Everybody knows that top corporate executives get paid much more than they’re worth—and that ever-rising income inequality is the result. It’s tempting to conclude that the federal government has never tried to do anything about this, but that isn’t quite right. It’s tried a little bit, and it’s failed. An executive-pay tax included in the recently enacted Covid relief bill furnishes a denouement to this sad story.
The provision, tucked quietly into the $1.9 billion stimulus measure, increases from five to 10 the number of executives at a given firm for whom any compensation above $1 million may not be deducted from the firm’s taxable income. Executive compensation is typically considered an expense, not revenue or profit, but at a certain point the Internal Revenue Service throws up its hands and says, in effect, “Don’t tell me that to run your company you need to throw all this money at these guys.” (And yes, it’s almost always guys.) For any firm’s five highest-paid executives (or 10 highest-paid, under this new provision) who pull down more than $1 million, corporations (banks, mostly, and some tech companies) pay taxes on that portion of those salaries above $1 million. That additional cost raises by about 25 percent the total compensation paid out to these executives in excess of $1 million.
The Joint Tax Committee calculates that by increasing this unprotected class of executives from five to 10, it can raise $7.8 billion over a period of 10 years. That return is supposed to partly offset the Covid bill’s $23 billion bailout for several insolvent union-negotiated multiemployer pension funds (chiefly the Teamsters’ Central States Pension Fund) that risk bankrupting their quasi-governmental insurer, the Pension Benefit Guaranty Corporation, if they go belly-up. In congressional budgetese, the change in the tax status of overpaid executives is a “pay-for.”
So banks and tech companies will have to pay the Treasury more money for overpaying their top executives. “But where’s the sad part?” you may be wondering. Well, the sad part is that there was a time when reform-minded Democrats thought this tax could be used to stop banks and tech companies from paying their top executives more than $1 million in the first place.
It was not to be.
Taxes have all sorts of purposes. Some taxes—most, actually—are intended to raise revenue. Other taxes, say on booze and cigarettes, are intended to alter behavior. The taxes in the latter group, known as “sin taxes,” usually end up doing some combination of both things—they discourage consumption of alcohol and tobacco a bit, but because the flesh is weak they also end up raising revenue.
The tax on executive salaries above $1 million was envisioned as a sort of sin tax. It was never intended to raise revenue. When presidential candidate Bill Clinton first proposed it in 1991, his idea was that if you forced companies to pay taxes on CEO salaries that exceeded $1 million—in Clinton’s scheme, this would apply only to CEOs, in part because at that time it was unlikely that even a bank would pay anyone besides its CEO more than $1 million—then companies just wouldn’t pay their CEOs salaries that exceeded $1 million. The proposal had a certain elegance to it, and in 1993, Congress enacted the necessary change to section 162(m) of the Internal Revenue Code.
But Clinton made one serious mistake—one flagged to him at the time by Labor Secretary Robert Reich, whom he ignored. CEO salaries over $1 million would be taxable but not CEO stock options. As a result, the corporate governance critic Nell Minow explained, two things happened. First, “everybody got a raise to $1 million.” Second, corporate compensation committees, which remained determined to throw cash at their CEOs, invented bullshit performance metrics that allowed them to reward their CEOs with stock options. (In one instance—I kid you not—AES Corp., a firm in Arlington, Virginia, that operates power plants, made it one of its chief executive’s performance goals to make AES a “fun” place to work.)
The net result was that Clinton’s ingenious policy initiative, rather than put out the fire of runaway CEO pay, poured gasoline on it. Corporations could throw stock options at their CEOs with abandon because, for a long time, the corporations didn’t even have to put the stock options on the books—on the ludicrous theory that their value couldn’t be calculated. Only after the 2000 Enron scandal did Congress finally require companies to put stock options on their balance sheets.
The stock-option loophole on taxing CEO pay persisted until Congress passed the Affordable Care Act in 2010. Tucked deep inside that bill was a provision disallowing health insurers from claiming deductions for executive compensation above $500,000. The provision applied only to health insurance executives, but this time stock options were included in pay calculations. The language reflected a general sense that health insurers should not be permitted to play the profiteer with the heavy subsidies coming their way from Obamacare. A 2018 study by economists Jessica Schieder of the Economic Policy Institute and Dean Baker of the Center for Economic Policy Research calculated that the new tax increased by more than 50 percent the cost of paying these health insurance executives in excess of $500,000.
It didn’t matter. Schieder and Baker later concluded that there was “no evidence that limiting the deductibility of CEO pay for health insurers lowered this pay relative to other industries.”
In 2017, Donald Trump passed a huge tax cut that, among other things, cut the corporate tax rate from 35 percent to 21 percent. Buried inside that bill was a provision that closed the million-dollar-plus deduction loophole that Congress had inserted into Section 162(m) back in 1993. Now stock options would count toward the $1 million. And the threshold would apply not only to a handsomely rewarded CEO but to all five of the top executives at a given company if they, too, earned more than $1 million.
It’s not entirely clear why this change was made, but the damage was limited by the decrease in the corporate tax rate. Now it would cost corporations only about 25 percent more to pay their top executives in excess of $1 million, as opposed to the 50 percent more it cost them under the Affordable Care Act before the corporate tax rate came down. On the other hand, $1 million in December 2017 was the equivalent of about $580,000 at the time Congress enacted its deductibility limit in 1993, so $1 million corporate paydays had become a lot more common.
Now the America Rescue Plan expands this group of five top executives to 10. CEO pay continued its stratospheric climb after the 2017 Trump tax bill became law, so it seems pretty unlikely that the change in taxable corporate income persuaded companies to cool it on executive pay.
Bill Clinton’s clever idea to alter corporate behavior turned out to be too clever. If you want to limit executive pay, it’s now clear that indirect incentives won’t work. You have to restore the top marginal income tax rate on rich people to a deliberately confiscatory 90 percent. It worked in the 1950s. It can work again.