According to an interesting article, “The Executive Pay Cap That Backfired,” by Allen Sloan, published in ProPublica on February 12, not only did tax code Section 162(m) not achieve its intended goal, it actually backfired – or at least led to a counter-intuitive result.  But it did not backfire the way that you (and I) have assumed. It turned out, the author observed, “that it has had little or no influence on corporate behavior.”

The article reports that, in 1992, income inequality was, as it is now, a significant political issue, which lawmakers proposed to address by providing a disincentive in the tax code for executive comp that was too high. As adopted, Section 162(m) limited the amount that companies can deduct annually  to $1 million for each covered executive, but only for specified compensation—qualified performance-based compensation was excluded from the cap. And it turned out not to be too difficult to qualify a great deal of executive compensation, including options and incentive pay, as “performance-based” under the tax code.

To analyze the impact of Section 162(m), ProPublica and The Washington Postcommissioned a study that looked at the history of executive compensation for the top 50 members of the S&P 500, excluding 10 companies (some of which were big, high-tech companies) that were not reporting in 1992 (the year prior to adoption of 162(m)).  In 1992, only 35% of the covered executives were paid more than $1 million of income of the type subject to deductibility limits, compared with 95% in 2014. Given inflation, the article suggests, that’s not a big surprise.

What was a surprise was the following data from the study: “From 1992 to 2014, compensation per executive in the limited-deductibility categories rose more rapidly — by about 650 percent, to $8.2 million from $1.1 million — than compensation in categories such as stock options and incentive pay that aren’t subject to deductibility limits. The latter rose by about 350 percent, to $4.4 million from $970,000.” (Emphasis added.) That is, compensation that was subject to the tax limitation rose almost twice as fast as compensation excluded from the limitation.

Sidebar: I bet that’s not what you expected to read. While we all recognize that Section 162(m) was a disappointment to its proponents in that it did not curb executive compensation as intended, that result has typically been attributed to efforts to avoid the statute’s limitations by shifting comp from salary and other non-performance-based comp to option grants and other incentive pay that turned out to be even more valuable. The study showed quite the opposite, at least for the very large companies within the scope of the study.

As the author observes, these large companies appear to have “shrugged off the statute.” Why?  According to one compensation consultant cited in the article, compensation committees don’t make decisions on pay mix “guided by the deductibility factor….Compensation committees are certainly mindful of the tax rules and meet the deductibility rules when they can. But the decision on the pay mix that’s appropriate is guided by their companies’ unique circumstances.’” Moreover, the author posits that “losing deductibility isn’t all that big a deal to companies — we estimated the effect of lost deductibility on corporate profits at only about 0.2 percent in 2010 for the companies in [another academic] study [of over 7,000 companies]. And there’s no reason to think those numbers have changed much.” Cited in the article were the comments of Senator Charles Grassley (R-Iowa): “‘Regardless of how you feel about limiting compensation through the tax code, the current law is like a gnat on an elephant in accomplishing its goal. It’s easy to swat away, and that’s exactly what many companies do.’”

How did that happen?  As originally conceived, the article maintains, the tax disincentive legislation would have provided that no compensation-related tax deduction would be available for any employee comp if executive comp exceeded 25 times the comp of the lowest-paid employees. But, after public outcry – emanating mostly from the highly paid – that idea morphed into quite a different and much less ferocious animal.  Instead, Section 162(m) limited the deduction only for executive compensation  (and only  five — now four— named executives) and excluded any concept of relative incomes.

As the author suggests, “trying to legislate corporate behavior and economic fairness — however you define fairness — through the tax system is a lot trickier than it sounds.” The question remains, has anything changed?