The Executive Pay Cap That Backfired

by Allan Sloan, ProPublica, Feb. 12, 2016, 7 a.m.

This story was co-published with the Washington Post.

Wealth, jobs and pay inequality are big political issues this presidential primary season, and they’re bound to become bigger once the parties pick their nominees. In the plethora of plans candidates tout for tackling these problems, one favored tool stands out: the federal tax code.

But trying to legislate corporate behavior and economic fairness 2014 however you define fairness 2014 through the tax system is a lot trickier than it sounds.

[drizzle]Consider the supposed solution to an equality and social-justice issue debated six elections ago 2014 a law designed to limit how much companies could deduct from their taxable income for lush pay packages to high-paid executives.

In 1992, as now, key electoral issues included inequality and the spectacle of American jobs moving overseas 2014 underscored by a gaping disparity between executives making multiple millions and ordinary workers with stagnant wages.

The idea was to give companies a tax incentive to rein in executive pay or just shame them into it. But a new study done for ProPublica and The Washington Post by S&P Global Market Intelligence shows that the law has had little effect. In fact, the titans of American industry and commerce shrugged off the statute and moved to pay top executives way more than the deductibility limit.

Bill Clinton, the not-yet-a-household-name Arkansas governor, proposed limiting deductions for what he called “excessive executive pay” during his first presidential campaign in the early 1990s. The concept had kicked around Washington for several years and was one of the planks that helped him win the Democratic nomination and deny George H.W. Bush a second term. In 1992, Bush had vetoed a budget bill containing a provision to limit how much companies could deduct for high-paid people.

Clinton’s victory and a Democratic Congress resulted in a tax law change that limited companies’ deductions for executives’ compensation to $1 million per executive per year. That’s the amount that Clinton proposed for chief executives in “Putting People First,” a campaign book that he co-authored with Al Gore.

The compensation deduction limit, known to tax techies as Section 162(m) of the Internal Revenue Code, was adopted in a 1993 bill that also increased taxes on higher-income Social Security recipients and reduced deductions for business meals.

The legislation, however, was stuffed with loopholes. It covered only companies with publicly traded stock; it applied to only five (and since 2007, four) “named executive officers” who aren’t necessarily the highest-paid; and it exempted “performance-based” compensation, including stock options, and huge bonuses based on easily attained goals, allowing unlimited deductions for them.

Section 162(m) fulfilled a campaign promise. But, in hindsight, it’s clear that it has had little or no influence on corporate behavior. Says Sen. Charles E. Grassley (R-Iowa), a leading congressional tax maven: “Regardless of how you feel about limiting compensation through the tax code, the current law is like a gnat on an elephant in accomplishing its goal. It’s easy to swataway, and that’s exactly what many companies do.”

We decided to see whether that was accurate.

Our study looked at the history of executive compensation for the 40 members of today’s “Nifty Fifty” 2014 the 50 companies in the Standard & Poor’s 500-stock index with the highest stock market value 2014 that also reported executive compensation information for 1992, the year before the pay-deductibility limits took effect.

To compare apples to apples, we eliminated the 10 members of the Nifty Fifty, including Facebook and Alphabet (Google’s parent company), that weren’t publicly traded back then or didn’t exist.

In 1992, only 35 percent of the people in our study 2014 executives whose income was reported in companies’ proxy statements 2014 had more than $1 million of income in the categories subject to deductibility limits. (Those are salaries, bonuses and restricted stock that vests over time.) But in 2014, the last year for which corporate salary income is available, the number had risento 95 percent.

(Read our complete methodology.)

Given inflation, it’s no surprise that more top execs would breach the $1 million cap. But the numbers also showed something completely unintuitive.

From 1992 to 2014, compensation per executive in the limited-deductibility categories rose more rapidly 2014 by about 650 percent, to $8.2 million from $1.1 million 2014 than compensation in categories such as stock options and incentive pay that aren’t subject to deductibility limits. The latter rose by about 350 percent, to $4.4 million from $970,000.

“That’s powerful,” Steven Balsam, a leading academic expert on executive compensation practices, said when told what our study showed. Balsam is a professor at Temple University’s Fox School of Business who published a 2012 study on the deduction cap for the Economic Policy Institute. “At best, 162(m) has had a marginal effect,” he said. “It hasn’t had a major impact.”

Some of the companies with the most notable increases in compensation subject to the limit include Allergan (to $77.4 million from $378,000), Cisco (to $75.2 million from $1.1 million), Oracle (to $119.4 million from $4.9 million) and Walmart (to $55.4 million from $2.9 million).

What happened? It turns out that losing deductibility isn’t all that big a deal to companies 2014 we estimated the effect of lost deductibility on corporate profits at only about 0.2 percent in 2010 for the companies in Balsam’s study. And there’s no reason to think those numbers have changed much.

(The 0.2 percent figure is based on Balsam’s estimate that the 7,248 companies in his study paid an extra $2.5 billion of federal tax because of lost deductibility in 2010, and on S&P Global Market Intelligence’s calculation that the 7,722 firms in its slightly larger database had $1.153 trillion in after-tax profits that year.)

“Decisions on the pay mix are not guided by the deductibility factor,” said Steven Seelig, executive compensation counsel for Willis Towers Watson, a big consulting firm. “Compensation committees are certainly mindful of the tax rules and meet the deductibility rules when they can. But the decision on the pay mix that’s appropriate is guided by their companies’ unique circumstances.”

One of the reasons that the deductibility limit has been so ineffectual is that it was watered down from what was originally proposed.

According to coverage by Tax Notes, which tracked the progress of 162(m) in great detail, the intellectual godfather of the legislation was then-Rep. Martin Sabo, a Minnesota Democrat.

Sabo, who represented Minneapolis and some of its suburbs, said in an interview that his goal had been to reduce economic inequality. “My proposal was trying to send a message,” he said. “This was a sort of symbolic thing because I felt that those at the top should care about the bottom.” He had pushed for deductibility limits in the 1992 tax bill that Bush vetoed.

But what became Section 162(m) a year later wasn’t Sabo’s original concept. “What I proposed was that you couldn’t take a tax deduction if the compensation exceeded 25 times the compensation of the lowest-paid employees,” he said.

That idea began life as the Income Disparities Act of 1991. Because it applied to all employees, not just top officers, the legislation would have had a sweeping impact across corporate America. How did it morph into something that affected only a few

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