Are big bonuses counter-productive?

The usual argument against high remuneration of senior executives is that it is often undeserved. I have some sympathy for that view. It is particularly difficult to understand how a person who is given a promotion to the top job can actually be worth substantially more than a competitor who narrowly missed being given that job. The person who is given the promotion will not necessarily add anything more to the profits of the firm than would the person who missed out. In many cases the prestige of the top position would be adequate compensation for the added responsibilities involved.

Nevertheless, it is possible to view the recipients of such unmerited rewards as the lucky beneficiaries of a system that generally produces good results for shareholders. Tournament theory recognizes that high remuneration for senior executives can be in the interests of shareholders for much the same reason as high prize money for winners of tennis and golf tournaments is in the interests of the spectators. The prize money is there to attract the top players and to encourage them to perform well during the tournament. Providing part of the remuneration in the form of a bonus helps to ensure that the interests of the chief executive are aligned with those of shareholders.

In his recent book, ‘The Upside of Irrationality’, Dan Ariely suggests, however, that big bonuses can actually be counter-productive. He argues that very high bonuses ‘can create stress because they cause people to overfocus on the compensation, while reducing their performance’ (p. 47). The general idea is that people (and other animals) tend to choke when exposed to very high incentives and social pressure.

I suppose readers would be most familiar with examples of choking from professional sport. Greg Norman’s habit of choking at the end of major golf tournaments is legendary. Rather than being remembered for the tournaments he won, he is more often remembered for not winning tournaments that he led until the last round. (Interestingly, this has not prevented the Great White Shark from becoming a successful businessman.) Several books have been written about choking and how to deal with it. Henry Scuoteguazza has recently reviewed three of them here.

The experiment that Dan Ariely reports that seems to me to be most relevant to payment of big bonuses involved payment of different levels of rewards to people participating in various cognitive games. The bonus rates ranged from equivalent to about one days pay to about five months pay. (To make the experiment affordable it was conducted in rural India.) The participants who stood to earn the most had the lowest level of performance – they choked under pressure.

How relevant are such experimental results to the world of business? Ariely tells us that when he presented his findings to a group of bankers they maintained that they were super-special individuals who work better under stress. I suspect the bankers were probably about half-right about themselves. Their work environment would have tended to favour people who are able to cope well with the stresses associated with high-powered incentives. At the same time, in my view events of recent years suggest that many bankers are affected by a herd mentality – too willing to follow their colleagues into risky territory and then to join the stampede when danger becomes obvious.

Coming back to tournament theory, the critical issue is not whether the incentive provided by the bonus system actually causes the chief executive to work more diligently and effectively, but the effect it has on the profits of the whole firm. Even though chief executives, like sports professionals, may sometimes have difficulty in coping with the pressures associated with huge rewards, a bonus system providing such rewards could still be in the interests of shareholders. Then again, ... !

Does anything rhyme with Ngapartji?

No. ‘Nothing Rhymes with Ngapartji’ is the title of a documentary to be shown on ABC television (when that august organisation gets around to it). It was produced by Alex Kelly and directed by Suzy Bates, my daughter.


Suzy’s involvement explains how I know about the documentary, but not why I am writing about it now. I am writing about it largely because of something I read last week:

‘Conservatism makes the case for continued existence in a deep sense – not just the trivial sense of having biological descendants.

Too many Australian conservatives still don’t understand this crucial point. They believe Aboriginal Australians will be content to survive physically and become prosperous and culturally assimilate into the great global English-speaking tradition. We will not’ - Noel Pearson, ‘Pathways to prosperity for indigenous people’ 2010.

I took notice not because I consider myself to be a conservative, but because Noel Pearson is an aboriginal leader who is better known for quoting Adam Smith and presenting strong views about the importance of economic incentives. I was surprised by the passion of his defence of traditional culture and language. I will quote another few sentences to help make the point:

‘Individuals have the right to choose the course of their lives; my hypothesis, however, is that the cultural and spiritual side of human nature is suppressed. Aboriginal Australian traditional culture is evidence that when human behaviour is at equilibrium, people build structures of tradition tied to language and land and pass these traditions to the next generation’.

Noel Pearson argues that indigenous Australians have to meet the challenge of preserving the parts of their cultural heritage that are most important to them while dispensing with elements of cultural heritage that prevent them from taking advantage of the opportunities that a market economy provides.

‘Nothing Rhymes with Ngapartji’ highlights an aspect of the challenge that traditional law can pose even to those aboriginal people trying hard to preserve culture, language and the history of communities and families. The film tells the story of how the award winning theatre show ‘Ngapartji Ngapartji’ - which had previously been performed in Sydney, Melbourne, Perth, Adelaide and Alice Springs – was taken to the remote aboriginal community of Ernabella in South Australia. The show ‘Ngapartji Ngapartji’ told the story of Trevor Jamieson’s family, while teaching the big city audiences a few words of Pitjantjatjara. Trevor Jamieson, a professional actor, was the star of the show.

The logistics of taking the show to Ernabella were difficult enough, but Trevor had to risk offending his audience by breaking the traditional law against mentioning the name of a deceased person. His father, a central character in the show, had died a few weeks before the Ernabella performance. Trevor had to decide whether he could still act the part of his father and show footage of him. (Further information about the film and a preview is available here.)

When Suzy first explained to me that ‘Ngapartji Ngapartji’ means ‘I give you something, you give me something’, I said something to the effect that it must be about the benefits of trade i.e. the concept of mutually beneficial exchange. Since then I can remember reading somewhere that the meaning of the concept is closer to an exchange of gifts, involving an element of bonding rather than a commercial transaction. When I attended the show in Sydney I certainly felt as though I was being given a valuable gift.

Postscript:
'Nothing Rhymes with Ngapartji' is to be screened on ABC1 at 3pm, 3 July 2011 and on ABC2 at 8.50 pm, 10 July 2011.

How does big government affect the social fabric?

In a recent post ‘Does big government weaken the social fabric?’ I presented a table showing the percentages of the population in various countries who say that falsely claiming government benefits, cheating on taxes and accepting a bribe are never justifiable. I was using this data as a measure of the strength of the social fabric in different countries.


A commenter (Lorraine) suggested that ‘never’ is a pretty powerful word and that my ‘inner paleoconservative’ was showing. On reflection, I agree that it is difficult to argue that any of these forms of corruption are never justifiable under any circumstances. For example, I would find it difficult to argue that a person living in a society where corruption is the norm has as strong a moral obligation to refrain from corrupt activities as a person living in a society where there is little corruption. That is why corruption is so insidious – the more prevalent it is, the more difficult it becomes for anyone to resist it. (I suppose that kind of reasoning must make me some kind of moral relativist, but I don’t think I will lose too much sleep worrying about that!)

Survey respondents are asked to give a rating from 1 to 10, depending on whether they consider each behaviour is never justifiable (1) or always justifiable (10). In the following tables I have labelled ratings of 1 and 2 as ‘very rarely or never justifiable’ and ratings of from 1 to 3 as ‘rarely or never justifiable’.

The relaxation in degree of opposition to welfare fraud, tax evasion and bribery does make some difference to the rankings. The general picture remains broadly the same, however. There is generally more red at the bottom of the tables than at the top, suggesting greater opposition to corruption among people in the countries with smaller governments.

 

 

Do family benefits provide a welfare pedestal?

The concept of a welfare pedestal has been popularized by Noel Pearson. As a lawyer and passionate advocate for the interests of aboriginal people who live on the Cape York Peninsula of North Queensland, some readers might expect that he would spend his time arguing for more government hand-outs to remedy social problems in aboriginal communities. However, Pearson recognizes that the welfare programs are actually a major cause of the social problems in those communities and his main focus is on finding ways to stop hand-outs from harming his clients. He is not against government help for his clients, he just wants to ensure that it does them more good than harm.


The insight behind the welfare pedestal is that welfare payments can provide perverse incentives by encouraging some people to remain on welfare rather than to seek paid employment. Over the last decade or so, concern about an emerging problem of inter-generational welfare dependency (in non-indigenous communities as well as indigenous communities) has led to some tightening up in the provisions attached to unemployment benefits. It is too soon to claim that the problems associated with unemployment benefits and pretend work schemes have all been resolved, but the problems are now widely recognized and some appropriate remedial action is being taken.

The example of a government program contributing to the welfare pedestal that Pearson gives in his recent lecture, ‘Pathways to Prosperity for Indigenous People’, is family benefits. He suggests:
‘Life on the welfare pedestal in a country that distributes money through a generous family tax benefit system is quite a rational choice’ (The Sir Ronald Trotter Lecture, New Zealand Business Roundtable, 2010).

I had not previously thought of the family tax benefit in that way. I have tended to view the family tax benefit as a kind of negative income tax, providing net benefits for families with low and modest incomes. I was previously aware of adverse incentives resulting from fairly high effective marginal tax rates for people on fairly modest family incomes above the point where the means test begins to cut in (about $45,000). According to the way economists usually look at these things, however, a family with four children obtaining $19,600 per annum from family benefits has no disincentive to obtaining additional income from work of more than $25,000.

In another paper Pearson acknowledges that the absence of punitive marginal tax rates is probably not an important consideration when people in Cape York Peninsula make their decisions about how many hours of the week they allocate to work or leisure. He writes:

 ‘Indigenous parents are having large families at an earlier age. Their welfare payments add up to a significant yearly wage. This income is received without them ever having to make any active decisions about education or work. When they have started receiving family payments, they face this choice: have an income which they are prepared to exist on for minimal work obligations or work longer hours for a limited increase in income and significantly less leisure time.

The behaviour of people in our communities indicates that many of our people do not intend to increase their income by increasing their labour supply. In some remote communities, it has been difficult to find applicants for the real jobs that do exist, despite the fact that the vast majority of people are unemployed’.

Pearson argues that ‘conditions and incentives to make active and beneficial life choices should apply to family payments’ even though he acknowledges that problems arise because such payments ‘are not indigenous-specific schemes’.

That poses a question: If people make the choice to live on generally available family benefits rather than to earn higher incomes, why should we view this as a problem? I see no problem in individuals choosing to live on low incomes. We should respect the choices that some individuals make to live a life of poverty (and of chastity too, if that is their choice). I can’t see why anyone should have a problem with individuals making whatever income/leisure choice that they desire.

I can see a problem, however, in governments providing family benefits to people who do not have adequate regard for the well-being of their children. I think we (taxpayers/voters) should insist that family assistance should only be provided to parents when they meet conditions such as ensuring that their children attend school regularly. Perhaps it would not be too difficult for a prime minister who has a special interest in educational opportunity to find a simple way for such a condition to be applied to family tax benefits across all sections of the community.