Who are the 1%?

In Income Inequality in the US, I noted that the top 1% (and especially the top 0.1%) have been taking a greater share of productivity gains over the last 50 years (especially since the 1980's).

But that raises the question who are these 1%-ers and why have they been able to take a larger share of productivity gains?

We'll start by looking at some data found in this study which gives a breakdown of the top 1% and top 0.1% for years between 1979 and 2005. Here's a summary of the 2005 data:

Occupation	Top 1%	Top 0.1%
Executives, managers, supervisors (non-finance)	30.0%	41.3%
Medical	14.2%	4.1%
Financial professions, including management	13.2%	17.7%
Lawyers	7.7%	5.8%
Computer, math, engineering, technical (nonfinance)	4.2%	3.1%
Not working or deceased	7.4%	6.2%
Skilled sales (except finance or real estate)	3.7%	2.1%
Blue collar or miscellaneous service	3.9%	N/A
Real estate	3.9%	5.4%
Business operations (nonfinance)	2.8%	2.3%
Entrepreneur not elsewhere classified	2.8%	3.8%
Professors and scientists	1.8%	1.2%
Arts, media, sports	1.7%	2.8%
Unknown	1.0%	0.6%
Government, teachers, social services	1.0%	N/A
Farmers & ranchers	0.8%	1.0%
Pilots	0.2%	N/A

There are two groups that stand out to me: Executives and the Financial professions. Combined, they represent almost 60% of the top 0.1%. That seems pretty excessive to me. If we were talking about medical and technological, I could probably appreciate that but those two groups only represent just over 7% of the 0.1%.

I would like to offer a brief sketch of the claim that those two groups (executives and financial professionals) are, on average, overpaid relative to their value in society. We'll start with the financial profession.

Financial Sector

The financial sector generally includes institutions such as commercial and investment banks, insurance companies and investment funds. One of the main functions of the industry is to act as an intermediary between those with capital (looking for investment opportunities) and those who need capital (to fund investment ideas, research, etc). Another function of the financial sector is risk management (e.g. insurance). The question is this: how much of our overall resources should be devoted to these activities?

Over the last several decades, the financial sector has grown at a dramatic rate. The Kauffman Foundation has an interesting research piece on the subject: Financialization and Its Entrepreneurial Consequences.

In Figure 1 (reproduced from the above article), it shows the proportion of GDP devoted to the financial sector from 1850 to 2009. In 1850, the financial sector represented about 1% of GDP; by 2009, that percentage grew to over 8%.

Now that, in of itself, may not be bad. As Richard Grossman points out in his book Unsettled Account, "Empirically, there is no doubt that finance and economic development move together." However, there is a sort of "chicken/egg" debate over whether finance causes economic growth or economic growth results in a greater need for financial services. As a result, I think it's a fair question to ask: is all of this finance a good thing?

The Kauffman Foundation article goes on by pointing to evidence that the growing financial sector has not had a positive impact on entrepreneurial activities. Both in resources and in human talent (particularly taken from math, science and engineering), the financial sector has diverted some resources away from activities that might have a greater social value and used those for "financial engineering" or "financial innovation".

The word "innovation" has a sort of positive connotation to it; isn't innovation always good? But in the case of some financial innovation, I think the answer may turn out to be negative. The value of some of these products are questionable at best.

Why is finance so big? That's an interesting question which I don't have an answer to but would be interested in some theories and evidence.

Executive Compensation

The other major group in the top 0.1% were (nonfinancial) executives, supervisors, etc. Shouldn't we be paying the best and the brightest leaders and planners a high wage?

I think that executives, on average, are overpaid. No doubt some of them work many long hard hours and many of them do provide do a good job. But that still raises the question of how much is too much. This all brings us to an interesting article:

Performance for pay? The relationship between CEO incentive compensation and future stock price performance

Stocks come with them a problem known as the "principal-agent problem". Corporations are run by executives (and boards of directors) acting as agents on behalf of the shareholders who are the principals. The problem is that the agents' interests are not always aligned with principals' interests.

The "solution" to the problem is incentive pay. Executives are given various payments such as stock options which should align executive interests with that of shareholders.

The above article suggests that this doesn't work all that well. The study found a negative relationship between incentive pay and subsequent stock performance. In other words, overpaid CEOs are not delivering adequate results to the shareholders they are working for.

Data extracted from Table X:

Since there's solid evidence that overpaid CEOs are not adequately serving their shareholders, why are they still paid so much?

Part of the problem stems from the fact that most shareholders take a very passive role in monitoring the company. Many companies are majority owned by institutions (retirement, pension funds, insurance companies, mutual funds, hedge funds, other financial institutions, etc). While some fund managers take active roles in companies they own for their clients (dubbed "activist investors") most do not. They defer to recommendations by the Board of Directors.

So who are the Board of Directors? They are shareholders who are selected to represent the interest of shareholders in managing the managers. Not a bad sounding idea but how does it work in practice?

For many companies, the Board of Directors are made up of executives from that company (iow, the managers are managing themselves) and executives from other firms (iow, managers are managing their friends). It's not too hard to see the inner connections.

While there is some appeal to the more cynical "I'll rub your back if you rub mine" compensation theory, there are alternatives.

In Compensation Benchmarking, Leapfrogs, and The Surge in Executive Pay, the authors propose that there is a positive feedback loop regarding executive pay. One technique used by compensation committees is to construct a benchmark of executive pay of firms of similar size and industry. Compensation for, say, the CEO of the firm will be compared with the compensation of CEOs at other, similar firms.

Since the group of peers are using a similar technique for determining their own executives' pay, then increases in pay of one executive of one firm will ultimately affect the benchmark that another firm is using and can then affect that executive's pay.

Conclusion

I guess I still have more questions than answers. I'm inclined to think that both executive compensation and the overblown financial sector have been taking too large of a share of income. What has caused this situation is not entirely clear. It's also not clear what measures can be taken to correct the situation.

I'm guessing it will persist for some time. While the current administration has shown some commitment to increasing taxes on the rich, he's been far too friendly to Wall Street to bring about any real change (the HSBC fiasco being a recent example in a long history of allowing Wall Street do what it wants.) I think there needs to be a more open discussion on the issues involved with some genuine research to get to the bottom of things and propose workable solutions.

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