffective.

There is some evidence that CEO compensa-tion is employed as a substitute for other moni-toring measures (Lippert and Moore, 1995 andTosi and Gomez-Mejia, 1995). This aspect ofCEO compensation and the related value ofpotential cost savings in other areas is usuallyignored in arguments about excessive executivecompensation. However, to the extent thatcompensation is used as a substitute for otherpurposes, for example, costly monitoringmeasures, the amounts expended for variouspurposes probably should be separated andtreated differently in arguments about excessivecompensation. Obviously, such a separationwould be extremely difficult, again making con-clusive arguments about excessive executive com-pensation difficult.

A second argument deals with compensationas function of the differential risk borne by themanager in managing different types of resourcesof the firm. Smith and Watts (1992) argue thatgrowth firms are likely to be riskier than theirnon-growth counterparts. This conjecture is sup-


ported empirically by Chung and Charoenwong(1991). Managers of growth firms will thereforedemand higher total compensation for bearingthis risk.

Smith and Watts (1992) also argue that firmswith valuable growth opportunities are expectedto have a high degree of informational asym-metry between managers and shareholders.Informational asymmetry arises because managershave private information about the value offuture projects (Bizjak et al., 1993; Clinch, 1991)and also because it is more difficult to observemanagerial effort in growth firms (Smith andWatts, 1992). As a result, greater potential formanagerial opportunism and higher shareholder-manager agency costs exists in growth firms.To reduce the manager-shareholder agency costsassociated with information asymmetry, wewould expect growth firms to emphasize incen-tive compensation over fixed salary, resulting inhigher total compensation (Gaver and Gaver,1995).5

As discussed earlier there are many papers inthe literature that suggest that CEO pay is notequitable. In the next section we discuss somearguments and suggest that CEO pay is notexcessive.

Arguments that executive compensationis not excessive

Economic analysis (market forces)

In our economy, allocation of resources,including labor force participation and remuner-ation, is generally determined by market forces.Deliberate government intervention in the labormarket has been undertaken very infrequentlyand reluctantly. The principal interventions bygovernment in the labor market have been at themacro level, such as collective bargaining, affir-mative action, and minimum wage legislation.These interventions have had considerable impacton businesses and the society. By contrast, thepreviously mentioned legislation on limiting thedeductibility of executive compensation is veryunique in nature. There is virtually no otherprecedent for intervention at the micro level,

such as focusing on the amounts paid to aparticular group of workers, in this case CEOs,especially when similar amounts paid to othergroups of workers, such as athletes and enter-tainers, are not penalized. Perhaps, because ofthe unique nature of the legislation, it has hadlittle effect. Either the legislation has not beenvigorously enforced, or few instances of “exces-sive” compensation have been detected, or com-panies have been willing to forgo the taxdeduction.6

Although there may be externalities, such asgovernmental regulation in the economy, theamount of products or services that are producedis generally dictated by supply and demand,which is in turn affected by the prices that arecharged for the product. Supply and demanddictate prices of most goods and services,including labor compensation. Executives workin a labor market just like other persons who selltheir labor, and those markets determine the levelof compensation that those persons will receive.Supply and demand in the CEO labor marketapparently dictate the necessity of the large com-pensation packages for CEOs.

However, investigating CEO compensationusing traditional economic analysis is extremelydifficult. Traditional economic analysis wouldsuggest that in a competitive market, each factorof production would be paid the value of itsmarginal product. Unfortunately, determiningthe value of the marginal product of a CEO,unlike any other worker or even a class ofworkers is probably impossible. Using this basis,some proponents find some limited evidence thatCEOs may be worth more than they are paid. Forexample, Jensen and Murphy suggest that CEOsmay actually be underpaid based on an analysis ofmarginal product. Changes in the market valueof a company at the time of a change in a CEOprovides a very rough estimate of the value of aCEO’s services. These market value changes areoften extremely large, suggesting the “value” ofCEO services may actually be larger than theircompensation. For example, the share price ofSunbeam doubled when Al Dunlap took over asCEO and ultimately tripled based on little excepthis reputation as a savior of financially troubledcompanies. One would expect little, if any


impact on share price if most other employeesrather than a CEO or very high level employeejoins or departs from a company, indicating amuch greater perceived value of contribution forhigh level executives.

A potentially troubling problem of usingtraditional economic supply and demand argu-ments is the possibility of a distortion in theexecutive labor market. This potential problem isnot unique to executives, since there may bedistortions in the market for any type of labor,but the potential is more apparent in the marketfor CEOs. The distortion can arise if the CEOpay is not set through an arm’s length processwhich may often be the case for followingreasons. First, the CEO is also the chairman ofthe board in more than 80% of the country’spublicly held corporations (Shivdasani andYermack, 1998). This provides the CEO with awider power base and locus of control. Second,the members of the board are usually nominatedby the CEO, with their election being a for-mality in most cases. In most cases incumbentscontrol the nomination process and there isonly one “candidate” nominated for each seat.Whether shareholders vote for them, againstthem, or not at all, they get management’s state.There is no mechanism for direct shareholdernomination of directors. In essence, says RalphWhitworth, President of the United ShareholdersAssociation, for all practical purposes corporatedirectors are appointed by incumbent manage-ment. This de facto power to select and compen-sate directors results in the members beingbeholden to the CEO. This observation is sup-ported by anecdotal evidence. F. Ross Johnson,former CEO of RJR Nabisco justified high levelsof director support by stating ‘If I am there forthem, they’ll be there for me’ (Business Week, 1991p. 94). The problem of big corporations show-ering large fees and perquisites on their board ofdirectors was also written up as the lead articlein Forbes (May 22, 1995). Graef Crystal, a notedcompensation expert, claims that the CEOappoints his or her friends to the board, catersto them, keeps them happy, pays them hand-somely, and expects to have the favor returnedwhen it’s time for the board to ratify a compen-sation plan.

In addition two-thirds of all outside directorsare CEOs. While good reasons may exist to haveother CEOs on the board, these outsiders whowould likely be considered independent directorsusually are sympathetic to the CEO’s problemsand may rarely argue when it comes to approvingthe CEO pay. This problem may be furtherexacerbated when interlocking directorships,when CEOs sit in each other’s board, exists. Theperception of I-will-scratch-your-back-if-you-scratch-mine is never far behind.

Directors vary in their relationship with theCEO, and a director’s participation on the boardmay range from being a totally passive pawn ofthe CEO to being a very conscientious repre-sentative of the shareholder. But the possibilityof market distortion exists because of the ratherunique relationship, and at this point, althoughindividuals may argue that large amounts paid toCEOs are appropriate in a free and unfetteredmarket, the validity of this statement can becalled into question in light of the potentialdistortions in the CEO labor market.

Correlation between CEO pay and company performance

Some researchers have attempted to determineif firm performance and manager pay are corre-lated. The idea is that a manager’s compensationshould be based on the firm’s performance andthat a strong correlation would suggest that (1)the managerial incentives are aligned with thestockholders and (2) managers are being com-pensated based on the level of their success.However, the empirical results have been mixed.Based on a survey of CEO compensationresearch, Gomez-Mejia and Balkin (1992, p.184), citing studies by Redling (1981) and Jensenand Murphy (1990b) among others, state that“the weight of the evidence points towardsa small, almost inconsequential relationshipbetween firm performance and CEO pay”.Crystal (1993) also finds little relationshipbetween firm performance and CEO pay.

In contrast, studies by Murphy (1985),Benston (1985), and Hall and Liebman (1997)point to a strong correlation between firm per-


formance and CEO pay. A recent study (Miller,1995) suggests that there are several reasons forthe previously observed low correlations betweenfirm performance and CEO pay, including thecontention that in many studies, performanceand compensation have been compared across alarge number of industries. In his more narrowcomparisons, Miller finds considerably highercorrelation between CEO compensation andfirm performance. Similarly, Tevlin (1996) con-sidered three possible reasons why previousresearch may have found a weaker link betweenCEO compensation and firm performance. Aftercorrecting for these, Tevlin found elasticities ofpay to firm performance many times greater thanprevious research.

However, we contend that even if a high cor-relation exists between pay and firm perfor-mance, this would not be conclusive evidencethat CEO compensation levels are appropriate.For example, a manager who increases netincome or some other performance indicator byten percent may receive a ten percent raise, sug-gesting appropriate compensation according tothis criterion. However, whether the percentageincrease in compensation should equal the per-centage increase in performance can be argued.Furthermore, the amounts of compensation thatthe ten percent raise is based on, the previousand current level of performance, may both beexcessive or inadequate. Thus, conclusions basedon correlations between raises and performancedo not consider the relation between improvedperformance and level of raise or the proprietyof the previous pay level.

Finally, even though measures of companyperformance and stock price would be heavilybiased toward suggesting generous compensationfor many executives in recent years, the evidencehas been mixed. CEOs of companies during thepast decade have managed companies during anextremely robust economy. During the 1990’s,rates of return for companies have averaged morethan 20 percent per year, the highest for manyyears. In addition, the stock markets have expe-rienced their largest increase in prices in historyduring the past decade or so. Thus, the economyand the stock market have provided an environ-ment that is conducive to company success and

stock price appreciation. Some persons point toa company’s success and the increase in acompany’s stock price as evidence of the pro-priety of large amounts of CEO compensation.However, given the strong economy and stockmarket for the past decade or more, it is hard todetermine what part of a company’s success isdue to efforts by the CEO and management andwhat part is basically a result of the “good times”.For example, if a company’s stock price increased40 percent during the recent five year period,should the CEO receive large compensation andlarge increases in that compensation if stocks ingeneral have increased 20, 40, or 80 percent?

Thus, for a number of reasons, the correla-tion between firm performance and executivecompensation may not be a determinative con-sideration. If a neither a free market argumentor the pay for performance argument can defi-nitely settle the issue of the appropriateness ofCEO pay, then we are left with the dilemmawhether there exists an appropriate measure todetermine if CEO pay is equitable or excessive.

Is the focus on executive compensationequitable?

Many persons may look at the amounts ofexecutive compensation and simply conclude thatit is too high without any particular explicit pointof comparison. As Kesner (1992) observes, “thereal issue in most people’s minds is the level ofcompensation. Period.” Reflective of a belief thatexecutive pay is simply too high, Stewart (1997)comments that we should complain about CEOpay because “. . . at some level pay becomesobscene no matter how richly it’s deserved, andLowenstein (1997) concludes that “. . . CEO payis out of sync with rhyme, reason or decency.”7

However, it is not clear why such views shouldbe limited to executives, since persons in otherfields also are paid large amounts of compensa-tion without the same degree of outcry. Casualobservation of the nightly news and the dailynewspaper would suggest that these situationsexist in other areas. Like executive compensation,the average compensation paid to the top workersin many other fields is large and rapidly


increasing relative to the average worker. We heardaily about the huge salaries paid to certaingroups, for example top actors, singers, come-dians, and professional athletes.

As individuals, we may feel that top athletes,actors and singers such as the “big Mikes”,Michael Jackson, Michael Jordan, MichaelDouglas, and Mike Tyson, are overpaid for theirwork. Yet there has been no general outcry oroutrage over the large salaries or large increasesin salaries for workers in these field.8 Similarly,there has been no serious discussion by Congressor other regulatory groups to intervene, restrict,or penalize compensation to these persons. Asmentioned previously, only CEO compensationwas covered by the legislation concerning the $1million limit for tax deductibility. Persons makingover $1 million compensation in other occupa-tions were not included or even considered. Whyis there great discussion and even outrage about“excessive” CEO compensation but not about“excessive” compensation for other groups? LikeCEOs, the average compensation for thesepersons in the top of many other fields is manytimes the average compensation of the typicalworker and the gap has also increased rapidly inrecent years. While compensation of CEOs havereceived much attention similar compensation oftop persons in other fields have received little. Isthis equitable?

Summary

In summary, various critics have argued thatexecutive compensation is excessive and, thus, isnot equitable. These arguments are based on anumber of factors and premises. Accordingly, assuggested in this paper, although arguments canbe made, it would be difficult if not impossibleto conclusively determine whether CEO com-pensation levels are appropriate or inappropriatebased on these arguments. These arguments fail,in part, because they attempt to determine pro-priety of CEO pay without having a definitivestandard for comparison. Usually, the argumentsare based on some kind of comparison toanother’s pay, and any such comparison is sub-jective and inherently fraught with potential error

and hence are unlikely to provide conclusiveevidence of inequitable treatment.

Similarly, the economic and finance literaturehave attempted to show that CEO pay be appro-priate either by arguing that it is set by a free andunfettered market or by showing a correlationbetween CEO pay and firm performance. It canbe argued that it is precisely the non-existenceof a free and unfettered market that has createdmuch of the controversy on the apparentinequities of CEO pay. In addition, we show thateven if a high correlation exists between pay andperformance, that does not imply that the sizeof the CEO pay is equitable.

As with most normative questions, thequestion of whether CEOs are appropriatelycompensated perhaps cannot be decided based oncompelling, conclusive evidence to support ananswer. In this paper we emphasize the point thatthe evidence that has been collected concerningthe question is not conclusive, and so thequestion is unresolved. Ultimately, whether onebelieves that CEOs are over or appropriatelycompensated probably is a personal judgment.Each of us may have our own personal answer,but it would be difficult to argue that it is theright answer.

In this paper, we have attempted to avoidunwarranted conclusions about whether execu-tive compensation levels are appropriate orinappropriate. Rather, we concentrate on thedifficulty of reaching a conclusion based on thearguments that have been presented in the past.Whether executive compensation is excessive orequitable appears to remain an open question inspite of the many arguments and research on thetopic.

Notes

1 In this discussion, the terms “executive” and“CEO” will be used interchangeably.2 The FASB is the primary standards setter for appro-priate accounting treatment of all transactions forbusinesses. A major component of executive com-pensation packages, stock option grants, is usuallyreported as zero compensation expense even thoughthey are often a significant part of the compensationpackage and are often large in value. For example, the


amount of the stock option grant in 1996 to MichaelEisner of Walt Disney was not reported as compen-sation in the financial statements even though thevalue of the options was estimated conservatively tobe over $200 million.3 Coss, of Green Tree Financial, was the only oneof the ten top paid CEOs in the survey whose com-pensation was entirely salary and bonus. Recently ithas been reported part of the reason for the largebonus payout was due to aggressive accounting andoverly optimistic expectations (Bailey, 1998).4 One can take the perspective of those who losttheir jobs during the restructuring and claim thatthere is no distributive justice since not everyonegains. Unfortunately, the only choice a CEO mayhave is to maintain all employees, remain unprofitableand go out of business or to reduce the size of thefirm and focus their effort in their core competen-cies which may result in increased loss of jobs, butimprove profitability and the chance for survival. Inthis case distributive equity may not be appropriate.5 Lazear and Rosen (1981) apply the theory of tour-naments to the compensation literature and suggestthat CEO pay represents the prize in a lottery andhence large differences between CEO pay and sub-ordinates is justified and in fact desired for incentivepurposes. O’Reilly III et al. (1988) do not findsupport for this model.6 In fact, the 1993 law may have legitimized the $1million paycheck. A survey of 200 companies from1992 and 1994 by Executive Compensation Reports,found that CEOs with lower paychecks generally gotbigger raises the further they were from the $1 millionlevel.7 Although the prevalent sentiment is that executivecompensation is too high, other articles argue that theamount of CEO compensation is actually too low( Jensen and Murphy, 1990a; Brownstein and Panner1992; Lederer and Weinberg, 1996). 8 Walters, Hardin and Schick (1995) argue that themethod by which compensation is paid to CEOs isless of a fair-market bargaining arrangement than themethod derived by a sports star’s agent and the ownerof the professional team. They believe the compen-sation of sports stars and entertainers are fairly set dueto the arm’s length transaction thorough which com-pensation is derived. CEOs on the other hand mayhave hand-picked the compensation committee andhence a conflict of interest exists.

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Department of Accounting,M.J. Neeley School of Business,

Texas Christian University,Fort Worth, TX 76129,

U.S.A.


executive compensation: excessive or equitable?

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