In recent years, the labor community has rightfully hammered corporate executives for their rising compensation and tax dodging while employees are asked to make larger and larger concessions (see Caterpillar, Verizon, Boeing, etc.). Now, the Economic Policy Institute has issued a new report showing the effect executive tax deductions have had on the U.S. Treasury. The report, “Taxes and Executive Compensation,” concludes that between 2007-2010 executive tax deductions cost the treasury $30.4 billion (see above).
Much of the problem comes from a well-intentioned IRS code that has allowed abuse to happen legally. Section 162(m) was adopted in the first year of the Clinton Administration to combat high executive pay:
Section 162(m) of the Internal Revenue Code, adopted in 1993 to discourage excessive executive pay, limits the deduction for executive compensation at publicly-traded corporations to $1 million in compensation per covered executive. An exception to the provision, however, allows corporations to deduct qualified performance-based compensation. This exception has a major weakness: While it requires that shareholders approve the performance-based compensation to preserve deductibility, corporations are only required to provide shareholders with general information. Thus, shareholders are asked to, and usually do, approve compensation plans without knowing the potential payouts from the plans or whether the performance conditions are challenging.
However, many of those involved with writing Section 162(m) now view it as a failure.
With respect to reducing excessive, non-performance-based compensation, many consider Section 162(m) a failure, including Christopher Cox, the then-chairman of the Securities and Exchange Commission, who went so far as to suggest it belonged “in the museum of unintended consequences.” Sen. Charles Grassley (R-Iowa), the then-chair of the Senate Committee on Finance, was even more direct, saying:
162(m) is broken. … It was well-intentioned. But it really hasn’t worked at all. Companies have found it easy to get around the law. It has more holes than Swiss cheese. And it seems to have encouraged the options industry. These sophisticated folks are working with Swiss-watch-like devices to game this Swiss-cheese-like rule.
Other key findings from the report include:
Companies are allowed to fully deduct components of executive compensation that meet the IRS requirements to qualify as “performance-based.” One of those requirements is shareholder approval. However, only very general information is provided to shareholders. Therefore, shareholders are asked to, and usually do, approve plans without knowing whether the performance conditions are challenging or not, and the potential payouts from the plan.
–Performance pay, such as stock options and non-equity incentive plans, that meets the IRS requirements for the “performance-based” exception is fully deductible. Salary, bonuses, and stock grants are deductible but subject to a limit of $1 million.
–In 2010 our estimate was that there was $27.8 billion of executive compensation that was deductible. A total of $121.5 billion in executive compensation was deductible over the 2007–2010 period. Roughly 55 percent of that total was for performance-based compensation.
–Seemingly tax-sophisticated corporations seem not to care about the restrictions on deductions and continue to pay nondeductible executive salaries. The number of executives receiving salary exceeding the maximum deductible threshold of $1 million actually increased from 563 in 2007 to 594 in 2010.
–For all that Section 162(m) is intended to limit excessive executive compensation, it is the shareholders and the U.S. Treasury who have suffered financial losses.
The code does not prohibit firms from paying any type of compensation; instead, they are prohibited from deducting that amount on their tax return. The result is decreased company profits and diminished returns to the shareholders.
Assuming a 25 percent marginal tax rate on corporate profits (a conservative estimate), revenue lost to the federal government in 2010 from deductible executive compensation was $7 billion, and the foregone federal revenue over the 2007–2010 period was $30.4 billion. More than half the foregone federal revenue is due to taxpayer subsidies for executive “performance pay.”
–Executive compensation will likely recover in the near future, exceeding levels seen in 2007.
To read the entire report visit the Economic Policy Institute website.