The Terrible Things That Happen When Santa Claus Visits CEOs

This week marks the 20th anniversary of an epic boondoggle in US policy-making history. On Dec. 20, 1995, a tax rule went into effect that was supposed to rein in CEO pay. Boy, did it backfire.

That year, the gap between pay for large company CEOs and average workers ran 180 to 1. Today, it stands at 373 to 1.

How did this reform go so very, very wrong? The idea was to put a $1 million cap on corporate tax deductions for executive pay, with the idea that boards might be loath to send pay levels into the stratosphere if it meant a corresponding spike in their IRS bills. The problem is that the new rule, Section 162(m) of the tax code, included a massive loophole. The $1 million cap didn’t apply to so-called “performance pay.”

It wasn’t hard for corporations to rejigger their pay plans so that (voila!) most of the money became fully deductible. The more companies paid their CEOs, the less they paid in taxes. So why not deliver them even bigger boatloads of pay?

Meanwhile, the rest of us got stuck with the bill. American taxpayers who have seen their wages stagnate have been forced to subsidize the pay of those who sit atop the largest businesses.

According to a report we’ve just co-authored, this “performance pay” loophole allowed 10 US corporations alone to cut their 2014 tax bill by more than $182 million through CEO pay-related deductions. And this is just part of their total subsidy, since loophole applies to four top executives at each company.

One CEO was off the charts. McKesson CEO John Hammergren pocketed $112 million in fully deductible “performance pay” in 2014. This included more than $60 million in stock options and more than $50 million in stock and bonuses tied to performance criteria. That translates into a $39 million taxpayer subsidy for the pharmaceutical company, assuming a 35 percent corporate tax rate.

The stock-pay incentives created by this loophole have also played a powerful role in deepening wealth inequality. Fortune 500 CEOs collectively owned more than $270 billion of their companies’ stock, according to Center for Effective Government analysis of proxy statements. This represents $550 million in stock wealth per executive. In contrast, the median total net worth of the average American household is only $81,400.

Obamacare closed the performance pay loophole – but only for health insurance companies. Big insurers like UnitedHealth and Cigna can deduct no more than $500,000 in pay per executive, with no exceptions. The reasoning is that these companies should not pass off increased profits from the public program into the pockets of their executives.

But other companies that have benefited from the expanded pool of insured customers, including pharmaceutical firms like McKesson, are not subject to the same deductibility cap. That’s obviously nuts. But the real solution is to eliminate the perverse performance pay loophole for all firms.

The Joint Committee on Taxation estimates that eliminating this loophole would generate $50 billion in revenue over 10 years. Several bills have been introduced that would do just that.

Most recently, Senator Elizabeth Warren introduced the Seniors and Veterans Emergency Benefits Act, which would use revenue from eliminating the loophole to provide about 70 million seniors, veterans, people with disabilities, and others a one-time payment equal to 3.9 percent of the average annual Social Security benefit, or about $581. According to the Economic Policy Institute, 3.9 percent is the average raise received by CEOs of large US corporations enjoyed last year.

By closing this loophole, we could make progress toward creating a fairer society and generating funds that could be used for greater public purpose. After 20 years, it’s time to pull the plug on this policy disaster.