Macey: Government Policy and Executive Compensation

Jonathan Macey is a law professor at Yale and a member of the Task Force on Property Rights at Stanford University's Hoover Institution. In, "Washington's Plans May Result in Even Higher Executive Pay," (Wall Street Journal, October 23, 2009) he writes

Executive pay has emerged, once again, as a major issue in Washington. This week Treasury and the Federal Reserve announced new regulations designed to oversee and limit executive pay at thousands of financial institutions. This is deeply ironic, because today's pay woes are the direct result of prior government intervention.

In 1992, Congress decided it would use the tax code to "improve" (i.e., reduce) executive compensation in publicly traded companies. Its vehicle was the Budget Reconciliation Act, a key provision of which became Section 162(m) of the Internal Revenue Code.

Noting that executive compensation levels had received negative "scrutiny and criticism" from the public, the new law targeted what it called "excessive employee remuneration." It did so by limiting the ability of public companies to deduct executive compensation for its top employees unless the compensation was paid out in a form that Congress found acceptable. Salary was bad. Stock options were tax favored.

Specifically, corporations were barred by law from deducting as a normal business expense any salary payments of over $1 million. Stock options, however, qualified for the corporate tax deduction without limitation. Much maligned today, stock options then were said to be "performance based" and therefore exempt from the new tax rules.

The new tax law immediately led to a tectonic shift in the way CEOs and other top U.S. executives were paid. Stock and stock options became the dominant feature of executive compensation packages.

In 1992, the government thought that managers were too risk averse. Stock options were seen as the magic bullet for making managers act more aggressively in the shareholders' interests. Today, many in Congress are blaming U.S. executives for causing the financial crisis precisely by engaging in "excessive" risk-taking. What they fail to mention is that it was Congress's own tinkering with the tax code that led to the very compensation packages that incentivized the risk-taking.

Fed Chairman Ben Bernanke asserted this week that "compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability." Mr. Bernanke promised that the government "is working to ensure that compensation packages appropriately tie rewards to longer-term performance and do not create undue risk for the firm or the financial system."