Excessive executive remuneration and income inequality will continue to be major issues this year as they are at the heart of growing criticism of our capitalist system.

This was highlighted again during the week in United States President Barack Obama’s State of Union address and the release of the OECD’s report “Less income inequality and more growth – Are they compatible?”

The OECD report shows that the top 1 per cent have a much higher share of total taxable income than they did 30 years ago (see table).

Only the Netherlands, which has seen the top 1 per cent have its share of total taxable income fall from 5.8 per cent to 5.6 per cent, has experienced a decline in inequality as measured by the OECD. The top 1 per cent now has 18.1 per cent of total taxable income in the US compared with 8.1 per cent in 1980.

In Australia, the top 1 per cent has increased its share of total taxable income from 4.8 per cent to 11.2 per cent, and in New Zealand from 5.6 per cent to 9.0 per cent.

The OECD report shows that income inequality is increasing in the English-speaking countries of New Zealand, Ireland, Australia, Canada, United Kingdom, and the US. By contrast, income inequality is fairly stable in the four Nordic countries of Sweden, Denmark, Finland, and Norway.

The OECD advocates economic policies that have a strong emphasis on reducing income inequality as well as achieving economic growth. According to its chief economist “Rising inequality is one of the major risks to our future prosperity and security. The main challenge facing governments is implementing reforms that get growth back on track, put people to work and reduce the widening income gap.”

Listed companies are major contributors to income inequality because there has been a significant transformation from owner capitalism to manager capitalism over the past few decades. By this we mean that managers, rather than owners, are controlling major enterprises and these managers are granting themselves huge pay increases. These then flow on to other organisations, including the public sector.

The problem starts in the US, where income inequality is the greatest. The share registries of most large companies are dominated by institutions, many of which are short-term holders. The talking heads on CNBC – who buy, sell, and short shares on a daily basis – generally have no interest in monitoring these companies from an ownership point of view.

Consequently, many US boards which have the same individuals as chairman and chief executive, overpay their chief executives and give them generous stock options.

Thus there has been a big switch from owner capitalism to manager capitalism, mainly because boards are dominated by an executive chairman, the non-executive directors are acquiescent, and institutions are disinterested.

The US sets a precedent for the rest of the world because boards of directors in other countries employ consultants to look at international salaries when assessing the remuneration of their senior executives.

So US senior executive pay levels quickly set a precedent for the rest of the world because consultants take these into account when advising non-US boards.

This process ratchets-up salaries in other countries, with Australia being a good example of this. As a result, income inequality across the Tasman, as defined by the OECD, has escalated dramatically over the past 30 years.

Australian directors argue that they have to pay international salaries to keep their top executives and this means they follow US trends. In addition, the share registries of nearly all the major Australian companies are dominated by institutions, rather than individuals. Many of these institutions are not long-term owners, as demonstrated by their aggressive selling of shares in Billabong, Kathmandu, and other companies when these ASX-listed entities announced recent profit downgrades.

New Zealand follows Australia and the remunerations of our senior executives are rapidly ascending as a result.

The Australian influence was felt strongly last year when Fletcher Building, SkyCity, and Nuplex, all chaired by Australians, sought substantial increases in director fees, although Nuplex withdrew its motion before the annual meeting.

GPG was a clear example of managerial capitalism, as opposed to owner capitalism. The executive-dominated board argued that the excessive executive remuneration and overly generous options schemes were in line with Australian and international trends.

The massive increase in executive remuneration has flowed into other areas, including the public sector. The controversy over the Christchurch City chief executive’s pay increase is an example of this and seems like a case of manager control rather than ratepayer control.

It shows that directors, public representatives, shareholders, and ratepayers have to be much more vigilant regarding senior executive remuneration and avoid acquiescing to consultant reports based on salary levels in Australia, the US, and other countries.

Governments are becoming increasing concerned about excessive executive remuneration and pay inequality, and this week the UK Government announced a number of measures to address the issue. They include:

  • Shareholders will have binding votes on pay policies, including how performance is measured. They will also have a binding vote on exit payments worth more than one year’s salary, and measures will be introduced that require executives to pay back money if a company performs badly.
  • Companies will be required to have greater disclosure and transparency regarding remuneration. This will include the benchmarks used to set pay and how the pay compares with other expenditures, including dividends and investments.
  • Companies will be required to have more diverse boards of directors, with two places on each board reserved for individuals who have not been directors before. Executives will not be allowed to sit on the remuneration committees of any outside boards they may sit on.
  • There will be requirements for boards to consult employees regarding board pay and senior executive salaries.

The response to these proposals was generally positive. A Financial Times editorial, with the sub-heading “Coalition plans put onus on shareholders to check pay”, stated that “Whatever the tools that are chosen, however, much depends on the willingness of shareholders to employ them. Many argue that only a minority of investors have the time or inclination to crack down on pay. Most prefer to vote with their feet [sell their shares] if unhappy”.

The Financial Times noted that a similar scheme was introduced in the Netherlands in 2004 – the only country to have a reduction in inequality since 1980 – and the newspaper was particularly pleased that the Government hadn’t insisted on putting workers on remuneration committees.

The guts of the issue is that the capitalist system gives shareholders the right to appoint directors and for these directors to allocate income between executives and non-executive employees, through dividends or reinvestment back in the business.

The system has broken down because managers have wrestled control away from owners. This is mainly because institutions are the new dominant shareholders and many of them are short-term holders with little interest in corporate governance issues, including the appointment of directors.

A number of countries are looking at higher income tax rates for top earners as a solution to growing inequality. Greater shareholder vigilance is a much better option than higher taxes.

It is extremely important that New Zealand shareholders, both individuals and institutions, exercise their full rights and wrestle control back from managers who have put themselves ahead of other stakeholders.

Shareholders have a powerful role to play in reducing income inequality. This power needs to be used more aggressively as it is highly unlikely the New Zealand government will introduce the same reforms as were proposed in London this week.

Share of total taxable income of top 1% – The gap widens

Capital gains are included in the Australian & Finland figures only
Source: OECD

  2008 or latest year 1980
Sweden 4.50% 4.00%
Netherlands 5.60% 5.80%
Denmark  6.50% 5.20%
Finland 7.10% 3.30%
Norway 7.50% 4.70%
Belgium 7.70% 7.00%
Spain 8.80% 7.50%
France 8.90% 7.60%
New Zealand 9.00% 5.60%
Japan 9.20% 7.20%
Italy 9.40% 6.90%
Portugal 9.80% 3.60%
Ireland 10.30% 6.60%
Switzerland 10.50% 8.80%
Germany 11.10% 10.80%
Australia 11.20% 4.80%
Canada 13.30% 8.10%
United Kingdom 14.20% 6.70%
United States 18.10%