Money Matters: Why Concerns About Income Differences Have Changed
The salaries of senior managers are often high because they are determined according to the principles of supply and demand in a very tight market, which is comparable to the market for top athletes where even higher sums are commonly paid.
Many critics of social inequality highlight the fact that differences in income have grown in recent decades. For example, a manager today earns much more relative to his employees than in the past.
So were income differences “in the past” more appropriate than they are today? Hardly, because the political groupings who complain about “too much inequality” today were doing the same in years gone by, despite claiming that incomes were more equitably distributed in the past. The “good old days” are only good today; in the past, they were just as “unfair” from the critic’s point of view.
In keeping with philosophical “theories of justice” and the everyday understanding of many people, a person’s reward for their work should be in proportion to their effort. We know from scientific research that individuals with a lower socioeconomic status in particular typically understand “performance” in terms of the disciplined completion of a certain set of tasks within a given period of time. In assessing a person’s “performance,” most people take account of both the time spent and the intensity of effort or endeavor involved in completing the set of tasks. I call this the “employee mindset” because it corresponds to the real-life experience of white- and blue-collar workers, whose wage or salary relates directly to the effort involved, i.e. working longer or harder usually equates to a bigger paycheck. And yes, most people see this as “fair.”
But what they don’t understand is that this correlation only applies to blue- and white-collar workers, not to entrepreneurs. For entrepreneurs, what counts above everything else is having great business ideas. Look at the list of the richest people in the world. Typically, these people became rich because they had a unique entrepreneurial idea and brought a product to market that was recognized as useful by huge numbers of consumers. This is the capitalist principle, but many people do not understand it. It is not the amount of work, but the benefit provided to society that is decisive.
Brian Acton and Jan Koum invented WhatsApp and sold it to Facebook in 2014 for $19 billion. Today, there are two billion people around the world using WhatsApp to send messages to each other and make free phone calls. Thanks to their innovative idea, the two WhatsApp founders have amassed a combined fortune of $13 billion. They became rich through an idea. Has inequality increased because there are now two more multibillionaires? Certainly. But has it hurt anyone, except perhaps providers of expensive phone plans? Ideas are what count.
And what about top-level managers?
Their high salaries are particularly heavily criticized by anticapitalists, often even more so than the (usually much higher) incomes of entrepreneurs. This is mainly because the details of managers’ salaries are often in the public domain. Anyone can read about the packages of a listed company’s C-suite executives, whereas this is usually not the case for entrepreneurs. Moreover, top-tier managers are held in lower esteem than entrepreneurs by many people (even those with capitalist sympathies).
But the salaries of senior managers are often high because they are determined according to the principles of supply and demand in a very tight market, which is comparable to the market for top athletes where even higher sums are commonly paid. Nevertheless, a survey I commissioned in seven countries showed that most people do not believe that senior managers deserve their high salaries or wealth. I was intrigued and wanted to know why so many people feel this way.
In Germany, 63 percent of the survey’s respondents said it was inappropriate for managers to earn one hundred times more than their regular employees as they do not work so much longer and harder than their employees. Of all the statements on why managers should not earn so much, this one elicited by far the greatest agreement. It reflects the prevailing employee mindset, which dictates that salaries should be determined primarily on the basis of how long and how hard someone works.
Thus, employees project their own performance and remuneration benchmarks onto senior-level managers and believe that there must be a close relationship between how hard and how long someone works and that person’s salary. With regard to senior-level managers’ salaries, the survey’s German respondents clearly do not see such a link. Instead, they conclude that managers’ salaries are excessive because no manager can possibly work one hundred times as long or as hard as an average employee. On the other hand, the respondents barely understood that senior-level managers’ salaries are determined by supply and demand in the market for top-tier executives. Only one in five German respondents agreed that companies can only hire and retain the best managers if they pay very high salaries because otherwise, those managers would go to another company that pays more or would work for themselves. In other countries, the situation was similar. Most respondents (above all, but not only those from lower-income groups) seem to have implicit salary expectations, according to which a person’s salary is, so to speak, a “perspiration premium” that compensates them for the hours they have worked.
Anyone who defends high managerial salaries should be prepared to become unpopular. Even ardent defenders of capitalism criticize “excessive” managers’ salaries because, after all, managers do not bear the same high levels of risk as entrepreneurs. What is frequently overlooked is that this is the reason managers earn far less than entrepreneurs.
Another argument that is often raised by critics is that managers receive substantial severance packages, even if they have failed to live up to expectations. However, severance packages are negotiated before a manager actually starts working for a company. They are part of a senior manager’s overall salary package. Of course, it may turn out later that the package was overly generous because the manager did not perform as well as everyone hoped. In the same way, a manager’s salary package may be too low if they end up overperforming—except a person can be sure that will never be reported in the media. This is similar to elite athletes who command huge transfer fees, which may turn out to be excessive if the athlete doesn’t perform as well as expected. This point bears repeating: whenever a company hires a top manager or a team signs a top athlete, there is no guarantee about how they will perform in the future. Their salaries are based on forecasts and these forecasts are based on past performance. And such forecasts can be right, but they can also be wrong.
If a person compares what top managers do for their companies in terms of performance, i.e. in terms of added value for their companies, then on average they are not overpaid, but underpaid, and this is a result of uncertainty. This is clear from studies that have looked at what happens to the value of a company when a CEO dies unexpectedly or falls ill: the value of the company falls. Research, according to Tyler Cowen, shows that “CEOs capture only about 68–73 percent of the value they bring to their firms. For purposes of comparison, one recent estimate suggests that workers, in general, are paid no more than 85 percent of marginal product on average. . . . In other words, workers actually seem to be underpaid by somewhat less than CEOs are, at least when both are judged in percentage terms.”
Rainer Zitelmann is the author of The Power of Capitalism and The Rich in Public Opinion.