Friday, October 27, 2006
While the primary purpose of the Internal Revenue Code (the “Code”) is to raise revenue, certain provisions are clearly designed to promote some other social or economic policy goal. Most of these non-revenue-related provisions provide a subsidy through the tax code by granting a special deduction (exclusion) for payments (receipts) associated with the desired activity. The classic example might be the home mortgage interest deduction, which allows a deduction for an otherwise non-deductible expense. As a result of this provision, the government forgoes the extra tax that would have been owed in the absence of the deduction in order to subsidize the activity of borrowing to purchase owner-occupied housing. Professors Stanley S. Surry and Paul R. McDaniel termed this type of implicit government spending through the tax code as “tax expenditures,” and a whole wealth of literature ensued debating the relative merits of such indirect spending versus direct and explicit government grants.
On the other hand, some non-revenue-related provisions seek to influence social or economic behavior by penalizing undesirable behavior by denying a deduction for expenses related to the behavior that, under a normal income tax, would be allowed. These “negative tax expenditureS” increase the after-tax cost of the expense, thus making the undesired activity more expensive.
In 1993, Congress enacted one such negative tax expenditure, section 162(m), which generally disallows publicly-traded corporations a deduction for non-performance-based compensation in excess of $1,000,000 paid to the CEO and the next four highest paid executives. The explicit purpose of this legislation was two-fold: to reduce the amount of executive compensation and to influence the mix of executive compensation towards performance-based compensation. This paper evaluates the efficacy of section 162(m) under the two currently prevailing (but opposing) views of how executive compensation arrangements are negotiated in the publicly traded corporation context. Under one view (the arm’s length model), the corporation’s board of directors negotiate effectively on behalf of shareholders in setting management compensation. Under the other (the managerial power model), as a result of structural biases and other problems, the board is captured by management and is willing to overpay management, subject only to the constraint of public outrage. To minimize public outrage, the board and management collude to disguise and understate the true value of executive compensation.
Ultimately, I conclude that, under either model, the likely effect of 162(m) is to increase executive compensation and decrease shareholder wealth, though the effect is more significant under the managerial power model.