Tax Analysts Blog

Capping Compensation: Good Economics or Pitchfork Populism

Posted on Sep 8, 2009

G20 finance ministers meeting in London last week agreed to continue developing proposals to the limit the pay of finance executives. And the topic will be on the agenda when their bosses meet in Pittsburgh on Sept 24-25.

This a hot button issue that probably gets more air time than it deserves. Some people consider it a distraction from more important aspects of financial regulatory reform. And U.S. Treasury Secretary Geithner is right to try to keep the focus of international coordination on raising capital requirements.

Yes, public outrage about lavish bonuses at moribund financial institutions is powerful motivation for politicians to take action. But from a policy perspective it is a little dicey. If shareholders want to pay their stockholders their amounts, why should the government intervene? Who is going to play God and tell us which work lacks social merit?

The emotion-charged arguments about executive pay are about its level. There is a whole other line of thinking about executive pay that focuses not on the level but the form of compensation. This policy approach to executive compensation is solidly grounded in economics. The arguments runs like this: finance exec receive performance-based compensation in the form of stock option and bonuses based. This type of compensation is bad for the economy because it encourages companies to take excessive risk. Downside losses are limited. And performance measures are tied to short-term indicators. Because of the systemic risk to the overall economy, and because the government must bail out large failing financial institutions, the government has a good case for intervention.

Sadly, the tax code has contributed to the problem. Section 162(m) became law in 1993. It capped business deductions for executive pay at $1 million, except for performance-based pay. The cap on deductions satisfied populist yearning to take high-flying executive down a peg. But the exception to the cap is a policy disaster. It encouraged the establishment of compensation packages that rewarded risk--exactly what we don't need if we wish to avoid another financial crisis. As part of the bailout legislation, Congress put limits on pay for financial firms that receive federal financial assistance. Some members of Congress want to strengthen limits on the deductibility of pay across-the-board and get rid of the exceptions that encourage risky behavior. That's an idea that both conservatives and liberals should endorse.

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