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Why the Rich Are Underpaid

Prof. Tabarrok at Marginal Revolution talks about Prof. Mankiw’s discussion of taxes, the top 1%, and productivity. I had a thought: The most productive employees are paid too little, including the most productive CEO’s.

An employee is paid his expected productivity. It is hard to tell productivity, especially for high-income jobs. Thus, half the bottom managers are paid too little, and half too much. Or, more accurately, the bottom 10% is grossly overpaid, the middle 80% paid about right, and the top 10% grossly underpaid. The top 10% do get promoted. At the next level, most having “reached their level of incompetence”, the pattern repeats. Eventually the creme de la creme become CEO’s— where it repeats again. If it repeated often enough, we’d discover each person’s true ability— but we are mortal, and an accurate eulogy is no great help to the economy.

Thus, for all but the last 5 years of his life, the most productive person is paid less than his value to his employers— and to the economy. To be sure, it is still true that on average executives are paid exactly what they’re worth—- but that’s because the less productive ones are overpaid.

The ideal contract for efficiency might be one like in the Parable of the Talents, where the Master takes away the one talent of the risk-averse servant and gives it to the smart servant who already is being paid the most. If managers don’t know their own abilities in advance, however, which is true (many don’t realize how bad they are even ex post), then the current system provides useful insurance. I think Professor Holmstrom may have written on this years ago.

Of course, many large fortunes are made by being equity residual claimants rather than employees, but the same unfairness is present there. The entrepreneur needs capital, and he can’t get it until he’s demonstrated his ability. My Parable of the Talents contract is actually used though, because the contract is that the entrepreneur puts up some of his own money and loses it if he turns out to have low ability, whereas the high-ability entrepreneur gets a higher profit rate on the capital he borrows. The PT contract is limited by the bankruptcy constraint, however: once the entrepreneur has put up 100% of his wealth, he can’t post any bigger bond to demonstrate his ability.

There are no doubt tax implications to all this, but they will have to wait for another day.

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