Frank on Populism:Why Big Paydays Aren't All Bad

If you're not angry at AIG right now, you probably lack the capacity for moral outrage. But anger at AIG is also spilling onto a broader range of targets. And unless we're careful, we'll shoot ourselves in the foot. Even before AIG's moment in the spotlight, angry populists had begun calling for executive pay caps at 20 to 25 times the average American worker's salary. If applied to the financial-industry executives who steered the economy into the ditch, such caps would be defensible. There are also many executives in other industries whose pay, at least in hindsight, was vastly greater than any reasonable measure of their value added. Yet any broader effort to cap executive salaries would do more harm than good.

The fact that overpaid people are found in every domain proves only that hiring decisions entail risk. Although most employers try to hire the most qualified candidate, there are bound to be mistakes. In time, however, most mistakes get fired.

We are such a rich country in part because our corporations hire the right people most of the time. In managerial jobs, an increment in talent has more impact in a big corporation than in a small one. That's why it's in everyone's interest that the most talented managers run large corporations rather than children's shoe stores. And that's what happens under current arrangements. But those managers would have little reason to seek the most important positions if salaries were the same elsewhere.

Executive pay is much higher in big companies because those executives' decisions—good and bad—matter more. Despite the occasional mistake, the people they choose are a remarkably talented lot. The highest-paid people in each domain are paid such large amounts because they are worth that much to the organizations that employ them. That's good for them and for the country, too. Capping executive pay would just encourage talented potential managers to choose careers as personal-injury lawyers or hedge-fund managers.

But executives surely don't need $20 million annual salaries to motivate them any more than the rest of us do. Neither do baseball players or bestselling novelists. And although market salaries serve an important function, the runaway income inequality of recent decades has also imposed enormous costs. One of the most endearing features of the American culture is that the middle class generally does not resent the spending of the rich. But it is nonetheless adversely affected by it.

Top earners have been buying bigger houses and cars simply because they have more money. When the rich build bigger, they shift the frame of reference that defines what those just below them consider necessary. So they too build bigger, and so on, all the way down the income ladder. To keep pace with escalating community consumption standards, middle-income families have been working longer hours, saving less, borrowing more and commuting longer distances. Failure to keep pace is usually not an option, since buying a less expensive house usually means sending children to inferior schools.

Although executive pay caps are no solution to this problem, there are other useful steps we could take. The top marginal tax rates in most other developed countries are substantially higher than ours. If our tax rates were higher, the top-paying jobs would still offer the highest after-tax salaries. And because it's relative after-tax pay that matters for job choices, the corporate vice presidents hoping to become CEOs would work just as hard even if we raised our rates a little further.

Better still, we could levy a progressive consumption surtax on all spending above some high threshold, say $500,000 a year. Each family would pay a rising surcharge whenever its annual income exceeded its annual savings by more than that amount.

Anger at AIG must not cause us to lash out at those whose talent and effort have made the country so wealthy. Taxing top earners more heavily simply brings their good fortune more in line with everyone else's. When they get a raise, we'll all have good reasons to celebrate.