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News : US Economy Last Updated: Jan 1, 2012 - 10:03 AM

US economist says rising executive pay gap has spawned expenditure cascades throughout the economy
By Michael Hennigan, Founder and Editor of Finfacts
Aug 24, 2010 - 5:09 AM

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US economist Robert Frank, a professor of economics at Cornell University, who has done a lot of research work on executive pay and inequality, says the rising US executive pay gap has spawned expenditure cascades throughout the economy.

In an article in the summer 2010 issue of Stanford University's Pathways magazine, Prof. Frank argues that consumption taxes rather than arbitrary limits would be a more effective mechanism to close the pay gap.

The economist says increases in executive compensation in recent decades have been spectacular. CEOs of the largest US companies, for example, earned 42 times as much as the average worker as recently as 1980, but by 2001, they were earning more than 500 times as much. He says many view this change as evidence of a breakdown in competitive market forces. In his article, he says that available evidence suggests that skyrocketing executive pay has actually resulted from heightened competition, reinforced by technological changes that have increased the leverage of executive decisions.

Prof. Frank says one cost of the rising pay gap is that it has spawned expenditure cascades that have made it more difficult to achieve basic goals. Step one in the development of such a cascade in the housing market, for example, was that higher incomes led executives and other top earners to spend more on housing.

That shifted the frame of reference that defines adequate housing for those just below them, so they, too, spent more on housing, and so on, all the way down the income ladder. The median size of a newly constructed single-family house, which stood at 1,600 square feet in 1980, had grown to more than 2,300 square feet by 2007. Since the median wage was essentially stagnant during this period, this growth cannot be explained by growth in income.

The economist says middle-income families felt they had to spend more on housing because other families like them were spending more. And those families were spending more because of an expenditure cascade launched by higher spending at the top. Failure to keep pace meant sending one’s children to inferior schools, a step few middle-income parents were willing to take.

He says if the widening pay gap gives rise to expenditure cascades that make it harder for middle-class families to make ends meet, we should see greater evidence of financial distress in places, and during historical periods, in which income inequality was relatively high. Examining Census data for the 100 largest counties in the United States, Adam Seth Levine, Oege Dijk, and Prof. Frank found that counties in which income inequality grew the most also had the biggest increases in several factors known to be associated with financial distress.

A Remedy Worse than the Disease: Why Higher Taxes are Better than Pay Caps : Robert H. Frank concludes that even if the dramatic increase in pay can be explained by simple market dynamics, it is still corrosive to American society and should be addressed by taxing excessive pay.

SEE also Finfacts article: America: A country you cannot tell a lie about

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