How the Rich Got Even Richer

House exterior lit up at night, with patio furniture
House exterior lit up at night, with patio furniture

Skyrocketing CEO pay has been much in the news for some time. Sky-high paychecks are identified as one of the principal causes of the explosion in inequality over the past 40 years.

The statistics are striking: In 1965, CEOs heading the corporations in the Standard and Poor 500 earned on average 29 times as much as the average worker. By 2013, they earned 354 times more. These soaring paychecks haven't been exclusively reserved just for CEOs. Top performers in acting and sports have experienced similar good fortune. For instance, the highest-paid actor, Robert Downey Jr pocketed $75,000,000 in 2014. In sports, boxer Floyd Mayweather hauled in $105,000,000. Even the salaries of university presidents have soared.

Much ink has been spilled on explaining why these top salaries have gone through the roof. Explanations have gone from the evolution of a new "winner takes all" economy to claims that they really do contribute sufficiently to the firm's interests to justify such largesse.

But surprisingly, the discourse has largely ignored the two major causal forces that were launched during the early Reagan administration. One is that in 1981, corporations distributed less than half their profits to shareholders and invested the remaining retained earnings. But this began changing in 1982 when the SEC eliminated limits on corporations' freedom to buy back their own stock so as to show higher profits per share. This strengthened the link between the rise in the company's stock value and CEO pay. A study by William Lazonick has found that the 449 companies listed on the S&P 500 list between 2003 and 2012 devoted 54 percent of their after-tax profits to buying back their own stock. They distributed another 37 percent to shareholders as dividends. This left little of their profits for investment, thus helping explain the sluggish growth in jobs and wages.

The second unnoted cause for such exceedingly high incomes is the radical reduction in marginal income tax rates since 1981. The tax on the last dollar earned -- the highest marginal income tax rate -- was 88 percent in 1942-43; 94 percent in 1944-45; and 91 percent between 1946 and 1950. Top marginal tax rates remained in the upper 80s from 1951 until 1964, and at 70 percent from 1965 until 1981. These high rates made it far less attractive for firms to pay extremely high CEO salaries since only a small percent would go to the CEO or entertainer, with the overwhelming amount going to the U.S. government (i.e., the American people).

Reagan's tax cuts in the early 1980s more than halved the highest marginal income tax rate from 70 percent to 28 percent. Under Clinton, this was raised to 39.6 percent, lowered to 35 percent under George W. Bush, and raised again to 39.6% during the Obama Administration.

Those who defend these lower rates claim that they are essential to motivate individuals to perform at their best. This argument was especially popularized by supply-side economists. But there is no evidence that individuals were less motivated when the marginal tax rates were so high between 1942 and 1981. Indeed, the economy grew far more robustly when the rates were at their "confiscatory" highs. For instance, total per capita income grew 90% over the 30 years between 1946 and 1976 when the rates were so high, but only 64% over the 30 years between 1976 and 2006 when they were so much lower (after 1981).

What motivates top players in business, entertainment, sports, or for that matter, in whatever domain? They strive to be recognized as the very best at what they do, or, failing that, to be among the very best. They want to be recognized as the alpha guys. Those who command the highest incomes receive confirmation of their value and this signal is usually public so that their achievements can be widely admired. "Surely they're great if they're paid so much!"

But how high must incomes be to provide such signals? In fact, it is only important that the highest achievers get the highest or among the highest incomes for their professions. It's only necessary that they stand out and be recognized as the best or among the best. If the average CEO salary were $500,000 and the highest were $750,000, then the individual receiving the latter would stand out as the very best. But this would be equally true for the individual who received the highest income of $250,000 where the average is $200,000.

Exploding incomes at the top have led to a consumption arms race as those with ever exploding wealth at their command compete among themselves for the very pinnacle of social status. Their wealth is so over-the-top that they flaunt it through conspicuous consumption in such highly visible goods as mansions, helicopter commuting, clothes, and jewelry. Those below them on the income/wealth ladder emulate this consumption to maintain their relative social status, and this struggle to maintain status ratchets itself down the social gradient, a prime driver for ecological devastation.

The most obvious step for addressing the problem of exorbitantly high incomes is to return to the "confiscatory" marginal tax rates of the post-World War Two period -- the so-called "golden age of American capitalism," when the economy grew robustly, inequality declined, living standards greatly improved for everyone, higher education expanded dramatically and became available and affordable for ever-more young people, legal segregation ended and the franchise was extended to African Americans. Many economists, even some "free-market" economists agree that such a measure would make good economic sense. The second obvious step is to reinstate limits on corporations' freedom to buy back their own stock.

Exploding inequality is undermining democracy and racing us toward plutocracy. It threatens the very future existence of humanity by impeding adequate responses to environmental devastation. Moreover, according to Richard Wilkinson and Kate Pickett, it is undermining the quality of our lives. Reducing one substantial cause of extreme inequality -- exorbitant pay -- is technically fairly simple. The challenge is nudging politicians to do it.