Lecture 9 The Structure of Compensation

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Lecture 9The Structure of Compensation

• Another set of factors influencing job
  choice and work effort decisions employer
  compensation policies both at one point in time
  and over several period of time.

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1. The Economics of Fringe enefits

• Employee Preferences
• Two categories of benefits
• Payment in kind compensation in the form of some
  commodity, e.g., insurance, paid vacation.
• Other things equal, people would rather
  receive X in cash than a commodity that costs
  X. However, other things are not equal. In
  kind payments offer employees a sizable tax
  advantage because for the most part, they are not
  taxable under current income tax regulations.

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• Deferred compensation compensation that is
  earned now but will be paid in the form of money
  later on. E.g., pension benefits
• Deferred compensation schemes enjoy a tax
  advantage over current cash payments. Because of
  lower income and special tax advantages given the
  elderly, the tax rates actually paid are
  relatively low.
• Note With both kinds of benefits there is a loss
  of discretion in spending ones total
  compensation, which tends to render fringes
  inferior to cash payments in generating utility.
  On the other hand, the special tax advantage of
  benefits as compared with cash payments tend to
  increase the demand for fringe.

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• Employer Preferences
• Suppose employers are totally indifferent about
  whether to spend X on wages or X on fringes,
  then the composition of total compensation is a
  matter of indifference to the employers, only the
  level of compensation is of concern.
• Suppose a firm must pay its workers X per years
  to remain competitive in both the labor and the
  product markets.
• ?The various compensation packages a firm is
  willing to offer fall along the zero-profit
  isoprofit curve drawn between wages and fringes.

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Wage Rate
Employers Zero-Profit Isoprofit Curve
Nominal Employer Cost of Fringe Benefits
The slope of the isoprofit curve is negative
reflecting the fact that the firm can increase
fringes only if it reduces wages. In this case,
the isoprofit curve has a slope of 1, reflecting
employers indifference about the composition of
compensation.

Note By increasing compensation in the form of
fringes rather than wages, employers can often
avoid taxes and required insurance payments that
are levied as a fraction of payroll. This will
make it more costly for an employer to increase
compensation by increasing salaries than by
increasing benefits.
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?A dollar spent on fringes could cost employers
more or less than a dollar nominally spent on
wages or salaries. When fringes enhance
productivity more than a similar expenditure on
wages would, the isoprofit curve will flatten.
When fringes increase other costs or reduce
productivity, the isoprofit curve will be steeper.
Wage Rate
X
A
B
Nominal Employer Cost of Fringe Benefits
X
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• The Joint Determination of Wages and Fringes

Wage Rate
X
Worker Y
WY
XX traces out the actual offers made by all
firms in this labor market.
Worker Z
WZ
Nominal Employer Cost of Fringe Benefits
FY
FZ
X
Those employees who attach relatively great
importance to the availability of current
spendable cash will choose to accept offers in
which total compensation comes largely in the
form of wages. (such as worker Y) employees who
may be less worried about current cash income but
more interested in the tax advantages of fringe
benefits will accept offers in which fringe
benefits form a higher proportion of total
compensation. (worker Z)
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• Note Because firms that pay high wages usually
  also offer very good fringe benefits, it often
  appears to the casual observer that wages and
  fringes are positively related. Casual
  observation in this case is misleading because it
  does not allow for the influences of other
  factors, such as the demands of the job and the
  quality of workers involved.

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2. Current Status and Future Prospect of Fringe
Benefits

• Current Status
• There are three major types of benefits
  provided to employees
• Paid vacations, holidays, sick leave maternity
  leave etc.
• Insurance Plans medical care, life, disability
  etc.
• Retirement and Saving Plans defined benefit
  pension, profit sharing, employee stock
  ownership etc.
• Additional Benefits parking, educational
  assistance, employee discount etc.

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• Future Prospect
• Over the past few decades there have been
  considerable changes in the composition of
  employee benefits offered to workers. While many
  of these changes have brought a new philosophy,
  and a new administration of employee benefits,
  all indications point to a continual expansion
  and redefinition of employee benefits packages.
  What can we predict for the remainder of the
  1990s?

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• Early Retirement
• Early retirement programs are designed to
  assist an organization in achieving some measure
  of cost savings in their direct wage bill.
  Typically, as employees tenure with an
  organization has grown in years, these employees
  salaries have risen to high levels. To address
  this concern, and realizing that age
  discrimination laws may be affected an incentive
  program to encourage these worker to sever their
  ties with the organization.
• ?The key issue in early retirement programs is
  to provide enough incentive for the employee to
  voluntarily take an early retirement, while
  simultaneously allowing for the direct wage bill
  of the organization to be reduced.

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• Parental Leave
• Parental leave can be defined as any leave
  from work, paid or unpaid, for employees to
  attend to child care responsibilities for a
  newborn infant or newly adopted child.
• ?Although the Family and Medical Leave Bill
  permits this time off, there is a financial
  concern The 9 to 5 organization estimates that
  fewer than 40 percent of working women would be
  financially able to take an unpaid leave.
• ?There was an even greater controversy
  surrounding parental leave-do fathers deserve the
  same time off as mothers with respect to family
  leave? Under the Family and Medical Leave Bill
  passed in 1993, they do!

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• Children and Eldercare
• Another major trend affecting corporations
  today is the push for an increase in child- and
  elder-care benefits.
• ?Dual-career couples with children and/or
  elderly live-in parents need to have some
  assurance that child- or eldercare programs are
  available to them without major disruptions to
  their lives.
• ?Companies are beginning to recognize that
  when its employees are faced with a choice
  between their jobs and their families, the vast
  majority of employees clearly place their job
  second.
• ?American Express, IBM, Work Family
  Directions, and Allstate Insurance have joined
  forces to offer quality childcare at a facility
  that is in close proximity to all of their
  employees. In coming years, we can only expect
  such cooperative arrangements to continue when
  they are feasible to both the employer and the
  employee.

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Flexible Benefits A benefit program in which
employees are permitted to pick benefits that
most meet their needs, within monetary limits
imposed.

• Flexible Spending Accounts.
• Modular Plans.
• Core-plus Options Plans.
• Add-on Plans.

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3. The Compensation of Executives

• There has been a lot of interest in recent
  years in the salaries of high-level executives,
  such as chief executive officers, or CEOs.
  American CEOs have much higher salaries than
  their counterparts in Germany and Japan. For
  example, the average salary of the top 20
  executives in the United States is 4.8 million,
  as compared to 1.8 million in Germany, and
  530,000 in Japan.

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• The Principal-Agent Problem
• The analysis of CEO compensation also raises a
  number of important questions in economics. In
  particular, what should be the compensation
  package of a person who runs the firm, yet does
  not own it?
• The CEO is an agent for the owners of the firm
  (the owners are also called the principals). The
  owners of the firm, who are typically the
  shareholders, want the CEO to conduct the firms
  business in a way that increases their wealth.
• The inevitable conflict between the interests of
  the principals and the interests of the agent is
  known as the principal-agent problem. The
  structure of CEO compensation can be interpreted
  in terms of a tournament where the
  vice-presidents compete for promotion, and where
  the winner runs the company. This interpretation
  explains why the prize spread is larger when
  executives are promoted to CEO than when
  executives are promoted from junior to
  middle-level management.

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• Suppose there are three levels of management the
  CEO, senior vice-presidents, and junior
  vice-presidents. Junior vice-presidents compete
  among themselves for promotion to senior
  vice-president, who in turn compete among
  themselves for promotion to CEO. Executives who
  won the first-level tournament and were promoted
  to high-paying jobs as senior vice-presidents may
  find that the compensation in their current
  position meets all their needs, and therefore
  may not want to compete for promotion to CEO. In
  order to elicit work effort from the senior
  vice-presidents, the prize associated with
  becoming a CEO must be even larger than the prize
  associated with becoming a senior vice-president.

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• The Link between CEO Compensation and Firm
  Performance
• In order to continuously elicit the correct
  incentive from the person who wins the
  tournament, the CEOs compensation will have to
  be tied to the firms economic performance. The
  CEO would then be restrained from taking actions
  which reduce shareholder wealth. The empirical
  evidence indicates that there is indeed a
  positive correlation between firm performance and
  CEO compensation, although the elasticity of CEO
  pay with respect to the rate of return to
  shareholders is small.