Skyrocketing executive pay has become an increasingly important indicator of income inequality and has prompted questions as to what policy tools can rein it in. The Biden administration recently proposed to tackle the problem by prohibiting corporations from deducting salaries over $1 million for all their employees. Although this approach may be an improvement to the status quo, it has some drawbacks compared to the more straightforward option of just creating a new top income tax rate for very high-earners.
In 1989, the ratio of CEO compensation to median worker pay was 59:1. By 2021 this had risen to 399:1. Much of this has been driven by the growth in stock-based compensation for executives, which now makes up the vast majority of executive pay. Yet despite the “performance-based” incentive of stock-based compensation, these higher paid executives have not necessarily brought higher value to companies they lead. One study found that the rate of return on $100 put into companies with lower-paid CEOs surpassed those with higher paid ones, $367 to $265.
As this issue garners more attention, many proposals have popped up to address it through the tax code. In last week’s FY25 budget, the Biden administration offered their own solution, proposing to expand section 162(m), a 1993 provision that reduced corporations’ ability to deduct certain high salaries from their corporate taxes. This provision currently prevents companies from deducting compensation over $1 million dollars for their five highest-paid executives. The administration’s proposal would extend this to all employees making over $1 million, and extend the eligibility to all corporations, not merely publicly traded ones.
Since its passage, the provision has in practice done little to address the growing pay of corporate executives. However, it has succeeded in subtly increasing the effective tax rates of those executives by imposing what is essentially an employer-side payroll tax on covered employee salaries. Because this tax is passed on to the employee in the form of lower earnings, covered workers face an effective top marginal tax rate of over 50% under current law (the 21% corporate income tax plus a 37% tax rate on the remaining 79% of their compensation in excess of $1 million). In conjunction with the budget’s other proposals to raise the corporate income tax rate to 28% and the top individual income tax rate to 39.6%, Biden’s approach would raise the effective top marginal tax rate on compensation over $1 million dollars to 56.5% — a massive increase over the status quo and close to the revenue-maximizing level.
Hiding such a large tax increase on high-earners in the corporate tax code may be more politically advantageous than doing so outright through a change in the ordinary income tax code, but it comes with some drawbacks. The proposal would expand the provision for only employees at C corporations like Amazon or Walmart, leaving out many high earners working at pass-through businesses like law firms or hedge funds. These types of businesses make up 95% of all businesses in the United States, yet would not be subject to the provision since they pay no corporate income tax. This would give a tax advantage to many high-earning professionals in consulting, finance, or law, where firms are less likely to be structured as C corporations.
In addition, it is also not apparent from their details whether the proposal would expand an existing provision for highly paid nonprofit executives that requires tax-exempt organizations to pay an excise tax equal to the corporate rate for their five highest paid employees. This risks creating a situation where an employee of a nonprofit or pass-through making $2 million a year is taxed at a 39.6% top rate, while a corporate employee making the same salary will be taxed at a top rate of 56.5%.
Creating a 56.5% bracket for incomes over $1 million would do a better job of taxing highly compensated corporate executives without section 162(m)’s uneven impacts. This option could raise substantially more revenue for progressive policies and avoid imposing an uneven system that only targets certain businesses or sectors.
If the politics are such that expanding section 162(m) is possible while significantly raising ordinary income tax rates is not, doing so would be an improvement over a status quo that chronically under-taxes the rich. However, the administration must take additional steps to address the distortions it would create and recognize that there are only so many ways to tax the rich before having to turn to other sources of revenue for a progressive agenda.