In the Money

Israel Has Gone Too Far in Capping Executive Pay

The bill limiting wages in the financial sector has no parallel in the democratic world — and we will all pay the price if it’s passed.

Trade-union members demonstrate in supporting of a referendum to limit the pay of executives to 12 times that of a company's lowest-paid employee, in Zurich, August 30, 2013. Demonstrators spell out the 1:12 formula with giant numbers and a colon that they carry.
Reuters

In November 2013, Swiss citizens voted on a referendum that would have limited the pay of top executives in Swiss companies to 12 times the salary of the lowest paid worker in the company. The formulation, which earned the initiative the nickname “the 1 to 12 referendum,” was not selected at random. It was intended to prevent the highest-paid executive in any given company from earning more in one month than what a different employee earns in a year.

The referendum was the first time in which a Western nation considered limiting by law executive salaries by linking the wages of low-level employees to that of management. A large majority, 65%, of Swiss voters rejected the proposal.

It is not clear whether Swiss voters rejected the proposal because it was too extreme — they considered the 1 to 12 ratio unfair to executives — or because they objected in principle to placing legal restrictions on executive salaries. It doesn’t really matter. There is still an important lesson in the result of the Swiss referendum: In free democracies, extremism is wrong by nature.

Until the draft law to limit executive salaries in financial firms was passed last week by the Knesset Finance Committee — the first step in the legislative process — the 1 to 12 referendum in Switzerland had been the most extreme measure of its kind proposed in a democratic country.

Paradoxically, the first country to impose such salary limitations was the United States under President Bill Clinton, in 1993. That law limits the amount of cash-based compensation to their executives that corporations can deduct as a business expense to $1 million a year. It does not, however, prohibit higher salaries. In addition, it does not apply to “performance-based pay,” such as bonuses and stock options. This allowed the Americans to express their opinion that executives should not be too greedy about the salaries they receive, or take, unless the structure of compensation serves shareholders by being based on performance.

In retrospect, the American approach turned out to be too simplistic. One of the reasons for the outbreak of the financial crisis in 2008 was an inappropriate compensation policy for banking executives in the United States: Almost all their compensation was dependent on performance, which pushed them to increase bank profits at any price. In other words, performance-based pay was unwise because it was derives solely from profits, without considering losses. This drove bank executives to increase their risks inappropriately. These risks almost led to the collapse of the entire American banking system when they became reality.

A double precedent

In response to the American experience, the Europeans instituted a compensation policy that linked regular salary to the variable part, with the variable part requiring special approval by shareholders. In addition, a few countries imposed a tax surcharge on bonuses over a certain level for bank executives in an attempt to rein in their appetite for risk, especially in the financial sector; while not limiting salaries themselves or linking executive salaries to the wages of the lowest paid workers.

The only country that is taking such action so far is Israel. The proposed law sent to the Knesset by the Finance Committee last week sets a double international precedent: It sets a limit for wages, both fixed and variable, above which there is a tax penalty; and second, the proposal sets an absolute salary limit, which cannot be exceeded by law, and links this salary limit to the wages of the lowest paid employees.

As opposed to Switzerland, Israel has chosen a ratio of 44 to 1 between the highest and lowest salaries. Israel is seemingly less extreme than Switzerland. But the difference is that in Israel this proposal is about to be passed, while in Switzerland it was rejected.

In doing so, Israel will now become the trailblazer in setting limits on executive compensation — though this is limited only to the financial sector. No other country has gone so far. Except for Switzerland, no other country has even considered it even though other countries paid a much higher price for their mistakes with bankers’ pay.

It is hard to understand the wisdom in Israel being the outlier in the area of compensation for the business sector, and even worse in such a far-reaching way, beyond that of any other country. Israel, as everyone knows, suffers from a very bad image as a place to do business. We are a country filled with geopolitical risks, far from any important business center and which suffers from stifling bureaucracy.

Israel’s ranking in the Doing Business ranking of the World Bank is rather poor: 53 out of 189 economies. In one measure in the rankings, registration of assets, Israel ranks 127 in the world, a situation seen as bad as a number of African countries.

The Finance Ministry even established a special committee two months ago, headed by ministry director general Shai Babad, in an attempt to try and improve the business atmosphere in Israel and its rankings. It is not clear why one branch of the ministry is fighting to improve the atmosphere, while another branch — Finance Minister Moshe Kahlon himself — is acting to destroy this image by imposing salary limits that exist nowhere else in the world.

Paradoxically, Israel suffers from this bad image, and instead of learning a lesson and acting to improve this image, the Knesset is doing exactly the opposite and crowning Israel as the most extreme nation in persecuting senior executives concerning compensation policy.

The paradox is that Israel is already paying a heavy price for its poor business image, mostly in the form of in a drop in investment and economic growth and critical damage to local capital markets. The Tel Aviv Stock Exchange is shrinking: In the past eight years, 30% of publicly-traded companies have delisted, as companies complain about excessive regulation and persecution of executives over pay. The writing is on the wall in huge letters, and it still does not stop the Knesset for a moment in its race to make anti-business legislation even more severe.

All this does not mean, of course, that it is not possible to act to rein in executive wages. The Knesset has already passed Amendment 20 to the Companies Law, which was intended to do so mostly by requiring compensation policy based on the link between compensation and performance.

Research conducted by Dr. Gitit Gur Gershgoren, the chief economist of the Israel Securities Authority, published three months ago, found Amendment 20 moderated executive salaries a bit — the rise in wages lagged behind the rise in company value on the stock exchange over the past three years — but did not succeed in creating a link between compensation and performance. She found that executive compensation in publicly-traded companies is clearly linked to the size of the firm (larger firms pay more), and the salary norms in the industry, but the relationship to profitability of accounting measures was very slight.

Because executive compensation is first of all intended to provide incentives to improve the management of the company — and to earn more without being exposed to unnecessary risks — it is clear Amendment 20 is the proper way to do so, but it needs to be further improved until it becomes effective. The Knesset has not yet weighed in on the issue.

Even if the goal is reining in salaries and increasing wage equality, it is possible to achieve this goal in wiser ways. A previous bill that was approved by the Knesset Finance Committee after the cabinet agreed to support it set a universal annual salary ceiling of 3.5 million shekels ($909,000), above which a tax penalty was to be imposed. It was not an absolute ceiling, and did not link the highest wages in a company to the lowest, but the very existence of a salary limitation and the requirement to publish the ratio between the highest and lowest salaries, advances the issue.

Extremism rules

The original bill, sponsored by former Finance Minister Yair Lapid, was received with understanding by the business community. We can assume it would not have reined in the salaries of bankers immediately, because the bankers have no real difficulty in exceeded the ceiling and paying higher taxes as a result, but it would have created a new appearance for bankers’ compensation, put pressure on them and maybe even on institutional investors to be more aggressive about approving the compensation of bankers and insurance company executives at shareholders’ meetings.

The feeling is that the previous proposal would have naturally caused at the very least a moderation in wages in the banking industry without causing any shock waves, as the present proposal has done.

But the Knesset didn’t even bother to examine the relatively much more moderate law. Israeli lawmakers have missed out on the wisdom of the Swiss, who understood that extremism is dangerous in a democratic form of government with checks and balances. Here extremism is in control. Here we aspire to be the first. But no one has added up price the Israeli economy will pay for that.