NCPA - National Center for Policy Analysis

Stock Options And The Law Of Unintended Consequences

September 25, 2002

Allegedly "excessive" corporate compensation results mainly from tax law changes enacted during the Clinton Administration, says Bruce Bartlett.

Clinton claimed "excessive" compensation of corporate executives was the result of the full deductibility of wages on corporate tax returns, no matter how large.

  • As a result, the 1993 tax increase 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.

However, the legislation applied only to cash wages and exempted performance-based compensation.

  • The unintended consequence was an explosion in the use of stock options to compensate chief executives, because they did not count against the $1 million limit.
  • The Clinton Administration aided the trend toward stock options by helping torpedo a 1994 effort to require that options be deducted from corporate profits.
  • Another tax problem contributing to stock options abuse is that under current law, options that are indexed have less favorable tax treatment than those that are not.
  • Many economists believe that non-indexed options in effect 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. Unfortunately, current tax law effectively prohibits the use of indexed options. As a result, companies are forced to use a method almost guaranteed to foster abuse without benefiting shareholders at all.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, September 25, 2002


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