Executive Pay and Taxes

This article about the subject was written 5 years ago, but it remains relevant. All quotes that follow are from it.

The Internal Revenue Code was changed about 24 years ago while Bill Clinton was President to change the taxation of executive pay. Section 162(m), which applies to publicly traded corporations, limits the corporation's deduction for executive compensation to $1 million per covered individual, with an exception for "qualified performance-based compensation." That means things like stock options and stock appreciation rights. See the Components table at the above linked page.

After a few years Section 162(m) was criticized for its unintended consequences and encouraging the proliferation of stock options. "[B]oth academic and practitioner research has shown a dramatic increase in executive compensation, with little evidence that it is more closely tied to performance than before. ...   Seemingly tax-sophisticated corporations seem not to care about the restrictions on deductions and continue to pay nondeductible executive salaries." ... "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." It has "more holes than Swiss cheese." 

The deduction limit only applies to compensation to the CEO and the next three highest paid individuals. Bonuses, which would seem to offer the most direct way of rewarding performance, are not considered pay for performance under Section 162(m) and are thus subject to the limit. What sort of idea is that?

Executive pay was down significantly in 2008-10, but that was the Great Recession. Lower stock prices lead to both fewer options being exercised and the gain from exercising them less. Suppose an executive has an option with a strike/exercise price of $70. With the stock at $100 per share, the option gain is $30 per share. With the stock at $80 per share, the gain is $10 per share. A 20% lower stock price translates to a 66.67% lower gain on the option.

"The belief of this author is that executive compensation will recover in the near future, exceeding levels seen in 2007. Some of that increase will be in the form of deductible performance-based compensation, but the level of non-performance-based compensation will increase as well." His prediction was good. Stock prices have risen dramatically since 2012. The value of options rose more. Executive pay has probably likewise risen. (Witness the amount of talk about income inequality and income of the top 1%.)

See the graph of federal government revenues here. There is a strong correlation between stock prices and federal income tax revenues. Higher stock prices lead to more taxable income from realized capital gains and stock option exercises. (Bill Clinton is often given credit for reducing the federal deficit, but I believe most of the credit goes to the stock market.) I suspect the correlation is much stronger than the (negative) correlation between unemployment rates and federal income tax revenues. Media folks often assume the latter correlation is strong.