Executive Compensation, Corporate Governance, and Tax Policy

Over the past four decades, persistent concerns about executive compensation have prompted the US Congress to enact penalty taxes aimed at various executive-pay practices.  First came the penalties for golden parachutes in 1984.  Responding to perceived abuses during the ‘merger wave’ of the 1980s, Congress enacted rules denying a tax deduction to a company making a large golden-parachute payment and imposing a 20-percent surtax on the executive who receives the payment.  Next came the $1 million deduction cap in 1993.  Amid broad criticism that U.S. executives were ‘paid like bureaucrats’, Congress enacted a rule denying a corporate tax deduction for executive pay over $1 million, but with broad exceptions for performance-based compensation and deferred compensation. 

Then came tax penalties for deferred compensation in 2004.  After the collapse of the Enron Corporation and revelations that certain executives had withdrawn their deferred compensation in anticipation of the company’s failure, Congress imposed a 20-percent surtax and an interest charge on any executive whose deferred compensation fails to meet certain statutory requirements, including requirements about when payment can be made.  And most recently, Congress in 2017 repealed the exceptions under the $1 million deduction cap for performance-based compensation and deferred compensation. 

As I argue in a forthcoming paper, two assumptions tie these executive-compensation penalty taxes together.  First, legislators assume that contemporary executive compensation generally represents a failure of corporate governance.  Legislators reason that exorbitant executive compensation cannot possibly be the result of arm’s-length bargaining and must be the product of outsized executive power and influence over directors.  Second, legislators assume that tax policy can correct this corporate-governance failure. 

But these assumptions do not provide a firm basis for using tax policy to regulate executive compensation.  The first assumption is contested.  Generally known as the ‘managerial power’ theory of executive compensation, it has some empirical support.  But there is also empirical support for the ‘optimal-contracting’ theory, which maintains that directors bargain with executives at arm’s length to reach compensation arrangements promoting shareholder interests.  It is difficult to declare one theory right and the other wrong, and it may be that other explanations are needed.

Whether or not the first assumption can be justified, nearly 40 years of experience have shown that the second assumption is almost certainly wrong.  Most of the tax rules for executive compensation have had only weak effects, and unintended consequences have often dominated the intended ones.  The enactment of penalties for golden-parachute payments appears to have led to an increase in parachute payments and the adoption of expensive tax gross-up arrangements to protect executives from the 20-percent surtax.  Similarly, there is good reason to think that the rules for deferred compensation work as intended only if one assumes away the corporate-governance failure that they are supposed to address. 

The $1 million cap has been particularly instructive.  Although it is impossible to know what would have happened if Congress had not enacted the cap in 1993, the cap does not seem to have led to a reduction in the level of executive pay.  As of 2016, more than half of all companies in the S&P 500 paid base salaries of more than $1 million to their CEOs, thereby choosing to give up tax deductions for at least some portion of CEO compensation.  Additionally, it is likely that the $1 million cap affected the types of executive compensation in unexpected ways—for example, by encouraging the substantial increase in stock-option grants during the 1990s.  In 2017, declaring that the original cap had led companies and executives to give priority to short-term results over both long-term results and the interests of rank-and-file employees, Congress repealed the exceptions for performance-based compensation and deferred compensation. 

This expanded deduction cap will almost certainly not limit the amounts that public companies pay their executives.  Corporations paid non-deductible compensation even when the $1 million cap included exceptions for deferred compensation and performance-based compensation, and there is no reason to think that they will change that practice now.  Studies of executive pay after the 2017 changes to the cap, after earlier reforms that targeted the health-insurance industry, and after legislation in Austria denying corporate deductions for executive compensation over €500,000 generally have found no meaningful effects on the level of executive pay. 

And there is a still more serious problem.  By definition, the disallowance of the deduction for compensation over the $1 million cap increases the corporation’s tax liability.  Although the precise incidence of the corporate tax remains uncertain, it is reasonably clear that both capital and labor bear a substantial portion of it.  The corporate income tax reduces the returns to shareholders and other investors, and it reduces the compensation paid to rank-and-file employees.  The important point is that the increase in the corporate income tax attributable to the expanded $1 million cap falls on investors and workers, but these are precisely the persons in whose interest the $1 million cap supposedly was enacted and then broadened.  It is hard to see any policy justification for that outcome.  It is like giving a red card to a player who commits a foul and then ejecting the player against whom the foul was committed.

Michael Doran is Professor of Law at University of Virginia School of Law.