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Executive Pay Curbs: Punitive or Progressive?

Earlier this week, I did a blog post for tax.com on the problems bedeviling Wall Street pay curbs. Here’s an expansion on that post, inlcuding some observations of the state of play among liberals talking about tax.

Executive Pay Curbs: Punitive or Progressive?

By Joseph J. Thorndike

Recent efforts to curb executive pay are facing some predictable problems. The return of the guaranteed bonus, highlighted in a recent New York Times article, is just one of many pitfalls. More generally, lawmakers are discovering (as they have in the past) that regulations designed to limit compensation are prone to failure.

In a recent blog post, Matthew Yglesias, a fellow at the Center for American Progress Action Fund, tries to explain the disappointing results of pay regulation:

you don’t get to be an important person in the world of finance without being really, really, really good at figuring out ways to pay yourself a lot of money. That’s what the field is all about. And it’s extremely difficult for the government to catch up with the ingenuity that can be deployed when people’s livelihoods depend on it.

This observation is hardly a revelation, at least to compensation experts. But Yglesias thinks he has a solution: don’t cap executive pay, just tax it.

Yglesias isn’t suggesting that we use the tax system to discourage excessive compensation, as the Clinton Administration did when it engineered the 1993 cap on deductions for executive pay not tied to performance (a reform that notoriously encouraged the explosion of stock, option, and bonus compensation). As history demonstrates, such techniques often prove wanting, or even counterproductive.

Rather, Yglesias is arguing for a more straightforward tax-based attack on excessive pay: higher rates. “The world of finance has been the main driver behind the growth in inequality at the extreme high end, and establishing additional tax brackets with higher rates would help lean against that trend,” he explains. He also endorses the Obama proposal for limits on itemized deductions.

Kevin Drum, blogging at Mother Jones, isn’t so sure that taxes are the answer. Taxes can help, he says, but they’re a “pretty broad brush.”

But that’s the point, isn’t it? Higher tax rates are more likely to effectively curb outsize pay because they apply a broad brush. Sure, avoidance will increase along with rates, so they are no progressive panacea. But that doesn’t mean higher rates will fail entirely to collect additional money from well-paid executives.

Back in the day, when statutory rates on the rich were really high (during World War II, for instance, when they reached 94 percent), effective rates on the top 1 percent of earners were pretty high, too (58.6 percent, according to historian Elliot Brownlee). Even after the war, effective rates stayed fairly high (in the low to mid 30s).

Eventually , Congress riddled the tax law with enough favors to force effective rates below 25 percent (they reached 24.6 percent in 1963). But it took a while: for almost twenty years, higher rates did their job. The broad brush worked until Congress plucked out most of the bristles.

When it comes to executive pay, then, the broader the brush, the better chance it will actually work. Problems creep up when policymakers start trying to make fine distinctions in the tax law. Nearly every tax rule contains within itself the seeds of its own avoidance. Try to target a tax provision narrowly — especially one designed to separate rich people from their money — and you almost guarantee failure.

Of course, broad rate hikes have a broad impact. In the case of executive pay, they would force rich people outside lower Manhattan to pay more, just like the bad boys on Wall Street. If compensation limits are just about punishing a few high-profile malefactors of great wealth (to steal a characterization from Teddy Roosevelt), then taxes aren’t the answer.

But if the real problem is gross inequality, especially in the midst of economic hardship, then taxes might actually get the job done. As Yglesias writes:

we actually have a well-established method of taking market distributions of income and trying to transmogrify it into a more just, useful, and welfare-enhancing deployment of social resources—taxes and public services … It strikes me as ultimately unlikely that the political process will be able to micromanage high finance in a way that strikes people as meeting the claims of justice. But the political process very much can collect tax revenues and use that revenue to finance things that we currently “can’t afford” like more widespread provision of health care services, better rail transportation, cleaner streets, more police officers, more and better pre-kindergarten, etc.

Yglesias has managed to illuminate an important issue dividing progressives today. Most liberals are more focused on punitive taxation than they are on progressive taxation. Liberal activists (with the exception of a few key organizations, like Citizens for Tax Justice and the Center for Budget and Policy Priorities) seem to regard taxation as epiphenomenal (as my dissertation adviser once put it to me). The important issues – labor organization, for instance, or anti-trust policy – take aim at the fundamental distribution of economic power. Taxes, on the other hand, simply reflect whatever distribution is currently in place.

As a result, many liberals start talking about progressive taxation (and especially higher rates) only when they have particular targets in mind: hedge fund managers, for instance, or bankers employed by bailed-out banks. This penchant for whipping boys is not new. Over the long history of American taxation, progressive reform has often been galvanized by the demonization of a few key figures. Like J.P. Morgan, Jr. in 1933. Or the famous non-payers of 1968 who jumpstarted a policy process that ultimately led to today’s AMT.

But the problem with narrow targets is that they are exceedingly easy to miss. Try to bring down a few evildoers (and no one else), and you’ll probably miss the mark. Worse, you’ll miss the larger problem altogether.

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This entry was posted on Thursday, August 13th, 2009 at 5:19 pm and is filed under Financial crisis, executive compensation, political culture. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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