The Bottom Line On Cutting Defense-Industry Compensation: You Get What You Pay For

For nearly 20 years, the federal government has used a formula to determine how much executive compensation it is willing to cover at its leading contractors. The ceiling is adjusted each year, and currently stands at $763,000. But critics of the defense industry in Congress say that number is too high, and want to reduce the cap to either what the President makes each year ($400,000) or what the Vice President makes ($230,700). The President has endorsed capping reimbursable compensation costs at the latter number, after which any additional costs would presumably have to come out of company profits.

This is a dangerous precedent for three reasons. First, there is no apparent connection between the proposed cap and what level of rewards is required to secure top talent in the labor market. Second, similar caps will likely be extended to other industries such as pharmaceuticals as the government increases the scope of its relationship with those industries. And third, no effort has been made to ascertain how capping reimbursable compensation costs will impact contractor performance.

The question here isn’t whether CEO’s will get paid what the Vice President gets. His pay is less than twice the median family income in Fairfax County, so corporate boards will gladly take millions of dollars out of company profits to assure they have first-rate leaders at the helm. Doing otherwise would be penny wise and pound foolish. The real question is what everyone else in the company is paid, because you can’t cover compensation costs for thousands of program managers, software engineers and other high-end employees from profits without undercutting the company’s ability to raise money in capital markets.

What the Congress would be saying if it embraced lower compensation caps would in effect be, “We don’t care what it costs to get the best cybersecurity talent or scientific expertise, we’ll pay 190% of the median household income in Fairfax County and then you’re on your own.” Faced with a choice between slashing profits to get the best people and maintaining profits by using lower-cost, less competent talent, most companies would opt for the latter strategy. When it comes to complicated activities like cyber, the government isn’t very good at judging bids once it gets beyond price anyway. So in the end, the nation’s cyber defenses, its medical system, its vital infrastructure and its next-generation weapons will end up being designed and sustained by second-rate people.

Something tells me that this approach to managing contractors will cost the government more money than it saves — maybe trillions of dollars if the wrong people end up running really crucial projects. The logic of market economics is that the free interplay of supply and demand sets the cost of production inputs like labor, and then companies must figure out how to remain competitive within that framework. When the government decides it is going to interfere with the pricing mechanism for political reasons, it distorts outcomes and reduces efficiency. It won’t do to say this is just about the defense industry, because soon it will be about drug companies, then construction companies, and before you know it the whole system will be fouled up. Besides — if you don’t like weapons makers today, imagine how you’ll feel once all the really talented people have left for more lucrative pursuits.