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  The Tax Code Encourages Big Wall Street Bonuses

  
  

Jeffrey D. Korzenik,
02.04.09, 03:00 PM EST

Washington should dismantle the rules.

Our politicians have sharply criticized Wall Street's
bonus culture. President Obama has referred to the latest round of
industry bonuses as "shameful;" Sen. Dodd has demanded their return and
Paul Volcker pointed to this compensation system as a contributory factor in our current crisis.

What hasn't been
discussed is the way misguided regulation fostered these pay
arrangements in the first place. IRS Code 162(m) places strict limits
on the deductibility of certain executive salaries, a proscription that
has spurred short-term thinking and excessive risk-taking. We've
learned the hard way that Wall Street firms are particularly ill suited
for the type of culture that this rule encourages.

President Clinton followed through on campaign proposals to limit executive compensation,
signing into law the Revenue Reconciliation Act of 1993. Compensation
rules within the act became codified in IRC 162(m), which governs the
salary-based compensation of the top five executives within publicly
traded companies. The rule influences compensation by limiting the
deductibility of salary expense to $1 million for each of these
executives. Deductibility above that ceiling was permissible as long as
the excess came in the form of performance-based compensation, whether
cash bonuses or equity-based compensation like options (various
technical rules needed to be followed as well).

IRC 162(m) is
generally believed to be inconsequential because overall executive
compensation, even of individuals covered by the act, has largely been
unhindered. A few companies chose to accept the lack of deductibility
of large salaries, but most simply find other ways to compensate their
leaders. Over time, this has meant that executive pay has generally
become more skewed to deductible bonus and option grants. The fact that
deductibility limits were never indexed for inflation (which would have
added about 40% to the deductible salary amounts) has only exacerbated
this trend.

However, it is wrong to think this structural change
has no consequences. It is likely that, rather than limiting the
executive paycheck, the act has increased the average magnitude of that
pay to compensate for the uncertainties inherent in bonus and
equity-based formulas. Academic work done by James Wallace and Kenneth
Ferris suggested that option-oriented compensation is linked to higher
volatility of share prices and stingier dividends. It should be no
surprise that pay influences performance, not just through the size of
a paycheck, but through its shape as well.

Wall Street, in particular, is poorly served by IRC 162(m).
Pay based on equity options or bonus formulas using business metrics
like return on equity (ROE) and earnings per share (EPS) can lead to
decisions that are not in the long-term interests of shareholders, let
alone the general public. After all, these are businesses where the
easiest way to increase profits is to leverage up the balance sheet, promote proprietary products regardless of quality, churn accounts, etc.

Those
business strategies have become all too familiar to clients, regulators
and investors. None of this is to suggest that IRC 162(m) alone was
responsible--numerous market forces were at work, but clearly the bonus
culture of Wall Street played a role in blinding executives to the
risks their firms were taking.

more..http://www.forbes.com/2009/02/04/wall-street-bonuses-opinions-contributors_0204_jeffrey_korzenik.html