Gabaix on CEO Pay

One highlight of my week was attending a seminar by Xavier Gabaix, the young star economist who was formerly a student in the Harvard PhD program and is now on the Princeton faculty. Xavier presented his paper on CEO pay . The above graph, from the Wall Street Journal earlier this week, shows the striking fact in need of explanation.

Here is the abstract of the paper (coauthored with Augustin Landier):

This paper develops a simple equilibrium model of CEO pay. CEOs have different talents and are matched to firms in a competitive assignment model. In market equilibrium, a CEO’s pay changes one for one with aggregate firm size, while changing much less with the size of his own firm. The model determines the level of CEO pay across firms and over time, offering a benchmark for calibratable corporate finance. The sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies during that period. We find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The data broadly support the model. The size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.

In Xavier's view, CEO's are earning the value of their marginal product. Top CEOs are paid high salaries because they are directing the fortunes of large enterprises, and even a small amount of extra talent is worth a lot.

Some people on the left have suggested that high CEO pay is a reflection of poor corporate governance, which allows CEOs to, in effect, steal value from shareholders. Xavier tests for this possibility using a measure of corporate governance and concludes, "Poor governance does increase CEO pay, but the effect seems small."

Another aspect of Xavier's work, however, should appeal to those on the left: In his model, high CEO salaries are pure economic rents. CEOs are paid what they are worth to their companies, and their high pay reflects the extraordinary value of their talent, but the supply of talent is inelastic, and the allocation of talent would not be affected if everyone faced high tax rates.

Xavier's model encourages people to think of CEOs as similar to Tiger Woods. Woods makes a lot of money because he is really, really good at golf. He is not stealing from those companies that pay him millions for endorsements. To the people paying Woods for his services, he is worth every penny. Yet if Woods were taxed at 50 percent, rather than 35 percent, he probably wouldn't give up golf or forgo the lucrative endorsements. (Response from the right: On the other hand, at a higher tax rate, Woods might play fewer tournaments each year. He might retire earlier. He might take more compensation as untaxed fringe benefits, such as a cushy private jet to fly to tournaments. And so on.)

Have Gabaix and Landier found the right model of CEO pay? It is too early to say. But there is no doubt that their paper will be a focal point of the literature on this topic.