Posted
Jul 2011
Today’s Rising One-percenters
The growing gap between the very rich and everyone
Based on the research of Steven Kaplan And Joshua Rauh
Few understand how the gap between the wealthiest 1 percent and the rest of the United States’ population has grown so enormous in the last few decades. In fact, it has not been clear who these one-percenters are. In the early 2000s, scrutiny turned to the growing salaries of top executives at publicly-traded companies such as Home Depot and Oracle. But according to economists Joshua Rauh, an associate professor of finance at the Kellogg School of Management, and Steven Kaplan, a professor at the University of Chicago, it is worth taking another look. After all, top executives of “Main Street” companies comprise only 5 percent of the top .01 percent wealthiest people in the United States—a division whose members earned individual salaries of at least $7.2 million per year in 2004.
Instead, “Wall Street” employees—including investment bankers and managers of hedge funds, mutual funds, and private equity funds—have become increasingly common members of the richest classes. According to Rauh and Kaplan’s report on who contributes to the rise in the nation’s highest incomes, the combined yearly income of the top 25 hedge fund investors exceeds the combined income of the top five hundred executives listed in the S&P 500 index. That sum was $6.3 billion in 2004 and it has been rising ever since. Rauh says, “By 2007, the top five investors likely made more than the combined five hundred executives at publicly-traded companies in the U.S.”
Thus, the intense focus on Main Street executives has not been entirely justified. “S&P 500 executives—Main Street CEOs—have taken quite a beating in terms of public perception of their compensation,” Rauh says, “but when you look over time, their share of top incomes has been pretty constant, whereas groups on Wall Street have increased in a dramatic way.”
“By 2007, the top five investors likely made more than the combined 500 executives at publicly-traded companies in the U.S.”
Tracking Down Wealth
Details on the salaries of Wall-Street high-rollers have always been difficult to obtain. While publicly-traded firms report executive salaries to the Securities and Exchange Commission, investment banks report little information on employee compensation.
The authors used careful data analysis combined with statistical models to estimate how much managers on Wall Street earn. They looked at company reports to find out how much a firm paid out in total compensation as well as the number of managing directors. Through interviews, Rauh and Kaplan learned that managing directors at investment firms typically make upward of $500,000 per year, and at least a quarter of managers earn over $2.5 million per year, one of many facts they used to calibrate their estimates. They used similar methods of analysis for calculating the salaries of other high-earning professionals, namely corporate lawyers, athletes, and celebrities. They estimated corporate lawyer salaries by figuring out the profit of the law firm and dividing that among partners and non-partners.
“Salary data for individuals outside of the top five executives of public companies are not that easy to come by,” Rauh explains. “We did a lot of modeling based on what we heard from compensation consultants and by studying the distribution of pay. The main thing we found at investment banks and law firms was that there were increasing profits shared among a consistently small number of managing directors and partners, which means you have a number of individuals making a lot of money.”
“We were surprised by the results,” he adds. “Of course we had a sense that people we knew on Wall Street were making a lot, but we had no idea that the top 25 hedge fund investors made more than the top five hundred CEOs in the S&P 500.”
However, it is not as if CEOs at publicly-traded companies have moved into the poor house. About 3,500 top executives at publicly-traded companies earn more than $1 million per year (as do nearly 17,000 Wall Streeters).
Pulling Away
Collectively, top CEOs, athletes, and corporate lawyers make far more money than they did a decade ago, beyond increases expected from inflation. For example, the average professional athlete earned $780,000 in 1995 compared to $1.85 million in 2004. While these highly-paid professionals continue to claim territory in the increasingly exclusive top .01 percent of America’s wealthiest, doctors, trial lawyers, and successful entrepreneurs appear to make up a smaller share of the top brackets. Whereas a person earning $3.2 million was included in the top .01 percent in 1994, now that level requires a salary of $7.2 million. And for the wealthiest .001 percent, the qualification for entry has grown from $13 million per year in 1994 to $31 million in 2004.
“There are a number of theories for how this rise in income came about in recent years,” Rauh says. Rather than focus on tax breaks, changing salary limits, or worker exploitation, Rauh and Kaplan suggest the growth has to do with a mix of improved technology combined with skill. “The skills of talented athletes can be put to use in more profitable ways now,” Rauh explains. “Alex Rodriguez’s skills as a baseball player for the New York Yankees reach many more people than was ever possible before, and he’s claiming a share of the profits of that.”
Rauh says the principle holds on Wall Street. “Improved technology has allowed larger amounts of money to be managed by a team of individuals of a given size and skill,” he says. “While the number of professionals doing transactions and managing money has increased, the amounts of money being transacted and managed have grown far more.” This theory that technology allows skills to be applied to ever-larger pools of capital and other resources can explain why the top individuals in various groups—lawyers, athletes, and investment bankers—have all increased their income despite the differences in the way each conducts business.
“If you’re asking what contributes to the rise in the highest income, it’s that individuals who are really good at making money can now apply their skills to larger amounts of capital,” Rauh says. “That’s favored some groups more than others, and very clearly, it’s favored Wall Street most.”
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6 Comments
Jul 6 2011
How do you reconcile your conclusion about Main Street CEOs vs. Wall Street with the research cited in this article, which seems to draw the opposite conclusion?
http://www.washingtonpost.com/business/economy/with-executive-pay-rich-pull-away-from-rest-of-america/2011/06/13/AGKG9jaH_story.html
Jul 6 2011
Actually quite consistent, particularly on our main point that public company executives are not overpaid relative to other top earners in the economy. Their study shows that executives in salaried positions in non-finance firms (their proxy for public company executives) dramatically collapsed as a share of the top 0.1%, from 32% in 1979 to 14% in 2005. The biggest growth they found was in finance and in executives in privately-held firms.
Our data did not allow us to measure the prevalence of managers in privately held firms, which (even though that classification encompasses a huge range of activities) clearly are a growing portion of the top 1% and 0.1%. But that finding further supports our points. Corporate governance is a far bigger problem at public firms than private firms, so deteriorating corporate governance cannot be a main driver of the widening income distribution.
I would also very much like to see the tax data analysis on the top 0.01% and top 0.001%. My reading of the graphs in the study you mention is that within the top 0.1%, the finance professionals have the highest incomes and have experienced the fastest income growth, consistent with our findings.
Jul 6 2011
In the past few decades, there’s been an increasing trend in paying executives with equity. Does your study control for this? Or alternatively, has it looked at disparities of wealth in addition to disparities in income? I haven’t seen the data, but I wonder if one were to add the unrealized capital gains to the recognized income of the top-earning executives, would the disparity be even greater? Additionally, given the more favorable tax treatment of capital gains vs. regular income, net income disparites should, all things equal, be even greater, no? While technology was cited as a driver in the income disparities (which I don’t doubt), a cynic would probably add that these top earners have been increasingly more effective at taking advantage of weak governance and complex tax codes (e.g. hedge fund managers using carried interest for tax avoidance). Is there any truth to that or, perhaps more appropriately, any reason to reject that hypothesis?
Jul 15 2011
We do include equity compensation of executives in our measures. Option compensation can be treated two ways: either measuring their value as compensation when they are granted, or including them as compensation they are exercised. The former is a better measure of what the board expected to pay the executive, whereas the latter is closer to the executive’s actual adjusted gross income. These methods yield similar results. Stock grants themselves are measured at the value when the executive receives the stock, so unrealized capital gains are not an issue there.
Regarding your second point, if there is evidence on the extent to which hedge fund managers are using carried interest for tax avoidance, that would be very interesting to see. We are under the impression that most profits at hedge funds are taxed as short-term capital gains or ordinary income. In general, I would agree that there isn’t much evidence on whether tax avoidance strategies have contributed to the widening of the income distribution, although again that is a very different issue from the governance of public firms (i.e. the conflicts between managers and shareholders).
Jul 30 2011
Have you had a chance to look at consulting firms? The vast majority of them are a sub segment of private companies, so you probably have minimal data about their financials. However, I think that it is particularly interesting for two reasons: first, due to the partnership model, which may be similar to that of law-firms, but may have changed more in its pyramid ratio (partners vs. non-partners) over the last ten / twenty years. Second, as management consulting firms are top recruiters from top MBA programs, and are known to pay the higher salaries to recent MBA grads than most other firms except for financial firms.
Aug 1 2011
Very interesting but difficult to get data. My guess would be that employment income from consulting could have a non-trivial presence among private firms in the top 0.1% but probably not in the top 0.01%. From what I can tell, the revenue generating capacity per employee is a good deal larger in banking.