ceo pay

How to tame skyrocketing CEO pay

March 5, 2014: 10:43 AM ET

U.S. Congressman Dave Camp's tax reform plan could tighten a 1993 law that opened the floodgates.

By Steven Clifford

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FORTUNE – As part of an effort to revamp America's complex tax code, U.S. Congressman Dave Camp last week proposed to curb CEO pay by tightening a tax giveaway created in the 1990s. Perhaps unexpected for a Republican, Camp's plan would raise $12.1 billion in taxes over 10 years by prohibiting U.S. companies from taking income-tax deductions for their top executives' pay exceeding $1 million, even if it's based on performance.

Currently, laws exempt performance-based pay from the $1 million limit. The problem with that is it has encouraged companies to raise base salaries to that level and reward executives with options.

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Camp's proposal is a welcome move to help tame the ballooning CEO pay we've seen over the years. CEO pay began to escalate in the early 1980s, but salaries took off in big ways after the passage of the Omnibus Budget Reconciliation Act (OBRA) in 1993, which allowed unlimited deducibility of executive pay based on performance; at the time, President Bill Clinton signed it into law and it has been one of his greatest follies. In 2000, CEO pay was 383 times that of the average worker, compared with 123 times in 1995, according to a June 2012 study by the Economic Policy Institute.

During his 1992 presidential campaign, Clinton had promised to end unlimited tax deductibility for executives earning more than $1 million. He later softened his stance and capped deductibility at $1 million except for "performance pay." Once CEOs, compensation consultants, board directors and corporate lawyers caught on to the new law, they realized CEOs could be paid unlimited amounts so long as they could pass it off as "performance based."

One immediate consequence of OBRA was that many companies were forced to replace bonuses paid at the discretion of the board – subjective bonuses – with bonuses determined by rigid formulas. That's because, under IRS regulations, plugging objective data into a formula would qualify as "performance pay" no matter how absurd the result, but a discretionary bonus based on the board's after-the-fact subjective judgment will not. The mandate of blind objectivity proved far more remunerative for CEOs than discretionary bonuses had been.

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By restricting salary and requiring performance pay, the government inaugurated the mega-bonus era of the mid-1990s. Although long-term bonuses had been awarded to some executives as early as the 1940s, bonuses were not common enough to make a noticeable impact on median compensation until the late1950s. Between 1950 and 1970 bonuses ranged between 15% and 20% of current compensation, with no obvious trend. Today, the proportions are reversed. Salary is typically a small portion of CEO compensation, normally only 10% to 20% at larger companies.

Stock option awards almost always qualify as performance pay. Mega option awards and a booming stock market fueled the exponential growth in CEO pay between 1995 and 2000. In a 2011 paper, Kevin Murphy, professor of finance and business economics at the University of Southern California, wrote, "The explosion in stock options that led to the escalation in pay was in large part the (arguably unintended) consequence from government policy."  So let's hope Congressman Camp's proposal gains momentum.

Steven Clifford is retired CEO of King Broadcasting Company and has served on over a dozen private and public company boards.

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