The Van Hollen Plan Takes on Soaring CEO Pay: A Debate We Need to Have

January 15, 2015

Taxpayers are subsidizing ever-larger executive pay packages while their own wages stagnate. For the middle class to prosper, that needs to change.

The intrepid economic proposals in Rep. Chris Van Hollen’s action plan “to grow the paychecks of all, not just the wealth of a few” may not win over a Republican Congress, but they will reinforce the progressive economic messaging championed by Senator Elizabeth Warren and conceivably embolden more Democrats to finally take command of our economic debate in advance of the 2016 presidential election. Though Van Hollen’s tax credits for working families and dilution of tax breaks for the rich have grabbed the most headlines, another controversial but important piece of his plan is the CEO-Employee Paycheck Fairness Act, which aims to address one of the key contributing factors to soaring inequality and economic volatility in the U.S.

The CEO-Employee Paycheck Fairness Act stops corporations from claiming tax deductions for “performance pay” for executives – e.g. stock options and stock grants – “unless their workers are getting paycheck increases that reflect increases in worker productivity and the cost of living.”

The logic of this law is simple. Since 1979, productivity growth in the U.S. has risen eight times faster than the typical worker’s pay. At the same time, corporations have enjoyed a tax deduction for CEO pay levels (and compensation for other top executives) that are now 296 times median worker pay. Van Hollen’s proposal says that corporations can no longer continue to take these unlimited tax deductions for CEO and executive pay unless they are also giving their employees a raise that reflects worker productivity as well as cost of living increases. Specifically, to enjoy the tax benefit, corporations must raise the average pay of their workers earning below $115,000 by the U.S.’s average annual net productivity growth since 2000, which is about 2 percent, plus the annual inflation rate.

Most of us think of skyrocketing CEO pay as an ethical problem, not an economic one. But in fact, the problems that come with skyrocketing CEO pay – in 2013, the average CEO at S&P 500 Index companies was worth $11.7 million – are well beyond the issue of basic fairness. Exorbitant CEO pay comes with enormous economic costs to all of us.

Many of the problems stem from the tax deduction Van Hollen is referring to, the notorious “performance pay” loophole created by Section 162(m) of the U.S. tax code. Section 162(m) prohibits corporate tax deductions for executive pay over $1 million unless that pay is rewarded for meeting performance goals. This was supposed to curb skyrocketing executive pay, but after it became law in the 1990s, the predictable happened: companies started dispensing more compensation that qualified as performance pay, particularly stock options. Median executive compensation levels for S&P 500 Industrial companies almost tripled from less than $2 million in 1992 to more than $5 million six years later, mainly driven by a dramatic growth in stock options, which doubled in frequency. For more background on this issue, I recommend my primer, “Understanding the CEO Pay Debate.”

Because it makes executives very wealthy, very quickly, performance pay is not only a major driver of the U.S. inequality problem, which in itself wreaks havoc on our economy, but also encourages shortsighted, excessively high-risk, and occasionally fraudulent decisions in order to boost stock prices. What kind of effect does this behavior have on the economy at large? Many economists argue that executive compensation policies in the financial industry led to the global economic crisis. Performance pay also diminishes long-term business investments. According to economist William Lazonick, in order to issue stock options to top executives while avoiding the dilution of their stock, corporations often divert funds to stock buybacks rather than spending on research and development, capital investment, increased wages, and new hiring. And the rest of us are footing the bill: the Economic Policy Institute calculated that taxpayers have subsidized $30 billion to corporations through the performance pay loophole between 2007 and 2010. Let me rephrase that: in a three-year period, taxpayers have subsidized $30 billion for executive pay, all while seeing their own wages stagnate.

Van Hollen’s proposal to make performance pay contingent on workers’ pay is good political messaging that draws attention to the ways in which executive pay practices impact middle class wages. And if we think about it in light of Lazonick’s story about stock buybacks, it’s clear how Van Hollen’s plan could have a positive impact: either corporations would not pay their workers more, which would preclude them from using a loophole that has shaped their executive compensation strategy for the last two decades and been a core driver of the rise in CEO pay, or they would have to spend money to raise wages that would have otherwise been spent on stock buybacks, which could reduce the amount of performance pay issued. In other words, the condition on which corporations could use the performance pay loophole might force them to use it less.

But there is also a potential drawback to Van Hollen’s CEO pay proposal. Because it doesn’t fully close the problematic loophole, but instead adds another condition, it may create further complexity in a corporate tax scenario that is already hyper-complicated and thus open to manipulation by corporate accountants. A more straightforward approach can be found in the Reed-Blumenthal and Doggett bills that would close the performance pay loophole entirely and cap the tax deductibility of executive pay at $1 million.

Another idea that would match the boldness of the financial transactions tax in Van Hollen’s action plan is to peg corporate tax rates to the ratio of CEO pay to worker pay. Last year, California state Senators Mark DeSaulnier and Loni Hancock introduced SB 1372, which raised the tax rate on companies that pay their CEO 100 times more than the median worker. According to the senators, “A CEO would have to make 300 to 400 times more than the median worker for a company to see a 3% increase in the corporate tax rate.” Companies with ratios less than 100 would see their tax rates decrease. DeSaulnier and Hancock’s bill got a majority of votes in the state senate, but did not move to the other chamber because, in California, a tax bill requires a two-thirds vote to advance. Nevertheless, the idea of holding corporations accountable for the relative amounts they pay their executives and their workers has been circulating in the U.S. Dodd-Frank already includes a requirement that companies disclose this pay ratio, though the SEC has been slow to put it into effect.

Van Hollen’s action plan is an exciting set of ideas for moving the country toward a more prosperous future. Ultimately, we need policy that erases the performance pay loophole entirely, but the CEO-Employee Paycheck Fairness is important in terms of drawing attention to executive pay practices and the way they affect working families and middle class wage earners, the engines of our economy. It’s time to have the debate about how we can effectively curb soaring CEO pay while building a broad middle class.