The Price of Inequality: How Today's Divided Society Endangers Our Future (19 page)

The adverse effects of so-called incentive pay

The Right, like many economists, tends to overestimate the benefits and underestimate the costs of incentive pay. There are certainly contexts in which monetary prizes have the potential to focus minds on a thorny problem and deliver a solution. A famous example is detailed in Dava Sobel’s
Longitude: The True Story of a Lone Genius Who Solved the Greatest Scientific Problem of His Time.
As she reports, in the Longitude Act of 1714, the British Parliament set “a prize equal to a king’s ransom (several million dollars in today’s currency) for a ‘Practicable and Useful’ means of determining longitude.” This was critical to the success of transoceanic navigation. John Harrison, a watchmaker with no formal education but a mechanical genius, devoted his life to this quest and ultimately claimed the prize in 1773.
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However, it is a great leap from the power of monetary incentives to focus minds on a great quest to the idea that monetary incentives are the key to high performance in general.

The absurdity of incentive pay in some contexts is made clear by thinking of how it might apply to medical doctors. Is it conceivable that a doctor performing heart surgery would exert more care or effort if his pay depended on whether the patient survived the surgery or if the heart valve surgery lasts for more than five years? Doctors work to make sure each surgery is their absolute best, for reasons that have little to do with money. Interestingly, in some areas we recognize the dangers of incentive pay: expert witnesses in litigation are not allowed to be paid contingent on the outcome of the case.

Because financial incentive systems can never be perfectly designed, they often lead to distorted behavior, an overemphasis on quantity and an underemphasis on quality.
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As a result, in most sectors of the economy simplistic (and distorting) incentive schemes like those used in finance and those provided to CEOs are not used. Instead, assessments take into account performance relative to others in a similar position; there is an evaluation of long-term performance and potential. Rewards often take the form of promotions. But it is assumed
,
especially for higher-level jobs, that employees will do their best and not hold back, even in the absence of “incentive pay.”
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Incentive pay, especially as it was implemented in the financial sector, illustrates how distorting such compensation can be: the bankers had an incentive to engage in excessive risk taking, shortsighted behavior, and deceptive and nontransparent accounting.
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In good years the bankers could walk off with a large fraction of the profits; in bad years the shareholders were left with the losses; and in really bad years so were the bondholders and taxpayers. It was a one-sided pay system: heads the bankers won, tails everyone else lost.

Even if the bankers’ pay system had made sense before the Great Recession, it didn’t afterward, when the banks were put on life-support systems provided by the public. I described earlier how the government essentially gave them blank checks—lending them money at near-zero interest rates that they could “invest” in bonds paying much higher returns. As one banker friend put it to me, anyone, even his twelve-year-old son, could have made a fortune if the government had been willing to lend money to him at those terms. But the bankers treated the resulting profits as if they were a result of their genius, fully deserving of the same compensation to which they had become accustomed.

But while the bankers’ compensation schemes demonstrated some of what was wrong with the so-called incentive pay systems, the problems were more pervasive. Stock options were as one-sided as bankers’ compensation—executives did well when things went well, but didn’t suffer commensurately when stocks went down. But stock options also encouraged dishonest accounting that made it seem that the company was doing well, so the stock price would go up.

Part of the creatively dishonest accounting involved accounting for the stock options themselves, so shareholders wouldn’t know how much the value of their shares was being diluted by newly issued options. When the Financial Accounting Standards Board (the nominally independent board that sets accounting standards), supported by the Securities and Exchange Commission and the Council of Economic Advisers, tried to force companies to provide honest accounting of what they were giving their executives, the CEOs replied with a vehemence that demonstrated their commitment to deception. The proposed reforms didn’t require firms to do away with stock options, but only to reveal what was being given to their executives in a way that their shareholders could easily grasp. We wanted to make markets work better, by having better information.

It is because accounting standards affect how markets perceive firms’ future prospects, and because firms want standards that make them look good—leading to a higher stock price, at least in the short run—that we created an independent board to set these standards. But then corporations used their trump card—their political influence—as senior government officials weighed in, in a process that is
supposed to be independent and nonpolitical
, to maintain the deception.
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The pressure worked.

Indeed, if one were really interested in incentives—and not in deception—one would have designed a quite different compensation system. Stock option incentive pay rewarded executives when there was a stock market boom for which they could fairly claim no credit. It also gave CEOs a big bonus whenever the price of what they sold soared or the price of a critical input fell—regardless of whether there was anything they had done to bring these price changes about. Fuel costs are critical for airlines, meaning that airline CEOs got a bonus anytime the price of oil fell. A good incentive system might base pay on how the company performs relative to others in the industry, but few firms do this. That’s testimony either to their lack of understanding of incentives or to their lack of interest in having a reward structure that is related to performance, or to both.
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The lack of well-designed compensation schemes, such as one based on relative performance, compared to a group of comparable peers, reflects
another
market failure, to which we called attention in the last chapter: deficiencies in corporate governance that provide scope for executives to do what is in their interests—including adopting compensation systems that enrich themselves—rather than in the interests of society, or even of shareholders.

The criticisms of incentive pay that I have discussed so far are well within the confines of traditional economic analysis. But incentives are about
motivating
people, for instance, to work hard. Psychologists, labor economists, and other social scientists have studied closely what motivates people, and it appears that, at least in many circumstances, economists have gotten it all wrong.

Individuals can often be better motivated by intrinsic rewards—by the satisfaction of doing a job well—than by extrinsic rewards (money). To take one example, the scientists whose research and ideas have transformed our lives in the past two hundred years have, for the most part, not been motivated by the pursuit of wealth. This is fortunate, for if they had, they would have become bankers and not scientists. It is the pursuit of truth, the pleasure of using their minds, the sense of achievement from discovery—and the recognition of their peers—that matters most.
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Of course, that doesn’t mean that they will turn down money if it’s given to them. And, as we noted earlier, an individual preoccupied with where his and his family’s next meal will come from will be too distracted to do good research.

In some circumstances, a focus on extrinsic rewards (money) can actually diminish effort. Most (or at least many) teachers enter their profession not because of the money but because of their love for children and their dedication to teaching. The best teachers could have earned far higher incomes if they had gone into banking. It is almost insulting to assume that they are not doing what they can to help their students learn, and that by paying them an extra $500 or $1,500, they would exert greater effort. Indeed, incentive pay can be corrosive: it reminds teachers of how bad their pay is, and those who are led thereby to focus on money may be induced to find a better-paying job, leaving behind only those for whom teaching is the only alternative. (Of course, if teachers perceive themselves to be badly paid, that will undermine morale, and that will have adverse incentive effects.)

An often told story provides another example: a cooperative day center had a problem with certain parents’ picking up their children in a timely way. It decided to impose a charge, to provide an incentive for them to do so. But many parents, including those who had occasionally been late, had struggled to pick up their children on time; they did as well as they did because of the social pressure, the desire to do the “right thing,” even if they were less than fully successful. But charging a fee converted a social obligation into a monetary transaction. Parents no longer felt a social responsibility, but assessed whether the benefits of being late were greater or less than the fine. Lateness increased.
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There is another defect of standard incentive pay compensation schemes. In business school we emphasize the importance of teamwork. Most employers recognize that teamwork is absolutely essential for the success of the company. The problem is that
individual
incentives can undermine this kind of teamwork. There can be destructive as well as constructive competition.
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By contrast, cooperation can be facilitated by pay that depends on “team performance.”
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Ironically, standard economic theory always disparaged such reward systems, arguing that individuals would have no incentives, because typically the impact of each individual’s efforts on team performance (if the team is of even moderate size) is negligible.

The reason that economic theory failed to gauge accurately the effectiveness of team incentives is that it underestimated the importance of personal connectiveness.
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Individuals work hard to please others in their team—and because they believe it is the right thing to do. Economists overestimate, too, the selfishness of individuals (though there is considerable evidence that economists are more selfish than others, and that economics training does make individuals more selfish over time).
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It is thus perhaps not surprising that firms owned by their workers—and who therefore share in the profits—have performed better in the crisis and laid off fewer employees.
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The blinders in economic theories in this arena are related to a broader deficiency in the field. The prevailing approach to behavior in standard economic theory focuses on rational
individualism
. Each individual assesses everything from a perspective that pays no attention to what others do, how much they get paid, or how they are treated. Human emotions such as envy, jealousy, or a sense of fair play do not exist or, if they do, have no role in
economic
behavior; and if they do appear, they shouldn’t. Economic analysis should proceed as if they did not exist. To noneconomists, this approach seems nonsensical—and to me, it does too. I have explained, for instance, how individuals may decrease effort if they feel they are being unfairly treated, and how team spirit can spur them on. But this individual-centered, bottom-line economics, tailor-made for America’s short-term financial markets, is undermining trust and loyalty in our economy.

In short, contrary to the assertion of the Right that incentive pay is
necessary
to the country’s maintaining its high level of productivity, the kinds of incentive pay schemes employed by many corporations, while they create more inequality, are actually counterproductive.

Overestimating the costs, and underestimating the benefits, of more-progressive taxation

The Right has not only underestimated the costs of inequality and ignored the benefits that we have described in eliminating the market distortions that give rise to it. It has also overestimated the costs of correcting inequality through progressive taxation, and underestimated the benefits of public spending.

We observed in the last chapter that President Reagan, for instance, claimed that by making the tax system less progressive—lowering taxes at the top—one would actually raise more money, because savings and work would increase. He was wrong: tax revenues fell significantly. President Bush’s tax cuts fared no better; they, like those of Reagan, simply increased the deficit. President Clinton raised taxes at the top, and America experienced a period of rapid growth and a slight diminution in inequality. Of course, the Right is right in noting that if marginal tax rates were near 100 percent tax rates, incentives would be significantly weakened, but these examples show that we’re nowhere near the point where this should be of concern. Indeed, University of California professor Emmanuel Saez, Thomas Piketty of the Paris School of Economics, and Stefanie Stantcheva of the MIT Department of Economics, carefully taking into account the incentive effects of higher taxation and the societal benefits of reducing inequality, have estimated that the tax rate at the top should be around 70 percent—what it was before President Reagan started his campaign for the rich.
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But even these calculations do not fully reflect, I believe, the benefit from more-progressive taxation, for three reasons. First, we noted earlier that increasing fairness (and the perception of fairness) increases productivity, and in keeping with most economic analyses, those calculations ignored this.

Second, the sense that our economic and political system is unfair undermines trust, which is essential for the functioning of our society. In the next chapter, we’ll explain in greater detail how inequality and the way in which it has arisen in the United States has undermined trust, and how the weakening of trust weakens our economy and our democracy. A more-progressive tax system might contribute a little to a restoration in confidence that our system is, after all, fair. That could have enormous societal benefits, including to our economy.