Squeezing the Balloon Once More, and Expecting a Different Outcome

Posted by Marc Hodak on January 23, 2015 under Executive compensation, Unintended consequences | 2 Comments to Read

Americans seemed, at least for now, to have reached their saturation point on direct wealth redistribution. So for those who still feel we have more redistribution to do, they are trying via the tax code.  A Democratic congressman has proposed to penalize executive pay if the company “fails [the] test of pay fairness.”  Specifically, if a public company fails to raise the average pay of its workers making less than $115,000 by a percentage equal to the overall US growth in productivity plus inflation, the government will eliminate the deductibility of top executive compensation above $1 million. What could go wrong?

Well, let’s look at a brief history of attempts to use the tax code as a vehicle for social engineering.

We begin with the tax on “golden parachute” payments in 1986. Executives being ousted in takeovers got big payouts, while many of the workers left behind got laid off. Very unfair. So the government imposed an excise tax on those “parachute payments” when they became “excessive.” They felt that such a tax would either limit the compensation or limit the deleterious M&A activity. How did that work?  Employment agreements began to proliferate for executives stipulating that shareholders pay the excise tax should it be triggered.  There were good business reasons for doing this. Given that this tax reimbursement was itself taxable, and the shareholders would be on the hook for that, too, the tax policy basically transferred a chunk of change from corporate treasuries to the U.S. Treasury. It didn’t affect the M&A activity.  And it left overall compensation largely untouched.

When the corporate critics saw what was happening with these excise tax “gross-ups,” they urged new policies to prevent these payments, or to shoulder them back onto executives as Congress had intended. And many corporations did implement these policies, and their executives successfully negotiated for other offsets, and the ridiculous complications that ensued now account for several pages in employment agreements whose net effect is close to nothing on overall pay, but significant expenses for shareholders.

In 1992, when $1 million CEO salaries were becoming the norm while the average American was experiencing a recession (very unfair), Congress put a cap on the deductibility of top executive pay above $1 million, with an exception for “performance-based pay”—the so-called §162m provision. The reaction to that tax, and the reaction to that reaction and so forth are now responsible for most of the harrowing complexity that executive compensation has become. Institutional investors, tasked with deciphering 30+ pages of pay disclosure, are crying out “why does it have to be so damn complicated!”  They can thank §162m. And the net effect on executive pay, on a size-adjusted, risk-adjusted basis, is close to nil. But shareholders’ cost of compensation is now much higher.

The initial corporate reactions to the law may have been unintended, but they were not unpredictable.  If you assume that the pay of the people at the top is arbitrarily determined, then simple-minded laws like 162m are bound to produce some surprises.  If you assume that executive pay, like all pay in the private sector, is the product of negotiations in a market for talent, and see ham-handed laws like 162m get implemented, you get exactly what you would anticipate.  When the left saw the logical impact of 162m, i.e., the shift of all pay increases to “performance-based” compensation, they said, “Those rascally corporations are getting around the intent of the law!”  They proceeded to push for additional rules to contain executive “greed” or “board capture” based on their original assumption about the arbitrariness of executive pay, triggering the next step in the cycle.

Democrats are now similarly assuming that all pay is arbitrarily, consistent with long-held union attitudes about compensation.  So, they expect that this law will either force shareholders to give raises to nearly everyone in the company in most years, or they will pay even higher taxes on their executive pay.  The former outcome will make sense if pay is arbitrary.  The latter outcome is just punishing corporations for having high earners.

So, what are the odds that public companies will raise everyone’s pay, regardless of how their company or sector is doing, based purely on a long-term, national average of productivity gains plus two percent?  Well, the question practically answers itself.  It’s far less costly for shareholders to eat the foregone tax deductions of executive pay.  The proponents of the bill would be fine with that.  The effect on CEO pay will be nil, but corporations will pay more, making this a populist way of increasing corporate income taxes.  But what if some corporations actually plot for a way to avoid having to pay that extra tax?  The best way to do that would be to aggressively cut pay for their rank-and-file in bad times, when they can get away with it, so the company has an opportunity to make up for it with tax-compliant raises in good times.  In other words, logical conclusion of such a law will be to leave top executive pay untouched, but to more pay variation, and possibly declines, in average worker pay over time.  Again, I don’t think that would happen at more than a handful of companies, but wherever it does happen, the left will be screaming about the unfairness of it, and proposing new restrictions on how companies can pay their people.

And the cycle will begin again.

  • Tony Bergmann-Porter said,

    Glad you’re back.
    I’d simply note that the two aspects of contemporary American life that seem to be utterly and completely FUBARed are Education and Health Care. And the FUBARation of said domains seems (to me at least) to have started with the involvement of the federales.

  • Short-term Myths » Hodak Value said,

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