Corporate executives comprise an important, albeit small, part of the labor force. As the main decision makers in public corporations, top officers have been responsible for a large fraction of assets in the economy ever since the separation of corporate ownership from corporate control at the turn of the century. Although finance and labor economists have analyzed the market for managerial personnel extensively during the past 20 years, far less is known about the evolution of the market during earlier times. This dissertation fills in this gap by studying the determinants of executive compensation and the evolution of the market for managers over the course of the twentieth century. I begin by setting forth the long-run trends in the level and structure of executive compensation. I then study how the documented changes in compensation shaped managerial incentives. Finally, I demonstrate that the evolution of absolute and relative executive pay and the mobility of managers can be related to a shift in the labor market for managers from firm-specific to general managerial skills.

Although the recent changes in executive compensation are well documented, an understanding of longer run trends has been hampered by the lack of consistent data. Prior studies have reported information on managerial pay for earlier time periods, but these data cannot provide a consistent description of the long-run evolution of executive compensation because they are based on short time periods with different sample designs and employ different methodologies to value the components of pay.¹

The first chapter of my dissertation (joint with Raven Saks) establishes the long-run trends by constructing a new, comprehensive panel dataset on the compensation of the three highest-paid executives in 102 large corporations that extends from 1936 to 2003. This information is collected from proxy statements and 10-K reports of publicly held firms, which have been required to disclose the remuneration of their top officers ever since the Securities and Exchange Commission (SEC) was established in 1934.² The sample contains more than 15,000 executive-year observations, for a total of 2,694 individuals.

We begin by presenting the central facts on the longer run trends in executive compensation. The average real value of top managerial pay experienced three distinct phases throughout the twentieth century. After a sharp decline in the average real value of pay during World War II, compensation grew at a sluggish rate of 0.8 percent per year during the following 30 years. The rate of increase in the level of pay began to pick up during the 1970s and rose at a faster rate in each subsequent decade. By the end of the sample in 2003 the real level of total compensation was more than 5.5 times higher than it had been in 1940. These trends characterize the patterns in compensation for most of the executives in the sample, as compensation growth at the tenth, twenty-fifth, fiftieth, seventy-fifth, and ninetieth percentiles of the executives in the sample shows broadly similar patterns. However, the decline in real compensation that occurred during the 1940s and the rapid growth since the 1980s were experienced to a larger extent by executives at the higher end of the distribution. Thus, these two periods witnessed a compression and an increasing dispersion in compensation among top executives, respectively.

The most remarkable aspect of the long-run trends is the considerable stability in managerial compensation during the 1950s and 1960s, which contrasts sharply with the strong growth in the size of firms and the economic prosperity during this period. The degree of stability in the level of pay is also surprising because more recent decades have witnessed a much stronger positive correlation between the level of pay and the market value of firms.³

Another significant trend in managerial compensation has been a marked transformation in the structure of pay over the sample period: stock option grants and other forms of incentive pay have been growing shares of total compensation ever since the 1950s.

To explain the evolution in the level and structure of pay, we examine the contributions of tax policy and the growth in the market value of firms. Earlier in the twentieth century corporate executives faced exceedingly high marginal personal income tax rates, which created an incentive for firms to search for alternative ways to remunerate top executives. The widespread adoption of restricted stock options directly after the passage of the 1950 Revenue Act suggests that compensation arrangements were highly responsive to tax policy. Moreover, the share of stock options in total compensation declined following the 1964 and 1969 tax cuts. These findings indicate that for sufficiently large differentials in tax rates, the structure of managerial contracts is sensitive to tax policy.

If firms cannot get around the effect of taxes by offering alternatives that are equally valued by executives, high income taxes will also limit firms' ability to remunerate top executives. We find that when tax rates are higher, a given increase in the market value of firms results in a smaller increase in the real value of executive compensation. Simulation results suggest that had taxes throughout the past 60 years been at their low 2000 level, compensation during the 1950s and 1960s would have been 35 percent higher. Progressive taxation, therefore, restrained managerial compensation from keeping pace with the growing size of firms.

By tying managerial wealth to the performance of the firm, the increasing use of equity-based pay since the 1950s may have had important implications for managerial incentives. The scarcity of long-run data on executive compensation has limited our ability to document how the correlation between pay and firm outcomes has evolved over the longer run. Chapter 2 (joint with Saks) makes use of the new dataset on executive pay and provides consistent estimates of the responsiveness of an executive's wealth to firm performance. These data are particularly well suited for this exercise because the detailed information in corporate reports on stock option grants and exercises allows constructing the portfolio of stock options held by each executive at every point in time. Revaluations of stock and stock option holdings have been the primary source of increases in the sensitivity of pay to performance since the 1980s, and so including this type of wealth is fundamental to an accurate assessment of long-run changes in this correlation.⁴

Controlling for growth in the size of firms over time, the correlation of executive wealth with firm performance followed a W-shaped pattern over the century: the 1940s and 1970s were periods of unusually low pay-to-performance, whereas the correlation was higher in the late 1930s, 1950s, 1960s, and 1980s. The sensitivity of pay to firm performance continued to increase after the 1980s, and it is now about three times stronger than in any period since the 1930s. Except for the two decades of low pay-to-performance, the magnitude of the correlation was substantial. For the median executive, the increase in wealth associated with a movement from the fiftieth to the seventieth percentile in the distribution of firm performance would have been in the range of 20 to 40 percent, suggesting that the managerial incentives were not widely inefficient.

These findings indicate that pay-to-performance has been significant for most of the twentieth century, although the degree of the correlation has varied over time. Thus, the 1980s and 1990s were not the first period in which the structure of compensation arrangements generated a strong link between the wealth of top executives and the value of the firm. Consequently, compensation schemes may have served to align managerial incentives with those of shareholders—thus alleviating the agency problem of professionally managed corporations—over most of the twentieth century.

Not only have the absolute and relative levels of executive pay increased over the past two decades, but managers have also become more likely to move across firms. These recent trends suggest that the changes in managerial pay and external mobility may be intertwined. However, more convincing evidence would be if the mobility of managers had been low in the 1950s and 1960s, a period of slow growth in executive pay. Using biographical sources to obtain information on the education and career paths of more than 700 top executives, I confirm in chapter 3 that external mobility was lower during the earlier decades than in the past 20 years.⁵

To explain the long-run trends in pay and mobility, I propose that these changes may be due to a shift in the importance of skills from firm-specific to more general managerial skills. I present a simple framework in which there is both an internal and external market for CEOs.⁶

Firms know more about the composition of skills of inside candidates than do outside firms and a promotion to CEO reveals to outside firms that the individual is highly productive—all the more important when general skills are important. Large firms may find it attractive to replace their CEO with a high-ability outsider when executives have mainly general skills that are transferable across firms. However, a CEO of another firm is of little use to a competing firm when only specific skills are valuable. The productivity of an executive is revealed if he is promoted to CEO, but outside firms have much less information on the individual performance of other managers. This asymmetry in information creates a compensation gap between CEOs and other top managers, which increases as general skills become more important. In short, the model predicts a higher level of pay, higher within-firm inequality, higher variance in pay across corporations, and more mobility of managers across firms when the relative importance of general human capital increases.

I offer two main pieces of evidence to verify the rising importance of general managerial skills over time. First, the type of formal education of top executives changed significantly over the century. While it was common for managers to have a technical background in science or engineering early in the century, most executives now have a business education. Moreover, the diversity of sectoral experience has also steadily increased over time.⁷

Whereas executives now work in two sectors on average, managers had mostly risen from one sector of the firm at the beginning of the sample period.⁸

Using type of formal education and occupational mobility as proxies for skills, I construct an index of the generality of managerial human capital. Executives with higher general skills received on average higher compensation and were more likely to switch companies. Also, disparities in pay among top managers within the firm were higher when the highest-paid executive had more general skills. Thus, the evidence suggests that changes in the labor market for corporate officers are an important factor to understand the evolution of the compensation and mobility of managers.