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The law that failed to curb CEO pay, thanks to the biggest loophole ever

Oracle CEO Larry Ellison received $78.4 million in compensation last year — arguably enough for two of him (and then some).
Oracle CEO Larry Ellison received $78.4 million in compensation last year — arguably enough for two of him (and then some).
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Most workers who want a raise keep their expectations low: 3 percent, maybe — 5 percent might seem like pushing it. But just for fun, take your salary and multiply it by 331. If you're a more or less average American worker, you have now arrived in CEO territory. CEOs of S&P 500 companies make 331 times what the average worker at those companies do, according to new data the AFL-CIO. The union federation finds that CEO pay averaged $11.7 million in 2013 for 350 companies for which data were available.

It's no surprise that CEO pay is ultra-high. Everyone knows that. What's less well-known is that Bill Clinton once upon a time thought he could take on this problem. And so he inserted his idea into his first budget. Because budgets passed back then, that idea became law. And that law failed, thanks to a loophole that turns out to be big enough to drive a tens of millions of dollars through.

The statute in question is section 162(m) of the US Tax Code, which became law as a part of President Bill Clinton's first budget, in 1993. That section of the tax code says a company can only deduct only the first $1 million of a CEO's pay on its taxes, as well as the first $1 million for the next four highest-paid officers.

That sounds reasonable enough — using taxes to disincentivize higher executive compensation should, theoretically, cause businesses to rein it in a bit. But there's a huge loophole: 162(m) also says that performance-based compensation doesn't count. Performance-based compensation comes outside of regular pay including CEO's regular salary, and can include things like stock options — a form of compensation that allows a worker to buy stock in the company at a set price and during a specific time — as well as other kinds of incentive-based pay.

As Joe Nocera writes in the New York Times this week, the law was immediately exploited — some companies upped executives' annual salaries to $1 million and began setting low performance standards. Members of four major companies' compensation committees, speaking anonymously, told Businessweek in 2006 that the law was barely a stumbling block in their efforts to pay CEOs whatever they felt was appropriate. Since companies are free to define performance in different ways and change from time to time, it’s just not that hard to configure any pay package you want to be ‘performance-based

The loophole costs the government, as it turns out. A 2012 study from the liberal Economic Policy Institute estimated that the government posted a loss of tax revenue from this law. Because corporations were allowed to deduct the performance-based pay, the Treasury missed out on $7.5 billion. That said, the government did take in an additional $2.5 billion in revenues thanks to the law's restrictions.

All told, EPI estimated at the time that as of 2010, $27.8 billion in corporate compensation was deductible. In addition, the report estimated 55 percent of all corporate compensation between 2007 and 2010 was performance-based.

The $1 million cap doesn't appear to have done much to curb pay. According to AFL-CIO's numbers, CEOs earned less than 50 times production and nonsupervisory worker pay as of 1983. By 2003 it was around 300. However, the movement is not steadily upward, and in fact the gap has been shrinking; as of 2000, the ratio hit a high of 525, so it has narrowed considerably since then. Some declines in this ratio may have been due to the bursting dot-com bubble in the early 2000s, as well as the economic crisis, as Dylan Matthews has pointed out.

After more than 20 years, some politicians are still trying to change the law. Rep. Lloyd Doggett (D-TX) has introduced a bill called the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act. That bill would broaden the kinds of companies that fall under the jurisdiction of 162(m) and eliminate the exceptions for performance-based pay. Rep. Dave Camp's (R-MI) tax reform proposal put forward earlier this year would also eliminate that exception. However, given Congress' propensity for deadlock, there may be little hope for a brake on pay for the nation's top executives.