Crony Capitalism Pays Well for Rent-Seeking CEOs

When federal money is up for grabs, individuals and businesses invest resources to secure it through a process known as "rent seeking." Rather than making the entire business more profitable, however, this money often remains at the executive level.

Executive pay is on the rise. The latest proof comes from the data provider Equilar, which reports a 6% annual increase in average compensation for the 200 highest-paid chief executives. 

There are many reasons to pay CEOs well: They are often exceptionally talented people whose value increases as the economy grows stronger. But our new research sheds some light on another factor.

Companies frequently receive tax breaks, subsidies or other assistance from the federal government to create jobs, boost sluggish industries or spur economic growth.

When federal money is up for grabs, individuals and businesses invest resources to secure it through a process known as "rent seeking." Rather than making the entire business more profitable, however, this money often remains at the executive level.

In fact, it's not clear that shareholders or workers are getting a real return on their companies' lobbying investments.

In the wake of the financial crisis, businesses have rushed to ensure that their interests were and continue to be heard in Washington. With more than 12,000 registered federal lobbyists seeking influence in policymaking, the reported expenditures on lobbying federal government in 2013 topped $3 billion.

Remember Solyndra

This is perhaps no surprise, given that programs such as the Troubled Asset Relief Program (TARP) and the American Recovery and Reinvestment Act of 2009 (or the "stimulus") doled out more than $1 trillion in federal subsidies, grants and contracts directly to specific private businesses.

It's now a common belief that business success depends partly on a company's ability to secure favors through political connections. Known as "cronyism," in this system the government — rather than consumer-driven market forces — picks the winners and losers in the marketplace.

It doesn't take an MBA degree to realize that if government favors affect firm profitability, the business should manage this aspect of revenue. Similar logic is taught in actual business-school classes.

However, according to our new study through the Mercatus Center, the wisdom of the crowds may be wrong on this one.

In fact, political activity and connections do not lead to higher profits for the vast majority of firms or industries, with the only notable exception being banking-related firms.

Using firm-level data spanning a decade, we see no statistically significant correlation between firm or industry profitability and firm (or industry) lobbying or political action committee activity.

If lobbying and political efforts do not increase returns for firm shareholders, why would firm executives channel resources in this direction? Our research suggests that — while measures of firm performance and profitability are not correlated with political activity — the compensation of top firm executives is strongly correlated.

Our robust finding is that executive compensation is higher in firms (and industries) that devote more resources to lobbying. Simply put, firm executives — not the shareholders or owners they work for, and not the bulk of employees they work with — capture the benefits from political connections.

This finding is consistent with the fact that some politically favored firms, such as Solyndra and Ener1, went bankrupt despite receiving government favors. It also reveals a clear incentive for firm executives to devote resources toward developing political ties and connections.

Bonuses And Bankruptcy

If a firm's top executives — rather than the firm's owners and workers — primarily receive the benefit of political influence, then in reality, political connections have little effect on which firms survive and which firms don't.

Solyndra failed after being hailed as a poster child of successful government grants helping an innovative business. The company received three awards with a total value of over $535 million in stimulus funding. Solyndra's annual federal lobbying expenditures during this time soared from $160,000 to $550,000, and it went from having three to 11 lobbyists.

Soon after the company filed for bankruptcy, the FBI searched the homes of Solyndra CEO Brian Harrison and company founder Chris Gronet. Those searches, and subsequent court proceedings, uncovered that after Solyndra received government funds, the firm gave several top executives — including the CFO and two vice presidents — bonuses ranging from $44,000 to $60,000 in both April and July (beyond their base salaries, which ranged from $500,000 to $1 million).

This was just months before the company filed for bankruptcy.

In short, government-granted privilege does not increase prosperity for the vast majority of American workers and investors. Shareholders should pressure firm executives to devote resources instead to marketplace competition and capital investment, activities that do provide returns for owners and workers.

Government favor-seeking may help increase the salaries of firm executives, but evidence suggests that it does little else.