Wednesday, December 26, 2012
When the federal government wishes to change executive compensation practices it often attempts to do so through changes to compensation-related tax rules. These attempts to use tax policy to influence executive compensation – from Section 162(m) to the golden parachute provisions to more recent deferred compensation rules – have been routinely decried. This essay contends tax policy is generally ineffective in shaping executive compensation choices. 162(m) and 280G/4999 have either had no effect or perverse effects on compensation practices. Why have these kinds of tax interventions – the ones that try to optimize the pay-setting process between executives and boards – failed? Undoubtedly, there is a public choice explanation centered on political motivations and competence that is both popular and plausible. But the case for reforming executive pay through tax rules is even worse than that would imply. First, tax penalties pale in comparison with boards’ perception of the performance-related gains to be realized by either hiring the best (even if most expensive) executive or properly incentivizing that executive with a particular mix of compensation elements. This is partially due to the modesty of the tax penalties imposed to this point. But because even critics of executive compensation practices believe that there is substantial heterogeneity among firms regarding optimal compensation practices, tax levers are apt to remain weak in future attempts to influence pay-setting out of a fear of coercing firms to pay executives in inefficient ways.