Professor Calvin Johnson at the University of Texas Law School (he has a fancy long title, but I'm being informal here) has been collecting ideas to put on the "shelf" for the government to use when it collects its senses about the need to get rid of tax loopholes that cause the Code to leak revenues like a sieve without bringing commensurable benefits to the nation. I don't agree with all of the suggestions, in part because I think rates should increase for those at the top of the income distribution and in part because I have concluded that the corporate tax should constitute a more significant portion of the total tax revenues raised. But every suggestion is worth considering, and a rationale conversation based on those suggestions would be a good start to the appropriate national dialogue that we should be having about tax policy and tax progressivity.
Johnson's most recent suggestion regards the tax treatment of compensatory options, those neat little giveaways for corporate executives that siphon value from equity holders while adding to the total "rents" that high level managers are able to extract from firms. Johnson suggests ending the exemption for performance-based stock options from the section 162(m) $1 million compensation deduction limitation. It is expounded in Corporate Meltdowns Caused by Compensatory Stock Options, 131 Tax Notes 737 (May 10, 2011).
I think this idea is a good one. Compensatory stock options were touted as a way to align managers' interests with shareholders' interests. It turns out that they give managers even more reason to juice up the value of the stock in "timely" fashion, in order to give themselves more pay at shareholders' expense. As Johnson notes, these options encourage riskier behavior, when we should be demanding more prudence. There is no good rationale for excepting them from the $1 million limitation. (It might even be that limiting the amount of deductible pay would cause shareholders to think twice about just how much they are paying their top managers as well. Paying top managers more for a calendar day than most of their workers get in a year of work is scandalous, yet it has become all too common these days.)
The following is the abstract for the article.
Tax contributes to high-risk investments that cause meltdowns when the high risk turns into losses. This proposal would end the exemption of compensatory stock options from the section 162(m) $1 million limit on compensation deductions. A CEO with stock options has an incentive to increase the volatility of corporate assets, because an option holder participates in gains but does not share in the losses from volatile corporate assets. However, high-risk investments hurt outside parties when they collapse. In some cases, the government has had to pay bailouts to prevent further economic meltdown. It is far better not to induce high risk in the first place.
This proposal would disallow the deduction of credit-risk interest that covers the risk of default. Because the credit-risk interest is an assessment of how likely it is that the debt will not be paid, it tracks the protection against loss that gives equity its option-like character. Risk is an equity-like feature of an instrument. Current law’s attempt to distinguish debt from equity is a quagmire. Disallowing the extra credit-risk interest is a gradual, fair, and administrable way to separate debt features from equity.
This proposal is made as a part of the Shelf Project, a collaboration among tax professionals to develop proposals to raise revenue by defending the tax base. It is intended to raise revenue without a VAT or a rate increase in ways that would improve the fairness, efficiency, and rationality of the tax system. The hard work needs to be done now to develop viable proposals. Shelf projects are intended to foreclose both 85 percent income tax rates and 60 percent federal sales taxes.