An Example of Reforming Beyond Tax Expenditures: Executive Compensation

Before leaving for August recess, Senators Jack Reed (D-RI) and Richard Blumenthal (D-CT) introduced S. 1476, which would end the ability of businesses to deduct any executive salaries over $1 million. Currently, regular salaries over $1 million cannot be deducted for the five highest-paid employees, but performance-based incentives are fully deductible, per section 162(m) of the tax code. According to Reed’s press release, the bill to expand this deduction limitation to cover performance-based pay would raise $50 billion over ten years.

Reed and Blumenthal refer to their bill as closing a “loophole” which is currently “subsidizing” corporate bonuses. In fact, however, the deductibility of executive compensation is not a tax preference or tax expenditure; it is a normal feature of the income tax system. The corporate income tax system taxes net profits, which means companies deduct business expenses such as employee salaries in order to calculate their taxable income. Rather, this deduction is what we called a “Non-Tax-Expenditure Base Provision” (NTEBP).

In the CRFB paper, “Beyond Tax Expenditures," we describe NTEBPs: provisions in the tax code that narrow the tax base and allow for a reduced tax burden but are not classified as tax expenditures and are not automatically eliminated under a "clean slate" exercise because they do not represent a divergence from a clean tax code. Although most NTEBPs represent sound tax policy and should remain in place, others may warrant reform.

Efforts to limit the deductibility of CEO income fall under one of the criteria we identified for determining if an NTEBP merits reform: if the NTEBP works against a public policy goal. In this case, the goal was reducing inequality. For that reason, the deductibility of performance pay has been limited since the Omnibus Budget Reconciliation Act of 1993

However, they left a broad exception: companies could still deduct executive pay over $1 million if it was performance-based and pre-approved by the shareholders. This exception was so wide that the law did little to discourage higher executive pay. In the 20 years since the provision was created, executive salaries have risen dramatically, with little evidence that it is more closely tied to performance than before. As Senator Chuck Grassley, then-chair of the Finance Committee, explained in 2006:

162(m) is broken. … It was well-intentioned. But it really hasn’t worked at all. Companies have found it easy to get around the law. It has more holes than Swiss cheese. And it seems to have encouraged the options industry. These sophisticated folks are working with Swiss-watch-like devices to game this Swiss-cheese-like rule.

The Joint Committee on Taxation, which recommended repealing the deductibility limits entirely on the last page of its report on the Enron scandal, noted that the tax rule was ineffective at limiting executive compensation and suggested addressing the inequality concerns outside the tax code. Still, if Congress chooses to keep the limit in place, closing the performance-based exception should help it be more effective.

The bill put forward by Reed and Blumenthal would aim to address these flaws by making performance-based pay above $1 million non-deductible just like regular pay, and by expanding the limit to all employees as opposed to just the top five. As policymakers continue to work to enact tax reform, policies like this should certainly be taken under consideration. A comprehensive tax plan to lower the rates, broaden the base, and reduce the deficit will require looking at tax expenditures and Non-Tax-Expenditure Base Provisions alike.