Executives as owners vs. Executives as representatives
Stock Options on wage growth
Taxes on wage growth
Inflation on wage growth
Individual Wealth Education (Mutual Fund Fallacy)
A very contentious issue arising within public domain is that of compensation and its repercussions on overall society. Over the past 3 decades executive compensation has ballooned while the average worker continues to see only modest gains in income. The average annual earnings of the top 1% of wage earners grew 156% from 1979 to 2007; for the top 0.1% they grew 362% (Mishel, Bivens, Gould, and Shierholz 2012). In contrast, earners in the 90th to 95th percentiles had wage growth of 34%, less than a tenth as much as those in the top 0.1% tier. Workers in the bottom 90% had the weakest wage growth, at 17% from 1979 to 2007. If inflation averaged just 2% a year over this period, the gains of the bottom 90% would be negative. In 2007, average annual incomes of the top 1% of households were 42 times greater than in-comes of the bottom 90%, and incomes of the top 0.1% were 220 times greater. This is an increase of 1400% and 4700% respectively since 1979.
An answer to this question pertains mainly to management as owners vs. management as representatives. This statement may seem one in the same but prior to 1990, management's duties and responsibilities where polar opposite to those of today. In the 1980's management was seen primarily as a "representative" of the entire business entity. As a result, stockholder and investor interests where junior to the needs of the overall business. Managers did not use assets in a manner is which stakeholders benefited. In fact, most management was inclined to underuse capacity. Companies with competitive advantages such as economies of scale or distribution networks simply did not use them to their fullest extent. This benefited the manager who had compensations packages that were based very loosely on metrics that can be easily manipulated. This metrics included revenue, earning per share, and sales growth (Kaplan, 2012). All management had to do was to simply alter assumptions within the annual report to "create" earnings or manipulate earnings as their compensation was not in the form of stock. For example, one method earnings that can be "created" or "manufactured" is by manipulating the pension fund assumptions in the annual report. By "expecting" a higher growth rate within the pension fund, a company can contribute fewer earnings to fund the pension. These pension savings are then transferred to the bottom line as a profit increase, when in reality; the increase was a result of accounting gimmicks (Shaw, 2012). Such was the case in the 1980's as many companies used these gimmicks to manipulate financial information. To be fair, the 1980's and prior decades where marked with economic uncertainties that created a sense of caution among businesses. This cautious attitude can reasonably attribute to the notion of unutilized capacity. However, this underused capacity was still a detriment to shareholders as costs per unit and overhead per unit increases due to this unused capacity. What would eventually ensure was a wave of hostile takeovers and proxy fights in an effort to better align corporate goals with those of its owners. Many investors who found companies with assets that where not utilized to their fullest potential would simply obtain a majority stake in the business and either sale or use those assets to generate profits or cash. Companies began to take notice and began to better align corporate objectives with owner objectives through the issuance of stock options.
These stock options contribute heavily to the income disparity between executives and the average worker. First, in many instances the executive gains at the expense of the shareholder through the issuance of stock options. Furthermore, these options often times encourage extreme risk taking on the part of the executive which ultimately increases the executive's wealth at the expense of the long-term oriented shareholder. These shareholders are often those in the bottom 90% looking to gain dividend income and increase their own wealth.
This stock option grant problem is two fold in nature. First, where do these options come from? They simply are not created from thin air. Instead they are issued by the corporation in which the executive works. This is a very detrimental to the average shareholder of the company who overwhelming consist of individuals in the bottom 90%. When a company issues stock options to executives, it reduces the ownership stake of all the other owners of the business. The more shares outstanding that are issued, without a corresponding increase in earnings results in less earning per share for the average shareholder. This action ultimately increases executive wealth at the expense of the shareholder.
Even more alarming is that these options are given to executives at a discount to their intrinsic value. For example if a share is trading at $50 in the open market, an executive might be given the option for 100,000 shares at $20 fore each share. In essence, the executive is getting a $5 million piece of the company for only $2 million. As I mentioned above, these nearly issued shares take away ownership claims of the average shareholder. In addition, the shareholders will ultimately end up paying the $3 million dollar difference. Again, as was the case above, the executive benefits at the expense of the shareholder. Shareholders are literally giving pieces of the company away to executives at less value than they are worth in the market.
Shareholders have recently contested stock options very aggressively in light of recent events. Executives are being compensated without a corresponding increase in business value. As such, shareholders are limited or simply not approving executive compensation packages. I agree with this approach and believe shareholders should act more like owners of a particular enterprise. If owners begin to voice their concerns through proxy votes, I believe a sustainable change in regards to executive compensation will occur.
Another very important aspect to consider is that of taxes. Taxes are a detriment to wealth and income creation. Therefore, it is logically for an American citizen to reduce this burden in creating future wealth. The current tax system however, is heavily favored towards those with extreme incomes. Many of the wealthiest individuals in society are taxed at rates far lower than those of the median income earner. Below is a chart depicting the tax rates of the 400 wealthiest Americans. Notice how their rate is diminished substantially over the 12-year period.
Next is a chart depicting the tax rates based on income level. Again, notice the large decline in tax rates from the wealthiest group of Americans. Meanwhile, the remaining group of American tax payers realized no such decline in their rates but in many instances saw a minor increase in rates.
I believe the income gap can be attributed to many factors related solely to tax considerations. First, as noted by the above charts, larger wage earners are retaining more of their earnings. These earnings are then reinvested at the prevailing market rate to earn more money for these individuals in the future. In addition, the taxes for the wealthy come in the form of capital gains tax, which subsequently are 15%. Not only are more of the wealthiest individuals retaining a larger portion of their income, they are, in their prudence, reinvesting these earning for even more tax benefits. This behavior is logical and is very intelligent. However, many individuals in lower income brackets simply do not have those same opportunities. In fact, they are burdened more so than their wealthier counterparts. For one, they can not save or invest the same sums of money wealthier individuals can on a percentage of income basis simply because their tax rate is disproportionally higher. Therefore, they will not be able to achieve the same degree of benefit from the lower capital gains tax. This ultimately contributes to the income gap as wealthier individuals in percentage terms, can simply invest more of their income relative to their lower income peers. Furthermore, a vast majority of the top wage earners garner their wages from dividend income which again is -- you guessed it- taxed at 15%. Middle income earners do not have this same benefit as many of their earnings are taxed at the 25% average rate.
In addition, the cost of living, along with inflation continues to rise faster than wage increased for the middle class. This is particularly important as the U.S. government is forcing large amounts of dollars into circulation. At sum point in the future, inflation will have an effect on the cost of living. This provides two distinct problems in regards to income inequality. First, the purchasing power of the average American citizen will be diminished. As such, the amount of assets the individual can purchase will decrease at a corresponding amount. However, the top wage earners have their money tied to claims on…