Ordinary American taxpayers are subsidizing excessive CEO pay through a variety of channels. These five reforms could help end these perverse incentives for executive excess.
Close the “performance pay” loophole
The more corporations pay their executives, the less they pay in federal taxes, thanks to a tax code loophole that lets corporations deduct unlimited amounts of executive compensation from their taxable income — as long as they label the pay “performance-based.” This loophole stems from a 1993 Clinton administration reform meant to address widespread public outrage over runaway CEO pay. The reform — Section 162(m) of the federal tax code — placed a $1 million cap on the deductibility of executive compensation. But by exempting “performance pay,” the reform invited an explosion of executive compensation in the form of deductible stock options, performance shares, and other bonuses designed to meet the exemption criteria.
A recent Institute for Policy Studies analysis has found that America’s top 20 banks paid out more than $2 billion in fully deductible performance bonuses to their top five executives between 2012 and 2015, a windfall that translates into a taxpayer subsidy worth more than $725 million, or $1.7 million per executive per year.
Senators Jack Reed and Richard Blumenthal and Rep. Lloyd Doggett have recently introduced the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act (S. 82 and HR 399), which would eliminate the “performance pay” loophole. The Joint Committee on Taxation estimates this legislation would generate $50 billion over 10 years.
Limit tax-deferred compensation
Most CEOs at large companies now legally shield unlimited amounts of compensation from taxes through special deferred accounts set up by their employers. In these accounts, their money can grow tax-free until they withdraw it. By contrast, ordinary taxpayers face strict limits on how much income they can defer from taxes via 401(k) plans.
A December 2016 Institute for Policy Studies report found that Fortune 500 CEOs have nearly $3 billion in these special tax-deferred compensation accounts. In 2015 alone, these CEOs saved $92 million on their annual tax bill by putting $238 million more in these accounts than they could have if they were subject to the same rules as other workers.
Fortune 500 CEOs have nearly $3 billion in special tax-deferred compensation accounts.
A University of Virginia Law School analysis points out that corporations also have a tax incentive to encourage executives to defer their compensation because the $1 million cap on deductibility of non-performance-based compensation (see #1 above) no longer applies after an executive has retired or otherwise ended their employment.
In 2007, the Senate passed a minimum wage bill that would have limited annual executive pay deferrals to $1 million, but the provision was dropped in conference committee.
Link tax rates to CEO-worker pay ratios
In December 2016, Portland, Oregon adopted the first-ever tax penalty on corporations with extremely wide gaps between their CEO and worker pay. Such gaps, supporters of the new tax point out, both contribute substantially to our overall economic inequality and undercut enterprise effectiveness. Portland has had a 2.2 percent business license tax. Under the city’s new business tax policy, companies with CEO-worker pay ratios of more than 100-to-1 will pay a 10 percent surtax on their business license tax liability. Companies with ratios of more than 250-to-1 will pay a 25 percent surtax. Revenue from the surtaxes will go for homeless services. For more information, see this IPS fact sheet. Elected officials in Rhode Island and San Francisco are moving ahead with similar proposals.
San Francisco and Rhode Island legislators are working to build on the Portland tax on companies with extreme CEO-worker pay gaps.
At the federal level, the CEO Accountability and Responsibility Act (H.R. 6242), introduced in 2015, would increase tax rates on companies with larger than a 100-to-1 ratio, while giving a slight tax rate break to companies whose CEO-to-worker ratios fall below 50-to-1. These efforts build on Dodd-Frank Section 953b, which requires annual reporting of the ratio between CEO and median worker pay and is scheduled to go into effect starting with 2017 pay figures.
Meanwhile, defenders of overpaid CEOs have been working to protect executives from this potentially embarrassing information. In the past few congressional sessions, Republicans have called for repeal of the pay ratio disclosure rule, citing absurdly inflated compliance costs generated by corporate lobby groups. Michigan Rep. Bill Huizenga, now chair of the House Financial Services subcommittee on capital markets, has led the crusade against this regulation. In the last two sessions, he introduced bills for repeal (H.R.414 in the 114th session and H.R.1135 in the 113th).
In 2016 Huizenga introduced an amendment to prohibit the SEC from enforcing the disclosure rule. On the Senate side, Mike Rounds also introduced a repeal bill (S.1722) in the last session. The broader Republican proposal to roll back Wall Street reforms, the Financial CHOICE Act, would also repeal this pay ratio provision.
Just this week, Michael Piwowar, the acting chair of the SEC, re-opened public comment on the pay ratio rule and said he may ask staff to review it. Piwowar expressed his intense opposition to the disclosure rule when the Commission voted on it in 2015.
Close the carried interest loophole
This loophole allows private equity and hedge fund managers to pay a 20 percent capital gains rate on the bulk of their income, rather than the 39.6 percent ordinary income rate. As a result, some of the wealthiest Americans pay taxes at lower rates than millions of teachers, firefighters, and nurses. Many tax and finance experts from across the political spectrum argue that the profit share — commonly known as “carried interest” — investment fund managers now receive amounts to pay for services rendered and should not be treated as capital gains.
The Joint Committee on Taxation estimates that closing this loophole would generate $15.6 billion over 10 years. Other tax experts predict far larger amounts. Polls show a strong majority of Americans are opposed to this unfair loophole —by 68 to 17 percent, according to Bloomberg News, and by 68 to 28 percent, according to Hart Research Associates. Democratic reform proposals have passed the House several times, only to fail in the Senate. The Carried Interest Fairness Act of 2015 (HR 2889/S 1689) represents the latest such effort.
Lawmakers are also pursuing actions to close the loophole at the state level through surtaxes on investment management fees. Connect legislators introduced such a bill on January 31, 2017 and their counterparts have introduced or are considering introducing such proposals in New York, Massachusetts, New Jersey, and Rhode Island as part of a regionally coordinated effort.
End the stock option accounting double standard
Current accounting rules allow companies to claim deductions for stock options that run much higher than the option value they report in their financial statements. The high deduction claim saves corporations on their taxes. The low valuation reported on financial statements inflates profits and raises share values, numbers that pump up executive “performance” rewards. In the 113th Congress Senators Carl Levin (D-Mich.) and SherSrod Brown (D-Ohio) included a provision in the Cut Unjustified Tax Loopholes Act (S. 268) that would require corporations to value options for tax purposes no greater than their financial statement book expense. In 2011, the Joint Committee on Taxation estimated this reform would raise $24.6 billion over 10 years.
Sarah Anderson directs the Global Economy Project at the Institute for Policy Studies and is a co-editor of Inequality.org.
5 Ways to End CEO Pay Subsidies is an article on Inequality.org.