In 1993, Bill Clinton signed into law his first budget, which created section 162(m) of the Internal Revenue Code. The provision stated that companies could only deduct the first $1 million of compensation for their top five (later top four after changes by Bush's SEC) executives from their corporate taxes. The idea was to discourage companies from paying in excess of $1 million, as any additional compensation would be taxed. So why didn't it work?
According to a new paper from Temple University's Steven Balsam published by the Economic Policy Institute, the big flaw in 162(m) was its broad exemption of "performance-based" pay. The $1 million cap only applied to traditional salaries, bonuses and grants of company stock. Stock options (that is, stock grants that take time to vest and are meant to provide a performance incentive to workers) and other performance incentives are considered performance-based pay and are deductible even in excess of $1 million. So, unsurprisingly, businesses starting paying executives more in the form of stock options, such that fully 55 percent of deductible executive pay was "performance pay" between 2007 and 2010.
Interestingly, this increase didn't come at the expense of traditional compensation. Balsam found that non-deductible executive pay actually increased between 2007 and 2010, in spite of both the tax code limitation and the recession. As he put it, "seemingly tax-sophisticated corporations seem not to care about the restrictions on deductions." The people who should care, he argues, are taxpayers. While section 162(m) hasn't cut down on executive pay at all, it has reduced tax revenue by pushing corporations to reduce profits to pay their executives, which in turn reduces the amount of profits subject to the corporate income tax. He estimates that the rule lost at least $7 billion in 2010 alone and that more than half of that figure is due to the exemption of performance-based pay.