Why Many People are Wrong about Executive Pay and the Corporate Tax Code

April 16, 2014

We recently outlined a bill introduced by Senator Patty Murray (D-WA), which would expand the EITC and pay for it in part by further limiting the deduction for executive compensation. The Senator believes that the ability for corporations to fully deduct performance-based compensation represents a massive loophole, and should be limited, much like the tax code currently limits the deductibility of cash-based compensation as a way to tax corporations more.

Not only is this bad tax policy, but it is misleading to call the current tax treatment of performance-based compensation a loophole. In fact, current treatment of cash-based compensation is more of an anti-loophole that overly restricts how much a corporation can deduct in business expenses. A neutral tax code that properly defines business income would place no restriction on how much a business can deduct in compensation.

Down to the basics, the federal corporate income tax is meant to tax corporate profits in order to raise revenue for the federal government. Corporate profits are defined as revenues minus costs such as compensation (executive or otherwise), raw materials, and state and local taxes. Any tax system that does not allow businesses to fully deduct their business expenses for the calculation of their taxable income, overstates income, taxes businesses on losses and artificially inflates their tax bill.

There are many places in which our tax code does not allow corporations to fully deduct their business costs. One of these places is in regard to executive compensation. In 1993, a law was passed as part of President Clinton’s first budget that limited the amount corporations can deduct in cash-based compensation to $1 million. In other words, the IRS only considers the first $1 million in executive pay to be a business expense, while to the corporation every dollar of compensation is an expense.

However, the limitation in current law does not apply to what is called “performance-based” pay. This pay usually means compensation in stock options, which is tied to how well a company and thereby the CEO is doing. By design, the bill created an incentive for corporations to shift from paying its executives in cash to stock options due to the fact that they could recover the full cost of that compensation as a business expense.

The remaining ability for corporations to deduct the full cost of compensation in stock options has been characterized as a large “loophole.” The latest such characterization comes from Vox.com’s Danielle Kurtzleben, who argues that this is the “biggest loophole ever,” and it cost the government $7.5 billion in revenue in 2012.

This characterization is extremely misleading and is a misunderstanding of what the corporate income tax is: a tax on corporate profits. The limitation created in 1993 can be thought of as an “anti-loophole:” a provision that overly restricts the amount businesses can deduct in expenses. The ability for corporations to deduct the full cost of performance-based compensation is where the law treats business expenses properly.

Tax treatment of cash-based compensation should be brought back in line with the treatment of performance-based compensation. This would correct a major flaw in the corporate tax code and move it closer to properly defining profits.

It is also important to remember that the full deduction for compensation—performance-based or otherwise—is in no way a tax shelter for this money. Although the corporation deducts the compensation from its taxable income, the CEO still has to pay income taxes on it. Someone is still getting taxed.

We do not all have to agree on whether executives are being paid too much, or are being taxed too little. However, everyone should understand that trying to limit their pay through the corporate tax code is bad policy. The corporate income tax is meant to raise revenue for the U.S. government, not to dictate who is paid what. 

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