«A Tax Response to the Executive Pay Problem David I. Walker * Draft of February 7, 2012. Please do not cite without permission. TABLE OF CONTENTS ...»
A Tax Response to the Executive Pay Problem
David I. Walker *
Draft of February 7, 2012. Please do not cite without permission.
TABLE OF CONTENTS
II. THE EXECUTIVE PAY PROBLEM
A. The Magnitude of U.S. Executive Pay and the Increase over Time
B. Explaining Excessive Executive Pay
C. The Negative Consequences of Excessive Executive Pay
1. Who Bears the Cost of Excessive Executive Compensation?
a. Corporate Income Tax Incidence: Theory and Evidence
b. Is the Corporate Tax Incidence Analogy Sound?
2. Effect of Excessive Executive Pay on Corporate Investment
3. Infection of Other Executive Labor Markets
4. Impact on Growing Inequality of Wealth
5. Distortion in Executive Labor Markets
III. A TAX RESPONSE TO THE EXECUTIVE PAY PROBLEM: A SURTAX
A. An Overview of an Executive Pay Surtax and its Benefits
B. The Impact of a Surtax on Executive and Corporate Behavior
1. Executive Labor Supply and Income Elasticity
2. Incidence and Economic Effect of an Executive Compensation Surtax....... 27 a. Incidence
b. The Economic Impact of Surtax Gross Ups
3. The Creation of an Executive Pay Target or Focal Point
4. Avoidance and Other Responses
a. Compensation Design
b. Organizational Form
c. Career Decisions
IV. A TAX RESPONSE TO THE EXECUTIVE PAY PROBLEM: INVESTOR TAX RELIEF............... 40 A. Why Investor Tax Relief?
B. Investor Tax Relief Design Issues
1. Matching the Effect and Incidence of Pay Excesses
2. Protection against Surtax Gross Ups
* Professor of Law and Maurice Poch Faculty Research Scholar, Boston University School of Law;
Stanley S. Surrey Visiting Professor of Law, Harvard Law School. For their valuable comments, the author thanks Victor Fleischer, Dan Halperin, Louis Kaplow, Andrew Lund, Mike Meurer, Gregg Polsky, Stephen Shay, Fred Tung, Al Warren, David Webber, Chuck Whitehead and participants at workshops at the law schools of Boston University, Columbia, and Harvard. The author thanks William Becker for excellent research assistance.
A Tax Response to the Executive Pay Problem
3. Salience and Persistence
4. Other Issues
V. REGULATORY ALTERNATIVES
A. Coercive Regulation
1. What Coercive Regulation Might Look Like
2. Pros and Cons of Coercive Regulation (Relative to Tax)
3. The Inefficiency of Coercive Regulation Generally (Relative to Tax)........ 50 B. Enhanced Disclosure
C. Amend I.R.C. § 162(m)
Many observers believe that the executive labor market in the U.S. functions poorly. 1 At many public companies, senior executives exert excessive influence over the pay-setting process, and the outside directors who are charged with negotiating pay arrangements on behalf of shareholders lack the tools and incentives to bargain effectively. 2 Given the interconnectedness of the market, even well-governed firms must augment pay in order to attract and retain talented executives.3 The result, under this view, is systematic market failure with executives receiving more compensation across the board than they would in a well-functioning market. 4 This Article accepts the premise of market failure and considers potential regulatory responses. To the extent that commentators have focused on regulatory responses to date, their proposals generally have been aimed at improving the paysetting process by, for example, increasing board independence or giving shareholders greater influence over the process. 5 These are admirable goals, but this Article takes a more direct tack. After all, despite improvements in board composition and processes and in the transparency of executive pay disclosures, there has been no apparent slackening in the growth of executive pay.
This Article focuses specifically on the issue of excessive pay levels that result from deficiencies in the executive labor market.6 Excessive compensation is objectionable on several grounds. First, and most obviously, it strikes many as unfair that executives receive more compensation than they would in a well-functioning Lucian Bebchuk et al., Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. CHI. L. REV. 751 (2002); GRAEF S. CRYSTAL, IN SEARCH OF EXCESS (Norton 1991); Lucian Bebchuk & Yaniv Grinstein, The Growth of Executive Pay, 21 OXFORD REV. OF ECON.
POL’Y 2, 283 (2005); Lucian Bebchuk, Yaniv Grinstein & Urs Peyer, Lucky CEOs and Lucky Directors, 65 J. FIN. 2363 (2009); Lucian Bebchuk & Robert Jackson, Executive Pensions, 30 J. CORP. L. 823 (2005); Marianne Bertrand & Sendhil Mullainathan, Agents With and Without Principals, AM. ECON.
REV., May 2000, at 203 [hereinafter, Agents]; Marianne Bertrand & Sendhil Mullainathan, Are CEOs Rewarded for Luck? The Ones Without Principals Are, 116 Q. J. ECON. 901 (2001) [hereinafter, CEOs].
Bebchuk et al., supra note X, at 766-74; Bebchuk & Grinstein, supra note X, at 300-02; Bebchuk, Grinstein & Peyer, supra note X, at 2373-82; Bertrand & Mullainathan, Agents, supra note X, at 208.
Bebchuk et al., supra note X, at 840-42; Bertrand & Mullainathan, CEOs, supra note X, at 916, 929.
Bebchuk et al., supra note X; Bertrand & Mullainathan, CEOs, supra note X.
Lucian Bebchuk, The Case for Shareholder Access to the Ballot, 59 BUS. LAW. 43 (2003); Ran Duchin et al., When Are Outside Directors Effective?, 96 J. FIN. ECON. 195 (2010); Ronald J. Gilson & Reinier Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, 43 STAN. L. REV.
863, 873 (1991); Ira M. Millstein & Paul W. MacAvoy, The Active Board of Directors and Performance of the Large Publicly Traded Corporation, 98 COLUM. L. REV. 1283 (1998); Randall S.
Thomas, Improving Shareholder Monitoring of Corporate Management by Expanding Statutory Access to Information, 38 ARIZ. L. REV. 331 (1996); Robert C. Clark, Corporate Governance Changes in the Wake of the Sarbanes-Oxley Act: A Morality Tale for Policymakers Too (Harvard John M. Olin Discussion Paper Series, Paper No. 525, 2005), available at http://www.law.harvard.edu/programs/olin_center/papers/pdf/Clark_525.pdf.
Other commentators have focused on the impact of executive labor market deficiencies on compensation design. Bebchuk et al., supra note X, at 786-91 (arguing that executive compensation is structured to camouflage pay and limit outrage); Bebchuk & Jackson, supra note X, at 831.
A Tax Response to the Executive Pay Problem market, and excessive executive pay likely has contributed to the growing inequality of wealth in this country. 7 Second, from an efficiency perspective, one can think of excessive executive pay as an economic tax on investment in the corporate sector that inefficiently distorts capital allocation. 8 Recognizing the existence of a problem and coming up with an effective solution are two different matters, however. Most commentators have shied away from the idea of capping executive pay, and for good reason. Regulators do not have sufficient information to effectively cap executive pay without creating massive inefficiencies. 9 On the other hand, this Article argues that taxation might be a valuable tool for mitigating the adverse effects of excessive executive pay.
This Article proposes and analyzes a two-pronged tax response to the problem of excessive executive pay – the imposition of a surtax on executive pay in excess of a threshold combined with investor tax relief. If we assume that a surtax would have no impact on behavior, the imposition of a surtax would reduce the after-tax income of executives, which would directly respond to the unfairness of excessive pay. Investor tax relief would tend to reverse the inefficient distortion in capital allocation that results from excessive pay.
It would be a mistake, of course, to blindly assume that a surtax would have no impact on behavior, but this Article argues that distortions created by a surtax are likely to be minor. Evidence on the elasticity of executive labor supply and taxable income suggests that a modest surtax on executive pay would have little impact on hours worked. By these measures, an executive pay surtax would be a relatively nondistorting and efficient tax. However, experience with other tax penalties directed at executive pay – in particular the “golden parachute” tax – suggests that a portion of the surtax might be passed on to investors through increases in pre-tax compensation.
Any shifting in incidence would undermine the objectives of the surtax. There are reasons to think that executives’ ability to shift would be limited, and shifting could be mitigated by raising surtax rates, but shifting is a concern with a surtax proposal.
In addition, firms and executives might seek to restructure compensation to blunt the impact of the surtax. It is even possible that some public companies might go private or that private companies would be dissuaded from going public as a result of a surtax that was limited to public company executives. However, this Article argues that none of these concerns would be particularly serious or insurmountable.
Several forms of investor tax relief could effectively mitigate the inefficient distortion of investment that follows from the extraction by executives of excessive compensation. This Article considers both general and firm-specific relief targeted at the corporate and investor level. Given uncertainty as to who bears the cost of See supra note X and accompanying text.
See supra note X and accompanying text.
See supra note X and accompanying text.
A Tax Response to the Executive Pay Problem excessive executive pay and a variety of practical concerns, this Article argues that corporate tax relief would be preferable.
Of course, investor tax relief need not necessarily be linked to the imposition of a surtax on executive pay. Either regulatory response could be pursued independently.
However, this Article makes the case for a combined approach, principally because of the risk that a portion of the surtax could be passed on to investors. “Refunding” the surtax proceeds to investors would ensure that distortions in investment were mitigated, and not exacerbated, by the imposition of a surtax.
The two-pronged approach of this Article primarily targets symptoms of market failure – systematically excessive pay and its attendant distortions – rather than seeking to correct the underlying deficiencies in corporate governance, which have thus far proved to be irremediable. However, the adoption of these proposals would also send a powerful signal to managers and directors that could help to re-establish more reasonable norms regarding acceptable corporate behavior and pay practices. In this respect, the proposals that follow are aimed at the heart of the matter.
The remainder of this Article is organized as follows. Part II describes a conception of the executive pay problem that motivates the regulatory responses that follow and provides a basis for their evaluation. This Part lays out the negative consequences of excessive executive pay as well as the factors that purportedly result in market failure. Part III considers the first prong of a tax response – a surtax on executive pay – showing how a surtax would respond to the concerns associated with excessive compensation and demonstrating that the distortions created by a surtax would be minimal and manageable. Part IV takes up the investor tax relief prong of the proposal and is concerned primarily with the tradeoffs involved in designing investor relief.
Part V considers regulatory alternatives, with a particular focus on coercive regulation, such as pay caps. A considerable advantage of coercive regulation over the two-pronged tax response is that a pay cap is more difficult to avoid. However, the potential downsides of one-size-fits-all coercive regulation are simply too great for this approach to be seriously considered. The superiority of a combination of a surtax and investor tax relief as a regulatory response to the executive pay problem is reiterated in Part VI, which concludes the Article. In addition, this Part suggests that the arguments made in favor of a surtax could also be used to bolster the case for a very different regulatory reform that would not be addressed specifically at the executive pay problem, that is, increasing tax rates at the high end of the income distribution generally.
A. The Magnitude of U.S. Executive Pay and the Increase over Time Executive compensation in the U.S. is high in both relative and absolute terms, is economically significant, and has increased markedly during the last several decades.