Performance Pay Drives Inequality

Along with issues like environmental sustainability and the Half Beard, there is a growing concern over rising income inequality in the United States.  In spite of the hype, new studies suggest that income inequality is a product of rewarding harder work.  And I believe performance-based pay epitomizes fairness in a democratic nation.

Most economists agree that income inequality is growing in the United States.  Some fear that this is a sign of decline for our nation.  Politicians like John Edwards have pushed an idea that the privileged few are enjoying the spoils that come from a toiling and squeezed middle class.  But the truth is much different than the fear and hype.

A recent study by the National Bureau of Economic Research shows that rising income inequality is mainly driven by companies' increased use of performance pay.  They study found that "24% of the increase in inequality from 1976 to 1993 occurred because of the increase in performance pay" and that "performance pay explains almost all of the increase in inequality for the top 20% of wage earners."

Performance pay is increasingly common across our nation.  The percentage of all jobs with some form of performance pay increased from 30% in 1976 to 45% in 1998.  And half of all salaried employees have some performance pay today.  BusinessWeek points out that "new technologies have made it easier to measure performance of individuals workers."

I believe performance pay has grown in our society because we increasingly demand fairness at work.  Just as we are eliminating race and sex-based discrimination, we are rolling back the idea that each person deserves the same salary regardless of actual performance.  Higher pay for better performance is not only "fair" but it provides an incentive (or challenge) for harder work. 

I've worked in enough jobs with equal pay to see that it discourages harder work - in fact, I remember a summer of moving furniture in which my crew pressured me to work slower so that they wouldn't look bad.  We were all getting paid the same amount, so why hustle?

But if income inequality is actually a sign of improvement and opportunity - for both the rich and the rest of us who enjoy their successful products and services - there still seem to be negatives that public policy should address.  I believe our society (through the government) should work to ensure that all citizens have equal opportunity to succeed.  A few suggestions:

• Keep and raise the Estate Tax - I wrote about this a year ago.  If we let the rich pass their fortunes to the next generation - who didn't lift a finger to earn it - then we will have a generations of unfair inequality - remember the aristocrats of Europe?.
• Encourage further performance pay - There is nothing more fair than paying the higher performers more than the lower performers.  Our governments should ensure they are practicing this model everywhere they employ people, from schools to Congress.
• Help those who failed pick themselves up - There are bound to be losers in any competitive economy.  So we should have a safety net for those who are left on the sidelines.  This may include subsidized training for those whose jobs have been outsourced, and its another argument for national health insurance coverage.

Overall, performance pay is another great example of the Challenge Dividend at work.  The opportunity to increase income by working harder is directly driving improvement in productivity in our economy.  Income inequality is merely a byproduct - just like the byproduct of better products and profitability for the companies who use performance pay (who benefit along with their customers and shareholders).

An enlightened society should be able to ignore the neighbor's bigger house or bank account, and focus on making sure there is an equal chance for all to earn their way into the top earning percentile.

Comments

[Jay]

I take issue, in part, with your belief that eliminating the Estate Tax is consistent with your premise of the Challenge Dividend.

Much incentive for intelligent, hard working people is not compensation for themselves, but rather for taking care of their family - raising the standard of living (at the lower end) or providing opportunities to extend beyond the current (enlightened travel, higher education, material benefits).

In other words, the challenge incentive goes beyond the short-term/this generation and extends into other generations. Further, I would argue that our country was founded on the idea of helping our progeny to do better than the current generation - "to ensure the blessings of liberty to ourselves and our posterity."

Raising the estate tax will demotivate and un-challenge all the top earners/brains of our generation....if I've already earned enough to take care of myself and I'll never be able to spend all this money, why should I continue to think at all? No challenge, no incentive, no thinking.

I agree that inheritance might weaken the incentives of the next generation, but removing the ability to provide for our posterity will hurt the motivation of the current generation.

[Bob G]

We probably have to agree to disagree on this one.

First, there have been a lot of claims that higher taxes in the present (or hereafter) will reduce motivation, but I don't believe I have ever seen actual data or a study on the right "sweet spot". Even at 95% tax rates, the people who are successful and driven often keep going. Witness the Gilded Age times when tax rates were regularly this high. It didn't stop Vanderbilt or Carnegie from building their empires.

Second, there is a tendency for laziness among the next generation. Looks like you agree on this one.

Finally, opportunities for success for the next generation become unevenly distributed. There is already enough benefits of winning the birth lottery and being born into a smart or successful family. Add high incomes to the list, and suddenly the opportunities for college, starting a business, or affording a home move toward the trust funds kids and away from the middle class and down. That's just supply and demand.

Challenge Dividend is a bonus of leveling the playing field for newborns. But there is also a fairness principle which drives a recurrent Populism theme among U.S. citizens.

Today, most citizens would agree that the rich deserve to keep a large piece of their earnings because they got it by working hard. But imagine 20 years from now when the children of dot-com and CEO millionaires ease into society. I predict a much more harsh view of inherited wealth at that point.

Finally, someone has got to pay the tax bills, so the Estate Tax is also about a choice of taxation. We've already got the top 10% of earners paying a majority of taxes in the U.S. So, I would prefer to reduce taxes on the present generation of workers who earned their rewards, and shift the tax burden to those who are given it with no work. By cutting the Estate Tax today, we're just choosing to shift the liability to current workers - both the rich and middle class.

[Jay]

One last thought: Your reference to the Gilded Age made me think a little more. In fact, one of the key drivers of the Gilded Age, so I've read, was the lack of income tax (vs a 95% tax rate that you mention).

I'm not an expert here so I turn to the NY Times for my truthiness test...

http://www.nytimes.com/2007/07/15/business/15gilded.html?pagewanted=2&_r=1

The article basically says that high taxes after the Depression resulted in a lack of extreme wealth (and therefore a lack of philanthropy as we saw in the Gilded Age:
"Those earlier barons disappeared by the 1920s and, constrained by the Depression and by the greater government oversight and high income tax rates that followed, no one really took their place. Then, starting in the late 1970s, as the constraints receded, new tycoons gradually emerged, and now their concentrated wealth has made the early years of the 21st century truly another Gilded Age.

“I once thought how lucky the Carnegies and the Rockefellers were because they made their money before there was an income tax,” Mr. Sanford Weill said.

Interestingly, the article mentions that only 2 modern day people (Gates, Buffett) are among the wealthiest 30 of all time.

But, with the current tax structure, more wealth is actually being created, perhaps than ever before(and the hope, as witnessed by Buffett giving his money to Gates Foundation, is that philanthropy will follow):
"Only twice before over the last century has 5 percent of the national income gone to families in the upper one-one-hundredth of a percent of the income distribution — currently, the almost 15,000 families with incomes of $9.5 million or more a year, according to an analysis of tax returns by the economists Emmanuel Saez at the University of California, Berkeley and Thomas Piketty at the Paris School of Economics.

[dk2]

"I believe performance pay has grown in our society because we increasingly demand fairness at work. Just as we are eliminating race and sex-based discrimination, we are rolling back the idea that each person deserves the same salary regardless of actual performance. Higher pay for better performance is not only "fair" but it provides an incentive (or challenge) for harder work."

Well now isn't that just a wonderful statement! I would tell you that you may be correct in that there are other contributing factors, however! Pay for performance, while it could be good to promote working harder - it usually is misused to hold employees to standards that are unobtainable. I for one have had more that one manager to say at review time, that no one can get a perfect score on a pay for performance review - "after all, you would have to be perfect and walk on water to get a perfect score" - another item on pay for performance - the company that I worked for (a fortune 500 worldwide company with world headquarters in Memphis) used to penalize an employee and keep them from reaching the top possible pay raise, was sick leave - allow x number of days per year, and call it a company benefit, oh, but the big kicker - for each day you used, your review score was lowered.
Isn't that a great one to motivate your employees - give them a so called benefit but make it impossible to make use of the benefit.

Yea, I would say that those, $400,000.000.00 retirement settlements for executive is away of legal raping the income of the American workers. It helps put the middle class lower and lower, soon to be, just the very rich and then the very poor. Do you consider yourself in that top 5%, where the slop you are slinging doesn’t matter?

Job efficiency engineers - who count the steps you take and every move you make, or, for couriers count the stops and time the lights. But, never allow you to be human, they set standards that are above human ability to maintain on a daily basis, yea maybe you can hit those counts now and then, but what about the days you are sick and still report to work? Especially while your manager will remind you that "there flipping burgers down the street at Micky D's if you don't like it"

You sap - you made it big, and you had a crew telling you to slow down. Well you know what - you didn't have to just because they may not have been honest - doesn't mean that most are not. So for the sake of the few jerks you worked with, the whole rest of the working world should be made to preform! Your just a wonderful guy.

[Bob G]

DK2,

I think you bring some good real-world perspective as well. I'm not sure I can solve the bad managers and companies out there - but I'm proud to say that I have given out perfect scores and maximum bonuses to my best employees in the past year alone. I guess that's part of the reason our company was named one of the top 25 small businesses to work for in 2006 and 2007...

I would agree that "workplace engineers" brought a huge step backward in quality of work. But we are pretty far past that stage of industrial evolution.

Today (more successful) companies are discovering that it is more efficient and more satisfying to give workers greater freedom and personality. We want them to "build the business" in whatever way works best. Therefore, we increasingly link pay to business performance.