A Deduction for CEO Compensation is Still not a Subsidy

September 22, 2014

Representative Chris Van Hollen (D-MD) has introduced a bill called the “CEO-Employee Pay Fairness Act.” This bill would prevent a corporation from deducting the cost of compensating CEOs if the corporation did not raise the wages of all employees that earned less than $115,000 by a specific formula based on inflation and productivity growth.

In his press release, he argues that the current tax code subsidizes CEO pay by “allow[ing] corporation[s] to deduct unlimited amounts of “performance-based” pay for executives regardless of whether their employees’ wages increase.”

This is a mischaracterization of a tax deduction and how the current tax code works. In fact, the current tax code limits the deduction for executive compensation, rather than subsidizes it.

The corporate income tax is a tax on corporate profits. The 39.1 percent corporate tax rate should apply to a corporation’s revenues, minus its costs. A large part of these costs to a corporation is its labor compensation for both typical workers and executives. For example, if a company has sales of $100, but spends $50 in labor compensation, the company’s profits are $50. The tax is applied to that.

A subsidy in this case would be a deduction that is larger than the actual cost of labor compensation. This would drive down taxable income and taxes paid, while the company’s true pre-tax profits would remain the same. Current law is not a subsidy.

In fact, current law goes in the opposite direction. Congress has previously limited the amount of compensation company can deduct for CEOs. Section 162(m) disallows any deduction for executive compensation that surpasses $1 million. The only exception is for performance-based pay: a company can deduct stock options that exceed the $1 million threshold.

What this means is that companies that pay executives more than $1 million in non-performance-based pay actually overstate their taxable income and pay taxes on more than their true pre-tax profits.

Representative Van Hollen’s bill would further limit the deduction by applying it to performance-based pay, pushing current law further from being a subsidy and even further from being neutral.

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