In recent weeks, the press has made much of the bloated
compensation paid to corporate executives such as Dennis Kozlowski of Tyco
and Jack Welch of GE. Welch was even forced by public opinion to relinquish
benefits promised him 6 years ago, in order to calm a firestorm of
The impression is that most corporate executives are just a
bunch of greedy SOBs, who fleeced shareholders in order to line their own
pockets. In Kozlowski's case, this may be true, but in the vast majority of
other cases, including Welch's, the problem -- such as it is -- results
mainly from tax-law changes enacted during the Clinton administration.
It is now largely forgotten that one of Clinton's principal
campaign goals in 1992 was to curb "excessive" compensation of corporate
executives. In his campaign book, "Putting People First," he complained that
corporate CEOs were making 100 times that of average workers. This resulted,
he said, because wages were fully deductible on corporate tax returns, no
matter how large.
Clinton vowed to end this practice. In a rare case of being true
to his word, he insisted that the 1993 tax increase include a provision
limiting executive pay. As a result, the legislation denied a corporate tax
deduction for pay in excess of $1 million. With the corporate tax rate being
35 percent, in effect it cost corporations 35 percent more to pay their top
executives more than $1 million per year.
But as is so often the case, the law of unintended consequences
then took over. The legislation applied only to cash wages and exempted
performance-based compensation. The goal was to avoid penalizing salesmen
and those working on commission, for example. But the result was to
fundamentally shift CEO compensation in ways Clinton never imagined.
As financial writer John Cassidy explains in the Sept. 23 issue
of the New Yorker, stock options as a form of compensation have been around
since 1950. In that year, Congress decided that recipients of incentive
stock options need not pay taxes on them until exercised. Shortly
thereafter, the predecessor to the Financial Accounting Standards Board
(FASB) decided that such options need not be counted as an expense on
Nevertheless, stock options were a very small portion of
executive compensation for the next 42 years. It seems that executives
shunned them as too risky. They preferred cash on the barrelhead. But this
changed in 1993, when Clinton's populist pay constraint was enacted.
Subsequently, corporate boards searched for ways to compensate CEOs in ways
that would not overly burden the business.
Stock options were the answer, because they did not count
against the $1 million limit. The result was that options, as a form of
compensation, exploded. Even the liberal Cassidy concedes that the reform
"turned out to be counterproductive." The Clinton administration aided the
trend toward stock options by helping torpedo a 1994 effort by FASB to
require that options be deducted from corporate profits. It did so under
pressure from congressional Democrats such as Sens. Joseph Lieberman of
Connecticut and Diane Feinstein of California.
Another tax problem also contributed to the abuse of stock
options. Under current law, options that are indexed have less favorable tax
treatment than those that are not. Many economists believe that non-indexed
options are bad because, in effect, they reward executives for nothing when
the market as a whole is rising.
A preferable approach, economists say, would be to raise the
price at which options may be exercised according to a scale based on the
Standard and Poor's 500 index of stocks or some other index. Only those
executives whose stock prices rose by more than the index would benefit from
stock options, rather than gaining largely from a rising tide, as is now the
Unfortunately, current tax law effectively prohibits the use of
indexed options, as Columbia University law professor David Schizer recently
explained in the University of Pennsylvania Law Review. As a result, the
most sensible way of using options for compensation is foreclosed, forcing
companies to use a method almost guaranteed to foster abuse without
benefiting shareholders at all.
Consequently, there are growing calls to abolish the $1 million
limit on cash wages. On Sept. 17, a blue ribbon panel from the Conference
Board made such a recommendation. Should such action be taken by Congress,
it must also fix the problem that prevents using indexed options. This will
go a long way toward eliminating truly excessive corporate compensation and
ensure that CEOs are only given large rewards when shareholders benefit
through above-average stock increases.