Paul Graham wrote a typically perceptive article about income disparities, Mind the Gap. Graham argues that you can’t have economic progress without income disparities. For a variety of reasons, what he says is true.
However, there is one area where Graham makes an unwarranted assumption. Prior to discussing current income disparities, Graham says, “In a free market, prices are determined by what buyers want”. True enough, but the assumption that we enjoy a free market is unwarranted.
First, Americans pay about 27 percent of their income in taxes. Depending on how you calculate taxes, other estimates are much higher. The money is extracted by force, and distributed according to political considerations. Both the extraction and the spending distort markets. CEOs of large corporations increasingly spend more and more time trying to get financial favors from the government. The CEOs who operate best in such an environment are hardly products of a free market.
Taxes make it more difficult for workers to save capital. Thus, many who would start their own business in the absence of taxes remain as employees of corporations. Without the competition that entrepreneurs would provide, corporations become richer. Thus, the marginal utility of CEOs and their salaries are correspondingly inflated.
For more than 100 years, the United States has lived under an increasing regime of regulation. Regulation, like taxation, operates on the federal, state, and local levels. The net effect of regulation on the economy is probably on the same order as the tax burden. Note that regulation favors large firms who can buy influence and more easily deal with the regulatory burden. Mr. Graham probably does think very much about the regulatory burden because he deals with startups in the computer industry where the regulatory burden is relatively light. However, even in the computer industry, regulation is becoming an increasingly import factor(e.g., Sarbanes-Oxley).
The highest CEO salaries occur in the largest corporations, which in a regulatory environment, have advantages over smaller rivals. Limited liability corporations enjoy protection against torts which increases the value of the firm. Since the corporation is worth more, it follows that the CEOs salary would be higher.
In addition, the large corporations that pay the largest CEO salaries also derive much of their wealth from copyrights and patents. Copyrights and patents are really grants of monopoly by the state. As with any grant of monopoly by the state, those who own the monopoly can extract a monopoly price. Some of the monopoly price dividend ends up in the pocket of the CEO.
Mr. Graham talks about basketball players and baseball players as examples of people who make many times the average salary. However, nearly all basketball and baseball stadiums enjoy public subsidies running into the hundreds of millions of dollars. Note that the gigantic increases in salaries in basketball and baseball arrived in recent years, at about the same time that public subsidies for stadiums became common.
Even though it can be demonstrated that many current high earners benefit from market distortions, it is impossible to say what their earnings would be in a free market. It may be that their earnings would be less. However, it is possible that they, or somebody else, would earn spectacularly high earnings in comparison to the average. Without high taxation, and without the burden of regulation, it is possible that ambitious people would do even better relative to that average than is the case now.
One thing is certain: we are not living in a free market.