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Income Inequality and the Management of Organizations

This post is the first part of a blog forum about inequality and organizational theory. Bruce Kogut and Jerry Kim of Columbia University wrote the post, and Shamus Khan, also of Columbia, wrote the commentary.

Bruce Kogut and Jerry Kim

Why should we care about income inequality?  For many, an egalitarian society is a just society.  The argument for this belief ranges from  “I just think that” to sophisticated reasoning about declining marginal utilities and the distribution of natural abilities and the tradeoffs between efficiency and equity.  And for those troubled by such tradeoffs, this latter reasoning boils to the hoped-for compromise that ‘we can get a lot more equity at very little sacrifice in efficiency’.  Arguing about that claim, economics has spilled a lot of the proverbial ink.

But why should we in management and organizational theory care about income inequality in the context of what we study and teach?   The short answer is that the primary source for the massive growth in inequality in the US is due to the greater share going to those who are the top managers of public and private firms.  The share of total income in the US earned by the top 1 percent of income earners has gone from 9 percent in 1970 to 23.5 percent in 2007.   While an increase in inequality is to be found in many rich countries, the US distribution is remarkably more skewed.

If we take a closer look at this 1% (which was approximately for incomes greater than $400,000 in 2007), a substantial number of high-income earners are managers. In fact, according to a recent analysis of individual tax return data, close to half of the top 0.1%—those that make upwards of $2 million—can be categorized as non-finance executives, supervisors or managers.   What is it about business organizations today that are distributing such wealth to their top managers?

An answer to this story must be consistent with an important stylized fact: the share of remuneration of top managers has increased much faster than the market value of firms. One common argument is that technological change and globalization have led to increasing returns to general managerial talent. We call this ‘the best athlete’ argument.   However, the historical evidence suggests that such change predates this recent turbo-charging of pay.

Moreover, if an increased demand for scarce managerial talent drives salaries, then we should see a persisting inequality of pay among top executives.  After all, given all the pay for performance, shouldn’t executive pay be more unequal than the pay in the general population? Salaries in Major League Baseball (MLB)—a context that is perhaps closest to a perfect market for talent—exhibit a level of inequality that is slightly higher than what we find in the overall population, but more importantly, consistent over time.  The inequality for executive compensation, on the other hand, fluctuates a great deal, peaking at more than 15% in 2000 above of the inequality found in
baseball and then falling by 2009 about 15% below.

The alternative explanation that we offer in this working paper is that social norms have shifted in the past two decades. The internet boom was an exogenous shock: high stock prices and the adoption of pay for performance knocked some salaries into the stratosphere.  Social comparisons by benchmarking kicked in and inequality fell, BUT now the proportional share of executive compensation to firm market value went dramatically up.

Executives are surely often very hard working and markets tend to reward that.  However, there is also ambiguity that permits gaming of the system. A strike out or a single is pretty unambiguous and the market for players seems to sort into a fairly stable pay distribution.  This is not the case for executives whose performance is harder to observe.  You would think that boards would do their best to get rid of all the noise they can, such as stock market fluctuations.  But a good deal of research says this is not the case.

That directors of boards do not try harder to purge noise suggests that the rent-seeking theory of pay can explain this explosion.  However, managerial rent seeking to rise up the income rank seem to have been around much earlier than the start of this historical trend.  And similarly, the argument that the growth in pay is due to technical progress that drives up the value of executive talent also does not explain the pattern, for technical progress has been around for some time in any event.  But the real problem with this argument is that it just not particularly clear why technical progress should cause executive pay to skyrocket in absolute terms relative to skilled labor in general.

At all levels of society, social comparisons are bound to be made and to provide footholds into gauging self worth.  It’s not compelling that these comparisons need to require such historically astounding degrees of inequality as justified by stories of sudden technical change driving the demand for executive talent –for which there is little evidence.   And, to depart from data, one suspects that such stunning inequities have unpleasant cultural and democratic consequences that are bound to be reflected in the attitudes and behaviors of the business leaders of our age.

Organization theorists and economic sociologists are well positioned to join other social sciences in the study of the role that social norms and peer benchmarking as well as gender and racial bias play in generating inequality.  This is a global issue that nevertheless begins in the decisions made by business organizations.   That the topic of economic inequality is also entwined in the great political and normative debates of social justice makes our collective contribution all the more desirable.

Discussion by Shamus Khan

Bruce and Jerry’s piece is a wonderful primer on elites and inequality. My response is simply a chronicle of my thoughts upon reading it (and their paper, which I would strongly recommend to all).

First, I think we need to establish why we should care about inequality, particularly if it is driven by wage growth of elites rather than a lowering of the floor of wages for the poorest. Christopher Jencks has done some work arguing that greater inequality is either neutral or bad for societies (but never good), and I’m a little more convinced by it than I am recent work by Wilkinson and Pickett, which makes the same basic argument. But the Jencks and Wilkinson and Pickett arguments are hardly definitive, and it strikes me that some of the best reasons for caring about inequality are because of the relationships between inequality and mobility. Alan Krueger has argued that there is a “Gatsby Curve” (slides here), drawing upon the work of Miles Corak. This has come under some criticism, but I think Corak’s counter-arguments are quite convincing here: there is a tie between rising inequality and declining mobility.

While the rhetoric of the “1%” has recently led to an important social awakening of the findings of a 2003 study by Piketty and Saez, Kogut and Kim somewhat quietly point to an important corrective: there’s a lot of variation within this category, and perhaps we should be looking at the top 10% within it. From that Piketty and Saez and paper I would particularly point readers to Figure IV, which gets a little less attention than I think it should. One of the things it shows is that in earlier eras (1929), the very wealthy were fundamentally different from others within the rich, insofar as their income stream was from a different source (capital income rather than wage income). A quick way to think of this is that this is a Marxian condition – the super-rich were owners of capital like factories. Today it’s still the case that the very rich are more likely to have capital income than the somewhat rich. But the story is not nearly as dramatic. (Importantly, these data don’t include capital gains). And so today’s rich are more “Weberian” – their position is not as tied to capital ownership but instead tied to wage wealth (money). I point to this because Kogut and Kim argue about the importance of shifting norms, and this might help explain why such shifts have happened. That is, wages have embedded within them the idea of pay-for-performance. So if your wages are high you must be really smart and really hard working and provide lots of value, otherwise you could simply be replaced at a lower wage rate. Such arguments work better with wage income than with capital income.

The working paper by Kim, Kogut, and Yang provides a welcome evaluation for DiPrete, Eirich, and Pittinsky’s “leapfrog” argument (particularly, why the leapfrogging happens when it does and not in other times – why pay is similar among CEOs in the 2000s rather than an arms race). This argument differs from Olivier Godechot’s work, which makes an argument for managers “holding up” their firms insofar as they have control over assets and can thereby punish firms that do not comply with their salary and bonus demands. For Godechot, this is particularly unique to finance, where such assets are easily transferable to other firms.

For Kogut and Kim, an exogenous shock of the internet boom created inappropriately “stratospheric” salaries for some, which others started to benchmark themselves against this. This brings up some interesting implications. The first is that the financialization of the economy that has been the focus of so many might be a red herring. While Godechot’s argument is conditional upon finance (or a market sector with easily transferable assets), the mechanism that Kogut and Kim offer does not require the rise of finance. What do you need? Interconnected networks of CEOs wherein a subgroup suddenly is considerably overpaid – high pay diffuses through social networks. What matters is the network structure, not the structure of the economy.

Yet most readers will wonder: such exogenous shocks are not uncommon within markets, and so why did the diffusion happen now and not before (and not globally – the US was not the only nation to experience a dot-com boom)? There is a hint of an answer; pointing to McCall and Percheski and Western and Rosenfeld (unions), they suggest that organizations that might have constrained this process or sanctioned those engaging in it have been weakened or disappeared. This makes me wonder if we’re really talking about new norms (which I’m defining as expectations for action). Instead, what if the norms are somewhat constant and the constraints are what vary? This is important because if the norms vary we can argue about returning to the era of a “socially responsible CEO” but if they are constant, this kind of discussion doesn’t make sense and instead we ask ourselves about how to construct constraining institutions.

Finally, I’d point to the importance of inter-elite contention: something often ignored when thinking about constraints upon elites. And this returns us to the finance point. When constraining elites we often think in Marxian terms (even if we’re not Marxists). That means we think of elites as having fairly consistent (or shared) interests, and that to constrain elites, masses must act. But it may well be the case that inter-elite contention is far more effective than any other mechanism for constraining elites – by creating collective action problems and competing interests. Here, then, shifts in markets where certain sectors become increasingly dominant will have large negative effects. And as such, the massive transfer of wealth to the finance sector – perhaps around the order of more than 6 trillion dollars since 1980 – has created conditions wherein within-elite constraints have declined.

Written by orgtheoryguest

October 8, 2012 at 3:42 am

Posted in inequality, markets

20 Responses

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  1. Last week I heard veteran investigative reporter and Pulitzer Prize winner Hedrick Smith, speaking on “Who Stole the American Dream?” He talked about the destruction of the middle-class – how it happened, and what to do about it. It explores the rise of corporate lobbying, and social engineering that moved wealth from the middle-class to the corporate elite. I posted a video of that talk, here: http://8020vision.com/2012/09/24/hedrick-smith-who-stole-the-american-dream/

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    Jaykimball

    October 8, 2012 at 5:53 am

  2. They rich do not keep their money in cash vaults in their homes to porpoise in the coins and notes like Carl Banks’s Scrooge McDuck. They do not get paid in gold. They get paid in equities. Even their paychecks are deposited into banks where they become loanable funds. One way or another they are integrally tied to the very markets from which come their (largely symbolic) salaries. In case of a major catastrophe such as an electro-magnetic pulse, they would be worse off than street level black market operators (drugs, prostitution, gambling), which are, indeed, done in cash. In order to liquidate their equities, they need to find buyers, which defines their exposed risk. Little that they own is actually liquid. In that, they are in the same boat as the other 99%.

    The wages of the rich are the floor under widows and orphans.

    Clearly, firms must be bidding up their wages, as surely as the manufacturers of a previous age bid for tool-makers and die-makers. What is missing, perhaps, is evidence that they bid against each other, lowering their asking wages to get positions that are in short supply. Apparently, that is not the case.

    People may be “irrational” contrary to the models of classical economics. That would only raise questions about the validity of the models. … unless you think that economists should be allowed to predefine human nature.

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    Michael Marotta

    October 8, 2012 at 6:06 am

  3. A more general look at the reasons to care/not to care about income inequality is here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1992918

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    Filip Spagnoli

    October 8, 2012 at 1:12 pm

  4. Thanks for the chance to have the conversation, orgtheory! There is an English version of Godechot’s paper. It’s here: http://www.cairn.info/load_pdf.php?ID_ARTICLE=RFS_495_0095
    Should have linked to that one instead of the French…

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    Shamus Khan

    October 8, 2012 at 3:22 pm

  5. […] Oooh oooh ooh – and a really insightful (hopefully beginning to a) conversation about income inequality, particularly the role of organizations (and management) therein over at […]

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  6. @Michael Marotta: “The wages of the rich are the floor under widows and orphans.” I don’t know what this means. Are you arguing that the higher the wages of the rich, the better off poor people are? (That is, the higher the wages, the higher the floor). If so, what evidence do you have for this claim? All the evidence I’ve seen tends to trend in the exact opposite direction. That higher wages of the rich means greater inequality, which has negative impacts on all kinds of things (some impacts are neutral, none are positive).

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    Shamus Khan

    October 8, 2012 at 6:17 pm

  7. I find the post/discussion above very interesting. But similar to Marotta and his comment (which Khan contested), I want to intervene and say that sociologists have long pointed to wealth rather than income as the socially significant source of economic inequality. So in this light:

    @Shamus Khan: Would you immediately disagree were Marotta’s comment better stated “the [wealth] of the rich are the floor under widows and orphans”? Thanks.

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    Austen

    October 9, 2012 at 1:19 am

  8. @ Austen. I still don’t understand. Is the implication that the wealthier the wealthy are, the better off the poor are?

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    shakha

    October 9, 2012 at 3:13 am

  9. The wealth you speak of came from the computer revolution of the 1980s and 1990s. The 1% are the Atlases who have held us above the rising waters of regulation, legislation, and taxation. Just for instance, Anousha Ansari, her husband and brother-in-law invented a high-speed switching system which they sold to a telco for $60 million. With that money, they funded X-prise awards. She used her share to go to the International Space Station. She speaks to schools, encouraging young people, especially girls, to pursue STEM studies. If their $60 million had gone to Washington, what would we have to show for it? 60 miles of highway, so the President could claim that someone else built the infrastructure for your success.

    The Congressional Budget Office statistics are available for anyone who cares to know the facts. The top 1% earns 15% of all incomes and pays almost 30% (28.9%) of all federal taxes. The richest carry twice their fair share.

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    Michael Marotta

    October 9, 2012 at 12:32 pm

  10. @shakha: First, I have no truck with Marotta’s overall rhetoric, especially his latest comment. So let me leave his question behind, and try another tack. Second, I defer to you on this issue. I am not disagreeing; just asking. So, to answer your question, I would simply say the “poor” here are pretty well off when you compare them not to the “rich” but to poor people in other parts of the world.

    Would you agree the poor of “rich” advanced societies are better off than the poor elsewhere? If so, what do you think accounts for this? Do you agree that the US has the best (if imperfect) public school system in the world? If so, what accounts for this? (…thanks)

    And yes, I do realize my questions implicitly endorse a kind of “trickle down” economic vision that I am not entirely comfortable with.

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    Austen

    October 9, 2012 at 1:09 pm

  11. @michael marrotta: What a nice story about Anousha Ansari. It fits nicely with your ideology, but I agree with you, let’s stick to some broader evidence. You might be interested in the paper, “How Progressive is the U.S. Federal Tax System? A Historical and International Perspective,” particularly page 13, table 2. The richest Americans have seen their federal tax rates half since 1960. But on average, tax rates have gone up for Americans. You can see it here:

    http://timeopinions.files.wordpress.com/2012/09/piketty-saez.pdf

    The decline in such marginal tax rates among the rich has been associated with massive increases in inequality. Which has meant less mobility, and lots of other negative social outcomes. I’ll ask again, what is the evidence that the rich being richer is better for the poor? I mean this earnestly. Is there an actual study that shows benefits to inequality?

    @Austen are the poor better off here? Well, you might want to look at infant mortality rates, for example, where the US ranks 49th in the world (CIA factbook). And our low ranking is mostly explained by the rate among the poor — which is roughly the rate of the developing world. By that measure, then, our poor are about as well off as the average person in the developing world. Which is to say, not great. You can see infant mortality statistics here (by race are particularly telling):

    http://www.cdc.gov/nchs/data/databriefs/db09.htm

    It’s notable that these data show that as income inequality has increased, so too have negative health outcomes for Americans, largely driven by the experiences of poorer Americans. In the 1960s we had one of the lowest infant mortality rates in the world. Today, we’re middling among OECD nations.

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    Shamus Khan

    October 9, 2012 at 3:20 pm

  12. Bruce Kogut and Jerry Kim’s blog makes two claims not supported by my reading of the paper they cite (Bakija, Cole & Heim 2012). 1. The primary source for the massive growth in inequality in the US is due to the remuneration of top managers of shareholder-owned and privately held businesses. 2. The remuneration of top managers of shareholder-owned businesses has increased much faster than their market value. What the paper shows is that the primary source for the massive growth in inequality in the US is due to the remuneration of top managers of privately held businesses and financial professionals, which together account for 70 percent of the increase in the share of national income going to the top 0.1 percent of the income distribution between 1979 and 2005. The part played by top managers of shareholder-owned businesses declined dramatically. The paper further reports that, between 1979 and 2005, the remuneration of top managers of shareholder-owned businesses increased much less than market caps. I suspect that the stylized fact you refer to goes to the CEOs of Fortune 500 companies, but it should be remembered that they represent only one percent of the top managers in the .001 income class and are, therefore, hardly representative of the class.

    What Bakija, Cole & Heim ask us to do is explain why the remuneration of top managers of privately held businesses and financial professionals increased so much between 1979 and 2005. One answer is the huge increase in value of financial assets during that time period. Since most of the top managers of privately held businesses own those businesses, this factor accounts for a lot of increase accruing to both financial professionals and to top managers. The second answer is that tax changes made it a lot more attractive for owners of businesses to recognize more income in the form of wages and bonuses than had been the case prior to the mid-eighties. Neither of these issues go to the corporate governance issues stressed by Kogut and Kim.

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    Fred Thompson

    October 9, 2012 at 8:43 pm

  13. Again, the following is more to ask questions while I have the opportunity rather than to argue a point.

    I question what income inequality necessarily has to do with low infant-moratility rates. The causal mechanism would seem to me to run from income inequality, to the effect of disproportionate political power, to a situation in which the wealthy are able to block political reforms in health care that would help poor. Perhaps that is indeed the model you have in mind. However, the main social problem in that model is not the inequality of income, per se, but the inequality of power, it seems to me.

    I think what I’m trying to ask is: Would you say it is your position that economic inequality is bad because it will -necessarily- lead to concentrated and nefarious political power, or that there is something intrinsic to economic inequality that leads directly to outcomes I agree are terrible like the US infant-mortaliy rate. (E.g. With all the billionaires and inequality the US has, the US could still economically afford to give healthcare to everyone. The US politically chooses not to.)

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    Austen

    October 9, 2012 at 10:12 pm

  14. @Fred Thompson: Appreciate the comments. The question we pose is “Why should organizational scholars care about inequality?” We think that org theorists should pay attention to the compensation of executives and managers of organizations–both public and private–because they have been a major driver of the increasing inequality since 1979. To us, the distinction between public and private is not terribly important, as the question of why managers have taken an increasingly larger share of the pie applies to both public and private firms. It is true that most of the literature has focused on executives of public firms, mainly due to data issues. But I don’t see why the discussion of compensation and its role applies to only public firms. (As for the specific numbers in Bakija et al., the 70 percent of share of the increase in income is not for “top managers of privately held businesses and financial professionals” as you note, but rather “executives, managers, supervisors, and financial professionals” (p. 25), which includes both private and public firms. It is true that executives and managers of “closely-held” firms increased their share of the income growth substantially, but “salaried” executives and managers still account for roughly half of the income share, and have seen a significant increase in their share if you take into account capital gains.)

    As for corporate governance, I think the significant increase in compensation for executives of privately-held companies actually strengthens the argument that lack of oversight and governance is a key issue in explaining the rise in compensation and inequality. Misalignment of incentives may be a smaller problem for private firms, but without much of a check on the power of managers, they seem to be taking a greater and greater share of the value firms create. In fact, Bakija et al. seem to believe that governance is one of the main potential sources (along with stock price movements and the rise of the finance industry) of the increasing share for executives and managers.

    I’m not entirely sure where the remuneration for top managers vs. market capitalization numbers you cite can be found in the paper. (I may be missing this, so please let me know where I can find it.) But numerous studies (see Gordon and Dew-Becker, 2008) and our own analysis show that the sensitivity of pay to firm market value has increased significantly (close to threefold) in the past few decades. (This was not for just the Fortune 500, but rather, included compensation data for more than 3000 firms.) All in all, every study that I’ve seen has suggested that the share of value that executives capture has been rapidly increasing over the past few decades.

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    Jerry Kim

    October 10, 2012 at 1:26 am

  15. how is the internet boom an exogenous shock? When did asset bubbles (and crashes) become external to the system of incentives and social relations within an industry? This is a facepalm moment for me.

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    sd

    October 10, 2012 at 9:35 pm

  16. @sd: Unless the most talented CEOs predicted the internet stock market boom and pre-sorted into those companies, the (initial) rise in pay for those CEOs was, in our view, exogenous to executive talent. Of course, once the pay levels for the “lucky” CEOs become the norm, then these norms endogenously diffuse through social structures and further inflate the bubble of compensation…which was kind of our point.

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    Jerry Kim

    October 11, 2012 at 2:32 am

  17. i would agree with mr. khan’s intuition that what matters is constraining institutions (i.e. labor unions) that possessed the organizational capacity necessary to align the interests of executives more closely with the long-term health of the businesses that they were responsible for managing. i am puzzled, however, by his dismissal of ‘finance’ considerations, especially, when considering how the balance of power between unions, management, and capital shifted profoundly in the wake of a 1970s profit squeeze across much of advanced industrial west. did not the increasing mobility of capital – via an ICT revolution that made possible both the vertical disintegration of production and a thriving eurodollar market that allowed multinationals to invest their profits overseas instead of repatriating them – seriously undercut the bargaining power of unions that once could strike with relative impunity?

    i’m by no means suggesting that inter-elite conflict and domestic political struggle over corporate governance, financial regulation, or labor legislation have had no autonomous role in the shifting balances of power between labor, capital, and management. acemoglu and robinson have in this regard outlined a very elegant mechanism whereby rising levels of inequality exacerbate the destructive rent-seeking practices of elites that prefer extractive over inclusive political institutions. but the power of post 1970s financial innovation and its associated practices of regulatory arbitrage vis-a-vis the inherent sluggishness of law and legislative institutions nonetheless deserves inquiry in its own right . . .

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    polysemous

    October 11, 2012 at 2:36 am

  18. […] post is in the second in a blog forum about inequality and organizational theory (see part 1). Isabel Fernandez-Mateo of London Business School wrote the post, and Philip Cohen of the […]

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  19. […] blog post is the third in a blog forum about inequality and organizational theory (see parts 1 and 2).  Adam Cobb of Penn’s Wharton School of Management wrote the post and Leslie McCall […]

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  20. […] is the fourth and final post in a blog forum about inequality and organizational theory (see parts 1, 2, and 3). Michael Piore of MIT’s Sloan School of Management and the Department of Economics […]

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