Member of the Department of Finance faculty between 2009 and 2012
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.
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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.”
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.
Collectively, top CEOs, athletes, and corporate lawyers make far more money than they did a decade ago, beyond increases expected from inflation.
“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).
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.”
Related reading on Kellogg Insight
Member of the Department of Finance faculty between 2009 and 2012
Kaplan, Steve and Joshua Rauh. 2010. “Wall Street and Main Street: What Contributes to the Rise in the Highest Income.” Review of Financial Studies. 23(3): 1004-1050.
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