Uncapping Executive Pay

Michael Doran is Roy L. & Rosamond Woodruff Morgan Professor of Law at University of Virginia School of Law. This post is based on his recent article, forthcoming in the Southern California Law Review. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

This article sets out the case for repealing the $1 million tax cap on executive pay. In 1993, Congress enacted section 162(m) of the Internal Revenue Code as an aggressive effort to limit what companies pay their executives. Section 162(m) caps at $1 million the corporate deduction for annual compensation paid to senior managers. This limitation, proponents argued, would rein in manager pay, push companies to link executive compensation to corporate and individual performance, restore balance between the pay of executives and the pay of rank-and-file workers, or, if nothing else, impose a significant penalty on companies that lavish high levels of performance-insensitive compensation on their senior managers. More than two decades on, Section 162(m) has proven a spectacular policy failure.

The track record of the $1 million deduction limit has proven its original proponents wrong on almost every point. It has had little effect in reducing executive pay; instead, executive compensation has increased substantially over the last two decades in both absolute and relative terms. When Congress enacted Section 162(m) in 1993, a typical large U.S. company paid its CEO compensation of $4.42 million (in 2016 dollars), or about 195 times the compensation paid to a blue-collar worker. In 2014, a typical large U.S. company paid its CEO compensation of $11.34 million (again in 2016 dollars), or about 373 times the compensation paid to a blue-collar worker.

Additionally, the cap is easily avoided and, when not avoided, widely ignored. Contingent bonuses, stock options, and stock appreciation rights are broadly exempt from the $1 million cap but only loosely tied to corporate and individual performance—allowing for an easy end-run around Section 162(m). Companies also can shelter executive compensation from the deduction limit by deferring payment of the compensation until the executive’s retirement. And many companies simply pay their managers non-deductible salaries, bonuses, and other amounts above the $1 million cap. That practice directly increases corporate tax liabilities—liabilities that likely burden workers and investors more than executives. In effect, the cap punishes rank-and-file employees and shareholders for pay deals made by directors and executives.

Despite the substantial shortcomings of the deduction limit, many who remain faithful to a tax cap on executive compensation have proposed legislative and regulatory reforms to Section 162(m). Most prominent are proposals to narrow or to eliminate the exceptions for performance-based and deferred compensation. Alternatively, there is a plausible argument for retaining the $1 million cap exactly as it is, warts and all, in order to generate federal tax receipts and to make a symbolic statement against excessive executive compensation. Both approaches—reforms targeting the exceptions and simple continuation of the status quo—would be counter-productive. They both rely on the denial of corporate tax deductions for executive pay above the $1 million cap, but companies have demonstrated a widespread willingness to shrug off those lost deductions. This increases the economic burden on workers and investors without meaningfully affecting executive compensation. By aiming the tax sanction at the companies that pay excessive compensation rather than at the executives who receive it, these approaches double down on an existing policy failure.

A truly effective tax mechanism for limiting executive pay would have to target executives directly. Previous legislative responses to excess golden-parachute payments and aggressive deferred-compensation arrangements show that standard penalty taxes imposed on executives improve only slightly (if at all) on disallowed corporate deductions. By contrast, a confiscatory tax—that is, a tax equal to 100 percent of excessive executive pay—would impose a hard limit on manager compensation. Rather than attempting to discourage payments above a designated amount, a confiscatory tax would simply tax away such payments in full. But a confiscatory tax would be very bad policy. It would introduce serious distortions and disruptions into fundamental decisions about business organization and labor supply, particularly among highly capable individuals, and it would put government in the challenging position of setting actual pay levels in the private sector.

In the end, the better policy approach is to remove any tax limitation on executive compensation. Policymakers should recognize that market failures in the setting of manager pay are not a tax-policy problem and are not properly resolved through the tax law. From a tax perspective, the right answer is to repeal Section 162(m). Nonetheless, legitimate concerns about income inequality and corporate governance should be addressed. Although the $1 million deduction limit is a poor mechanism for mitigating income inequality, robust progressive tax rates—particularly when applied to a broad base—could effectively reduce the income disparities that have emerged as a pressing problem in recent years. And although the $1 million deduction limit has little apparent effect on corporate governance, meaningful reform to corporate law—such as narrowing the business-judgment rule and expanding director liability—could discipline director decisions about how much to pay executives and how closely to link that pay to corporate and individual performance.

The full article is available for download here.

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