In Search of Reasonable Executive Compensation

This article makes several observations on the extent of executive compensation and the forms it takes, relating these to the recent literature. I argue that the magnitude of executive compensation seems excessive in light of a wide range of academic studies. I then propose specific regulatory measures that make compensation transparent and predictable for shareholders. Next, a simple taxation of executive compensation above a certain threshold is proposed; I argue that it is a much more efficient way to deal with the issue, than the current legislation in the United States. Turning to the 'pay for performance' paradigm, I argue that it must be applied with great care, as, along with the incentives to exert effort it also provides powerful perverse incentives, which are not immediately obvious, may vary dramatically across firms, and may not be well understood by the compensation committees and academics. I outline the design of several generic contracts appropriate for different environments. Finally, I stipulate that the downside of providing too much 'pay for performance' is especially evident in financial industry, which is opaque and subject to contagion, thus compensation contract should play a more important role in financial regulation. (JEL codes: G30, K22, M50) Copyright The Author 2009. Published by Oxford University Press on behalf of Ifo Institute for Economic Research, Munich. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.