Tax Caps on Executive Pay Are Ineffective, Says Professor Michael Doran

Former Treasury Official Argues That Executive Compensation Should Not Be a Tax Issue in His Latest Paper
Michael Doran
March 28, 2017

In the wake of an election season that featured anti-elitist rhetoric, proposals such as stricter taxes on executive compensation may sound appealing to some populists. In his new paper, University of Virginia School of Law professor Michael Doran evaluates whether such taxes actually work.

Doran’s article, “Uncapping Executive Pay,” to be published this spring in the Southern California Law Review, analyzes the effectiveness of section 162(m) of the tax code, which places a cap on executive compensation. Doran argues that caps such as section 162(m) are not actually effective.

Doran, the Roy L. & Rosamond Woodruff Morgan Professor of Law, has experience working in the U.S. Treasury Office of Tax Policy as well as at Caplin & Drysdale, where he specialized in federal tax law and pension law.

What is section 162(m) of the Internal Revenue Code? What purpose was rule 162(m) intended to serve?

Section 162(m) attempts to cap annual compensation to a company's most senior officers at $1 million each. Specifically, section 162(m) says that a public company cannot deduct more than $1 million of compensation paid to the company's chief executive officer and to the company's three other top executives. The limit does not apply to performance-based compensation or to compensation that is deferred until retirement. 

Different members of Congress were trying to achieve different goals with section 162(m). Some legislators wanted to reduce the total amount of executive pay; others wanted to bring executive-pay levels closer to the pay levels for rank-and-file employees; others wanted to link executive pay more closely to performance; and others wanted to end what they saw as a tax subsidy for executive pay. None of those policy objectives emerged as the clear winner, and section 162(m) is therefore something of a muddle. 

How has rule 162(m) fallen short of its authors’ goals?

Since Congress enacted section 162(m), executive pay has continued to increase, both in absolute terms and in relative terms (that is, relative to the pay of rank-and-file employees). Executive pay has not become more sensitive to corporate or individual performance. And at this point, many companies simply ignore the $1 million cap and pay non-deductible compensation to their executives. Although that raises about $1 billion in tax revenue for the federal government every year, the economic burden of that $1 billion falls primarily on investors, in the form of lower returns, and on rank-and-file employees, in the form of lower wages. In effect, section 162(m) punishes investors and workers for pay decisions made by directors and executives.

Why are you skeptical about tax code reforms that leave a cap on executive compensation in place?

Congress has tried several times to influence executive-pay practices by imposing various tax penalties on companies and executives. It is child's play to shift the burden of those penalties to investors and rank-and-file employees. None of the penalties has had a meaningful effect on the amount or the form of executive compensation. 

In the article, I show how an effective tax penalty could be made to work — and why it would be a bad idea. Congress could impose a confiscatory tax (equal to 100 percent) on whatever it considers excessive or inappropriate executive pay. Unlike the burden of section 162(m) and similar penalties on executive pay, the burden of the confiscatory tax could not be shifted. It therefore would actually cap executive pay. But that would have very undesirable effects. Talented women and men would avoid careers as executives of public companies, and more businesses would avoid organizing as public companies. In short, a hard cap on executive pay would create serious economic distortions.

You argue in favor of eliminating tax controls on executive compensation entirely. Why do you think that is a better approach?

Executive pay is not a tax-policy problem, and Congress should not address it through the tax law. Income inequality is a growing concern, but executive pay at public companies represents a small part of that problem. Congress can address income inequality much more effectively through robust progressive taxation. Additionally, some critics argue that current executive-pay practices represent a failure of arm's-length bargaining between directors and executives. If that is accurate, the right policy response is an intervention in corporate law — for example, an expansion of director liability for executive-pay practices that harm investors.

What are you working on next?

I am still plugging away at issues on executive compensation. I have a paper about executive pensions that will be published soon in the Tax Law Review. The conventional academic wisdom about executive pensions centers on two competing accounts. The first account argues that companies use executive pensions to align the interests of executives with the interests of corporate creditors (banks and bondholders). The second account argues that companies use executive pensions as a form of "stealth" compensation that shareholders cannot fully understand or evaluate. I challenge both those accounts. I show that taxes explain executive pensions at least as well as — or better than — either of the other two accounts. In my view, the conventional academic wisdom simply has missed the main point about executive pensions.

I am also writing a short piece on the proper treatment of executive pensions in comprehensive tax reform. Since 2004, I have been beating a drum for what I call "accrual-based" taxation of executive pensions. The idea is simple. Each executive would be taxed on his or her unpaid pension as that pension is earned. Accrual-based taxation is the right tax-policy approach, and it eliminates unintended tax advantages for executive pensions. My approach would not apply to pensions that cover a broad segment of the company's workforce, only the pensions that are exclusive to executives. I was pleased that the prior chairman of the House Ways and Means Committee adopted the idea in his draft of the Tax Reform Act of 2014. Congress should do the same in the upcoming tax-reform effort.

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