- The Washington Times - Wednesday, September 25, 2002

In recent weeks, the press has made much of the bloated compensation paid to corporate executives such as Dennis Kozlowski of Tyco and Jack Welch of GE. Mr. Welch was even forced by public opinion to relinquish benefits promised him six years ago, in order to calm a firestorm of controversy.

The impression is that most corporate executives are just a bunch of greedy SOBs, who fleeced shareholders in order to line their own pockets. In Mr. Kozlowski's case, this may be true, but in the vast majority of other cases, including Mr. Welch's, the problem, such as it is, results mainly from tax law changes enacted during the Clinton administration.

It is now largely forgotten that one of Mr. Clinton's principal campaign goals in 1992 was to curb "excessive" compensation of corporate executives. In his campaign book, "Putting People First," he complained that corporate CEOs were making 100 times that of average workers. This resulted, he said, because wages were fully deductible on corporate tax returns, no matter how large.

Mr. Clinton vowed to end this practice. In a rare case of being true to his word, he insisted that the 1993 tax increase include a provision limiting executive pay. As a result, the legislation 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.

But as is so often the case, the law of unintended consequences then took over. The legislation applied only to cash wages and exempted performance-based compensation. The goal was to avoid penalizing salesmen and those working on commission, for example. But the result was to fundamentally shift CEO compensation in ways Mr. Clinton never imagined.

As financial writer John Cassidy explains in the Sept. 23 New Yorker, stock options as a form of compensation have been around since 1950. In that year, Congress decided recipients of incentive stock options need not pay taxes on them until exercised. Shortly thereafter, the predecessor to the Financial Accounting Standards Board (FASB) decided that such options need not be counted as an expense on corporate books.

Nevertheless, stock options were a very small portion of executive compensation for the next 42 years. It seems that executives shunned them as too risky. They preferred cash on the barrelhead. But this changed in 1993 when Mr. Clinton's populist pay constraint was enacted. Subsequently, corporate boards searched for ways to compensate CEOs in ways that would not overburden the business.

Stock options were the answer, because they did not count against the $1 million limit. The result was that options, as a form of compensation, exploded. Even the liberal Mr. Cassidy concedes the reform "turned out to be counterproductive."

The Clinton administration aided the trend toward stock options by helping torpedo a 1994 effort by FASB to require that options be deducted from corporate profits. It did so under pressure from congressional Democrats such as Sens. Joseph Lieberman of Connecticut and Dianne Feinstein of California.

Another tax problem also contributed to the abuse of stock options. Under current law, options that are indexed have less favorable tax treatment than those that are not. Many economists believe nonindexed options are bad because, in effect, they 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 & Poor's 500 index of stocks or some other index. Only those executives whose stock prices rose by more than the index would benefit from stock options, rather than gaining largely from a rising tide, as is now the case.

Unfortunately, current tax law effectively prohibits the use of indexed options, as Columbia University law professor David Schizer recently explained in the University of Pennsylvania Law Review. As a result, the most sensible way of using options for compensation is foreclosed, forcing companies to use a method almost guaranteed to foster abuse without benefiting shareholders at all.

Consequently, there are growing calls to abolish the $1 million limit on cash wages. On Sept. 17, a blue ribbon panel from the Conference Board made such a recommendation.

Should such action be taken by Congress, it must also fix the problem that prevents using indexed options. This will go a long way toward eliminating truly excessive corporate compensation and ensure that CEOs are only given large rewards when shareholders benefit through above average stock increases.

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