CEO pay study shows how much Australians tolerate inequality

Australia’s highest paid CEO Nicholas Moore saw his salary grow to $13.1 million this year. Tracey Nearmy/AAP

Almost everyone in a study soon to be published in Perspectives on Psychological Science thinks chief executive officers are paid significantly too much - almost everyone it suggests, except Australians.

The study, by Chulalongkorn University’s Sorapop Kiatpongsan and Harvard Business School’s Michael Norton uses survey evidence to discover “what size gaps people desire” when it comes to pay, comparing estimates of the wages of people in different occupations – chief executive officers, cabinet ministers, and unskilled workers – to their ideals for what those wages should be.

They measure the gap by the ratio of CEO pay to average unskilled worker pay, finding quite a high degree of consistency across people from 40 different countries and from diverse backgrounds.

Nonetheless, there is a surprising outlier — Australia. Responding Australians would like to see a ratio of 8.3 times. The average across the countries is nearly half at 4.6 times. Australia’s ratio is the highest in the 16 countries for which the authors’ have actual pay data.

Perhaps not so surprisingly, it is more than 400% higher than the desired ratio in egalitarian Nordic countries such as Denmark.

One country in particular outside the group of 16 outdoes Australians in tolerating inequality — Taiwan — with a desired ratio of 20.

Apart from revealing a general desire for equality, the study also reveals how out of touch with reality most respondents are. For example, the mean estimate across 40 countries of the respondents’ estimate of the actual pay ratio was ten-fold, about twice the average desired ratio. By contrast, the actual ratio across the 16 investigated countries is 101, ten times higher.

For example, for the US respondents the estimated pay ratio was 30, compared with the actual ratio of 350, meaning they believe the worker at the ideal ratio would be earning US$1.8 million, when in reality the average CEO earns US$12.2 million while the average unskilled worker earns US$34,645.

In the face of such ignorance, these survey results make the case for abolishing the survey profession itself!

Australians (and South Koreans) by far topped the list in guessing average CEO pay with estimates of 41 times. This is almost half the actual ratio for Australia and thus closer than respondents in most other countries who typically had far higher error rates.

Perhaps we should be relieved that for most countries these pay ratio estimates are substantially lower than the amounts company leaders actually earn. Would the truth stimulate more French Revolutions and huge hikes in tax progressivity?

Sweden, for example, once had a magnificent marginal tax rate of over 105% for high-income earners. This lasted until the voters discovered that their most beloved best-selling author had lower take-home pay the more she earned!

Actually, ignorance is not a monopoly possession of the respondents. Some of the “credit” must be attributed to those who did the survey and published the results. For example, it is meaningless to talk about CEO pay ratios without considering the size of the company.

What makes a good value CEO?

Typically, the larger the company, the higher the pay. Using raw pay numbers, each doubling of firm size increases pay by 30%. Since on average Australian companies are far smaller than in the US, our pay ratio falls way short of the United States’ 350 times score.

This means we miss out on the “bargain” to shareholders constituted by the highest paid CEOs at the largest US companies. Since pay far from doubles with each doubling of firm size, large-firm CEOs cost shareholders very little relative to market capitalisation and earnings, in contrast to small-firm CEOs.

In fact, some prominent CEOs, such as the late Steve Jobs of Apple fame, choose to be paid a notional salary ($1 in the case of Jobs) rather than the hundreds of millions they contribute to shareholder value.

Do they do this because of their love for shareholders and the average unskilled worker? No.

George W. Bush reduced the tax on dividends from the personal marginal rate to a maximum of 15%. But he still retained the double-taxation of company and personal income (unlike Australia). It then became more tax advantageous to receive dividends when one owned as much of the company as Jobs did.

Why does CEO pay go up with firm size at all? Actually, this relationship largely exists because size becomes a proxy for success and thus managerial talent. Such talent, the Steve Jobs' of this world, is in limited supply. If one controls for talent then pay only increases by about 22% for each firm-size doubling.

My research with Jaeyoung Sung shows that firms compete for talent largely by raising pay for performance sensitivity, that is, by encouraging stock and option ownership. The reason for this is that typically only the manager is aware of his or her own talent. With more “skin in the game”, the highly talented manager’s effective take-home pay is much higher and can in some cases amount to billions of dollars.

Smaller firms in particular cannot afford to pay as much in direct cash pay. Hence, we see sensitivity falling rapidly with increases in firm size. Larger firms can afford to pay more. For them talented CEOs are a bargain.

Australia benefits from its tolerance for inequality

The real message of the survey study for Australians is that we are more tolerant of inequality, including pay outcomes, than are most other nations. This makes it easier for us to attract talented managers out of the limited global pool.

Importantly, it means that outcomes for most Australians will be better than is the case in the rest of the world. We can expect our economy to continue to outperform.

But this will be true only for as long as the Abbott government restrains its enthusiasm for raising marginal tax rates — much to the nation’s long-term detriment.