Are CEOs Overpaid?

This question has been debated by regulators, practitioners, and the media for at least the past 40 years. Pick up The Wall Street Journal, Forbes, or any of the world’s business press on a given day, and there is a decent chance that you will see a feature questioning whether CEOs of large companies deserve the pay they get.

The frequent nature of such accusations has led regulators worldwide to require companies to provide greater transparency on CEO compensation decisions. These laws do not directly regulate the amount of CEO compensation, but they require listed firms to disclose it, along with the processes and criteria used to determine it. More recently, regulators have also required companies to give their shareholders a say on CEO compensation through a vote on executive compensation. Despite these interventions, the apparent overpayments have not been eliminated, according to investors and media coverage. One just needs to see the raging debate and the ensuing litigation over Tesla’s $50 billion pay package in 2018 for Elon Musk or the $212 million salary of Amazon’s CEO, Andy Jassy, in 2021, which half of the company’s shareholders felt was an overpayment.

Challenge

Scholars have sought to shed light on this important question by examining whether CEOs receive compensation beyond what is justified by their role’s effort and performance. However, identifying clear evidence on this issue has been difficult. Previous research has examined this question by investigating whether CEOs are compensated for industry- or market-wide returns, arguing that such gains are lucky occurrences beyond a CEO’s control and should not affect CEO compensation. However, payments for such industry or market-wide gains have been alternatively interpreted as optimal payments made to retain talented CEOs or as compensation for CEOs’ efforts to strategically reposition a company in the face of industry or economy-wide shocks. Overall, these alternative interpretations have left the issue of CEO overpayments unanswered.

Our Research

We investigate this issue by evaluating how CEOs’ compensation was influenced by one-off gains and losses arising from the passage of the U.S. Tax Cuts and Jobs Act of 2017, or TCJA. The TCJA was one of the most significant tax changes in the corporate history of the United States. Before it came into force, U.S. companies paid 35% of their profits in taxes to the government. The TCJA reduced this rate to 21%, leading many firms to report one-off transitional gains and others to report losses. These gains and losses were substantial. For example, Berkshire Hathaway reported a net tax benefit of $29 billion, whereas Citigroup suffered a net tax loss of $22.6 billion.

As the passage of the TCJA was not within the control of any CEO and the gains/losses are heterogeneous across firms within the same industry, the TCJA-induced transitionary gains or losses should not affect CEO compensation.

Our Findings and Conclusions

Our research shows that, upon the TCJA passage, CEOs of firms reporting large TCJA-induced windfall gains were paid significantly more than firms reporting small windfall gains after controlling for other pay determinants. In terms of economic magnitudes, CEOs of firms reporting TCJA gains in the top quartile were paid 8.3% more than firms in the bottom quartile. In dollar amounts, this pay-for-luck is about $330,000 for the median CEO. This pay-for-luck occurs mainly for CEOs whose pay is poorly scrutinized because the firm has a weak board of directors, few analysts following its activities, more transient investors, or attracts scant media interest. Also, the compensation for the windfall gains does not improve company performance in the future. So, these payments were not made to better align CEOs’ interests with those of shareholders or otherwise yield direct benefits to shareholders.

In contrast to the CEO rewards in firms reporting large tax gains, we find no evidence that CEOs were penalized for reporting tax losses.

We find these patterns occur only in CEO pay and, to a lesser extent, in CFO pay but not in other senior executives’ pay. Also, ‘ordinary’ employees do not share the tax windfall gain. These findings are consistent with the view that CEOs receiving pay-for-luck wield managerial power over their boards, enabling them to extract higher compensation than is merited for their effort and performance.

The excess compensation also does not lead to better future performance nor is it systematically related to the need to retain talented CEOs.

Lastly, the results show that CEO compensation relating to tax gains is not a reward for lobbying efforts or supporting Donald Trump’s candidacy, whose election victory made the TCJA gains possible. In fact, contrary to this explanation, the pay for windfall gains was equally likely to be awarded to politically neutral, Democratic-leaning, and Republican-leaning CEOs.

Overall, we find that CEOs of firms with poor pay scrutiny are paid excessively and are compensated for lucky windfall gains but not penalized for windfall losses.

We conclude that the CEO pay associated with the tax windfall gains is more consistent with the rent-extraction view of CEO compensation than with explanations based on shareholder value-maximization models. In other words, the pay relating to TCJA tax gains is not compensation that is in the interest of shareholders.