Friday, December 14, 2012

The Higher Education Salary Compression Function - A Fantasy

It's pretty weird what this retired economist fantasizes about, isn't it?  Before getting to the fantasy itself and discussion of the compression function, let me give a little background.  Higher Education has experienced hyperinflation in its cost for something like 30 years.  Isn't it about time to address the problem?  There then is the question whether the sector can self-regulate in a way to entirely eradicate the hyperinflation or at least to substantially lessen it's impact.

A second related issue is how the hyperinflation manifests.  I believe a significant chunk of that is sector specific economic rents paid to the star performers, then to the near star performers, and on down the line.  Let me explain what that means. An economic rent is a payment to a factor of production in excess of what is required to elicit supply from that factor.  David Ricardo was the first to write extensively about economic rents.  His focus was on land rents.  Since Ricardo's day economists typically associate economic rents with a factor that is inelastically supplied and for which there is strong demand.

Zeroing in on the stars, let's explain what this means.  Inter-university competition for star performers is fierce.  This bids up their compensation.  But for the most part it doesn't mean the performers would be more productive at the winning institution than they would be at another.   Further, most of these stars are fully committed academics.  They will not leave Higher Education for some other work even if they got a sizable cut in pay, as long as they continued to be well treated and recognized for their excellent work. Well treated, however, is an analog idea.  It depends on some reference point.  The intense inter campus competition may move the reference point upwards, but otherwise doesn't change the underlying motivation of these people.   Much of the fantasy is simply to lower the reference point substantially and get essentially the same output from these folks at far less expenditure.  That this is possible is what I mean by sector specific rents.

Let me also note here that compensation can take many forms and salary is just one component of a larger package.  Having grad assistants and post docs, funds for travel or to hold conferences, the costs of running a laboratory including the expense of the space and the various apparatus that are used, as well as many other items are also part of the package.  In principle we should be talking about the entire package, not just about salary.  But in this essay I won't do that because: (1) there is a lot known about income distribution in the society overall and thus one can make comparisons with income outside of Higher Education when considering salary compression and (2) what is necessary for maximum productivity or star faculty and what is the dispensable (economic rent) piece might very well vary from field to field and should be determined by experts in their area, not by novice outsiders like me.  So while the general issue might be considered here the specifics should not be and since I will be specific on the salary compression recommendation, for simplicity I will ignore the rest of the package in this discussion.

The next point is that the compensation for star performers sets an umbrella under which the entire salary structure is determined.  Driving upward the star compensation puts upward pressure on the other salaries as well.  It is therefore my opinion that much of the hyperinflation could be retarded or even reversed if the star salaries were brought under control.  The idea of the salary compression function is to have a one time reduction in the salaries above a certain threshold.  That in itself is not sufficient.  Doing nothing else would return the salary structure to its present trajectory in the near future.  Some systematic reduction in inter campus competition for performers after the one time reduction occurred would also be necessary.  This would be in the form of a salary cap coupled with principles that underlie the salary compression function.  (See my post Lessons for Higher Ed from the NBA.)   That such a form of internal to Higher Education regulation would be necessary seems transparent to me, but the specifics of it are far less clear so as with the question of the compensation package, I will leave this matter for another day and simply move on.

With the underlying salary mechanics understood at this basic level, another part of the fantasy is that a Gladwell-like Tipping Point mechanism emerges in service of the salary compression function idea.  It might begin with other economists, much better able to deal with the real empiricism of the situation than I am, to establish the extent and magnitude of the sector specific rents and the shape of the salary distribution function.  (Usually reported are mean salaries, perhaps sorted by academic rank, but that is really insufficient to understand the issue.  One needs to look at the entire distribution and see how that has changed over time.)  Then journalists and others spread the word about self-regulation as a possible alternative to government interference.  After that the star performers themselves would begin to embrace salary compression as the embodiment of a Ron Hunt, take-one-for-the-team approach to the hyperinflation issue.   Here I'm talking about Nobel Prize winners, MacArthur "genius" Award winners, and other illustrious scholars.  This group would form the vanguard of the movement.   In turn they would convince forward thinking high level administrators - university presidents and chancellors, that salary compression would be good for the entire sector and good for their individual institutions.  With this leadership group on board, faculty governance groups then take up the matter in earnest.  (At Illinois, this is the Faculty Senate.)  They too express their approval.

There are at least two different legal barriers that must be surpassed to implement the salary compression function.  The first is on whether across the board salary cuts above a certain salary threshold are consistent with tenure.  (In a world of substantial inflation one can obtain the desired sort of salary compression by simply giving smaller percentage salary increases to higher paid personnel and persist with that approach over many years.  Indeed, when I worked for CITES, the central IT organization at Illinois, this was the approach we followed in managing salaries in the recession that followed the burst of the bubble.  Those at the top of the hierarchy were told we'd get smaller percentage increases so the more modestly paid organization members wouldn't have to suffer too much from a too small pool to fund salary increases.  Without inflation, however, actual cuts are necessary.)  That tenure seems only to restrict nominal salary cuts but not real salary cuts is hard to understand as an economist.  But given that cuts would only be imposed on comparatively well off faculty and that the reason for the cuts was not at all punitive but rather to bring university budgets more in line with a realistic projection of future revenues, might allow the salary compression function to pass the tenure test.  It would certainly help on this point if AAUP were to embrace the salary compression approach, even if they do so for no other reason than that most of their membership would see no change in their salaries as a consequence. 

The other obvious legal barrier concerns Antitrust issues.  Would the requisite self-regulation imposed within Higher Education after the initial one-time cut be regarded as illegal restraint in trade?   One would hope not while citing the prior example of the professional sports leagues, each of which has some form of cap.  The difference here is that pro sports does not do salary compression, quite the contrary.  The stars are paid enormous sums.  They only willingly compress in the presence of strong complementarity with other teammates and potential teammates and a willingness to hold up on their own demands so the other pieces of the puzzle can be fit in under the cap.  This is the exception, not the rule.  Further, those sports stars with marketability can leverage success in their sport for income generation outside it.  For many of the scholars we are talking about here, that is not going to happen, nor would it be desirable were it possible.  Basic research is a full time job and it requires great personal commitment.  So there is an issue that needs to be addressed here that hasn't been considered previously.  But I would hope that it too could sail through a Justice Department review.

* * * * *

Let me turn to the Salary Compression Function itself, an example of how it might work, and the principles that underlie its design.  The compression function maps current salary into new salary.  The map is increasing and concave.  Further there is a threshold below which the map is the identity map - new salary equals current salary - while above the threshold new salary is less than current salary.  This means there is a kink in the compression function at the threshold.  These properties in themselves imply the following, which I take to be the main principles of any such salary compression function.

1.  Relatively low paid people are protected.  They aren't subject to salary shrinkage at all.  
2.  For those who are higher paid and do experience cuts in salary, both the magnitude of the absolute cut and the percentage decrease in salary are increasing in the current salary.  In other words, the high paid people bear the brunt of the compression.  In this sense, the compression function is like a progressive income tax.  
3.  Salary compression respects "the pecking order" by which I mean if you are making a comparison with a peer on which of you is paid more, the same answer will emerge after compression as before.  

Now let me turn to the example to illustrate.  The threshold is taken to be $100,000.  Is that too high or too low?  I don't know.  I don't think you can know without looking at the salary distribution figures.  I took it to make the numbers easy to work with and thus the explication of what is going on as simple as possible.  For the high end of the salary distribution, I took that to be $1,000,000.  I'm aware that some university presidents are paid more than that.  The particular function in the example can be readily extended to higher income levels.  If other functions are contemplated, how they'd extend is a necessary consideration.  In the example there is a 50% cut on an old salary of $1,000,000.  So the new salary is $500,000, still a lot of money in the world I live in, but also a sizable reduction from the previous number.  Again on whether that is too small or too large I can't say.  It was chosen just to have easy to remember anchor points in the compression function.  I then chose the compression function to be linear on the interval between $100,000 and $1,000,000 because that is the simplest possible function that works.  Thus the function in the example is given by:

new salary = old salary        if old salary is less than or equal to $100,000, and
new salary = $100,000 + 4*(old salary - $100,000)/9      if old salary is greater than $100,000.

A graph of this example salary compression function is below.  If you follow the above link and download the spreadsheet from there you can then plot your own salary and see how the example compression function would treat it.  My own reaction eyeballing it is that it may be too harsh in the $100,000 - $200,000 range and that the marginal rate there should perhaps be 75% instead of 44.44%.  But if the upper endpoint is held fixed, that would necessitate lowering the marginal rate above $200,000 to 40.63%.   More generally, the more you try to protect the middle earners from the cuts, the more you have to flatten the compression function at the high end or the less you cut at the high end.   This discussion is meant to show their are tradeoffs in what might be accomplished with a salary compression function.  Let me conclude that with the obvious.  For this to produce substantial reduction in current spending on personnel, many people will feel the pinch of salary compression.  It is not just the elite few who will do so.  Thus another part of the fantasy is that for the most part these others will accept salary compression willingly provided there is the right sort of leadership from the elite.

* * * * *

One of the reasons to think about salary compression in higher education is that on the revenue side, particularly revenue in the form of gifts, we in Higher Education seem to be playing a game that goes against our own principles.  In particular, on the issue of where universities should be on the proposed capping of the charitable contribution deduction of the income tax, I find myself personally uncomfortable with the public position that universities are taking - that this contribution should be exempt from the cap because it would result in less giving and these gifts provide a lifeline for Higher Education.  There are two issues behind this feeling, an economics issue and an ethical one.  Let me take those in turn.  

The rising inequality in society as a whole is one primary cause for the hyperinflation in Higher Education.  That is manifest in the increasing reliance on gift income in both operating and capital budgets.  (Income inequality is not the only cause of hyperinflation.  Two other factors are William Baumol's Cost Disease and Sherwin Rosen's The Economic of Superstars.  A third possible factor is that Higher Education has come under increasing regulation, for example, in animal research, where compliance dictates added bureaucracy.)  To the extent that the gift income gets turned into economic rent for the top performers, if leadership in our sector adopted a responsible tone it would look for ways to slow down the hyperinflation, even if the particular way articulated in this piece is ignored because it is deemed infeasible or impracticable.  To instead argue that we need the revenue or else our function will cease seems to me to be an abrogation of responsibility.  Cost containment must be an ongoing goal of Higher Education leadership.  This doesn't mean that leadership should not be on the lookout for gifts.  But it does mean that taxpayers should not be placed on the hook when universities receive these gifts.  They are in the present system.  The tax deduction for charitable giving is in effect passing an obligation onto (other) taxpayers to make up the tax revenue shortfall created by that deduction.  

The ethical issue is even more troublesome, in my opinion.  Some college gift giving is indeed charity, in an ordinary understanding of the term.  Most of it, however, is not.   Giving to expand the scholarship fund for needy students is charity.  Giving to expand the scholarship fund for merit awards, while perhaps a good thing, is not charity.  If charity means a gift to the poor, then if the recipient is not poor the gift is not charity.  So it is with endowed chairs and again with giving for a new building.  These gifts, viewed as income transfers, are typically from the very rich to the reasonably well off.  As I said, the gifts may enable good things to be accomplished, but they are not charity.  Would there be an ethical issue if the tax deduction were relabeled as "a contribution toward good works?"  In my mind, yes it would remain because there would still be the question - who determines whether this is a good work or not?  It seems to me that abuse is all too possible (and I know of stories that I would characterize as abuse even if they are perfectly legal).  So that Higher Education has become increasingly reliant on the charitable tax deduction is troublesome.  It is something to try to reverse, not to extend.

* * * * *

Let me turn to possible criticisms of salary compression, particularly from those who work in Higher Education and would agree with most of the underlying principles but think there are things lacking in the salary compression function as I've presented it so far.  The particular criticism I will focus on here occurred to me by asking whether I'd be in favor of this proposal were I still working or, alternatively, would I have been in favor of it four or five years ago had it been proposed then?  Salary compression is my fantasy yet a truthful answer to the question is that I wouldn't be in favor of the proposal myself, at least not in the bald form it's been presented so far, because when I was working I contributed to a defined benefit pension plan, one where in the benefits formula the average of the last four years of salary figured prominently.  In other words, salary compression as represented in the example above would have substantially lessened my pension annuity.  So I could not in conscience support salary compression unless the impact on retirement pay were lessened (e.g., use the highest four years of pay in the formula instead of the last four years).

This got me to think of the following criticism, which I think fair and needs to be addressed.   So far in discussing salary compression we've viewed salary from a cross-section perspective only, considering the salary distribution at a moment in time.  It also needs to be looked at from a longitudinal perspective.  That is, consider the life-cycle of earnings for the employee over the employee's entire career.  If high pay correlates strongly with a good deal of seniority, then salary compression becomes de facto a seniority tax, and that might be something to be avoided.  If so, one at least partial correction to the very simply approach discussed above would be to create a more complex salary compression function, one that uses an experience index in addition to old salary to determine new salary.  

Another possible criticism is that compressing the salary structure might destroy incentives implicit in the academic administrative job ladder (from department head to dean, from dean to provost, etc.)  In any job ladder, part of the rent in the current position is option value from the possibility of being able to go up the next step on the ladder.  Presumably this option value helps spur high effort when on the present rung of the ladder.  My own view of this in the Academic setting is that at least at the department head level many serve out of obligation to the department and look forward to a full time return to the faculty rather than a step up the ladder when they have finished their term.  For these people the salary compression should have no impact whatsoever on their administrative performance.  For those with further administrative aspirations, my experience is that these are fueled by a desire to accomplish greater things so salary is not of great consequence to them and thus salary compression should not be a big deal for them.

There is a different, more negative, way where salary compression matters in this job ladder way of thinking.  I've seen administrative burnout all too often.  High level Academic administrators are under a great deal of pressure because what they do is highly visible and sometimes they have to do things that are not popular and thus receive substantial and sustained criticism for their decisions.  During these times thoughts of getting out of the job are natural.   Then, in considering salary, it may seem to have a component that is combat pay.  (Economists call that a compensating differential.)  In other words, the salary may not be a big deal in recruiting the person into the administrative job, but it may matter a lot as a way to retain them in the position for an extended period of time, having already served a significant term.  I wish I could offer up some words of wisdom about administrative burnout.  I don't have them.  I have a sense that salary is the wrong way to deal with the issue, because it doesn't address the causes at all.  Mentoring might be a better alternative, but not everyone has a people network where mentors are readily available and the higher one rises on the food chain the scarcer the potential mentors become.  So I could see that if salary compression became the law of the land in Higher Education that there would be greater turnover among the higher levels of administration.  Perhaps that would be a healthy response in that it could encourage a reconsideration of higher administrative jobs, with the aim of removing some of the more insane aspects of the (implicit) job description.

* * * * *

It's time for me to wrap up.  I suspect that many of us in Higher Education have from time to time wanted to play Robin Hood. This piece is being written during one of those times for me.  In this day and age a mass movement of Robin Hoods is perhaps beyond the realm of possibility, especially when most of the Robin Hoods would then be part of the class that would be robbed from.  It is why I've called this piece a fantasy.  Were I a betting person, if an even money prospect were presented to me about whether the salary compression function will become a reality in the next five years, I'd have to bet against.  But even if it is unlikely I've got to ask, why shouldn't it happen?  If it did happen wouldn't it make Higher Education more sustainable?  

And wouldn't it happening awaken other audiences to the same sort of issue?  In my heart of hearts those in The State University Retirement System of Illinois (SURS) should go through a similar sort of benefit compression function.  It's known that the system is way out of balance and this would be a way to partially bring it back into shape.  But there is difference between an economic rent for a working person and an entitlement for a retiree and I couldn't come up with a convincing story for myself where SURS beneficiaries with a high annuity would willingly give up some of that for the good of the order.  They might however, if Higher Education were to move first, have their guilt feelings raised enough where the topic could be seriously discussed.  Who knows?  Maybe it's possible.  Climb that mountain and the next one, a far bigger one, is healthcare. 

1 comment:

Unknown said...

Nice knowledge gaining article.
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