The Executive Compensation Controversy - Fondazione Rodolfo ...

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THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISthought have emerged. The first is the “managerial power” view exemplified by Bebchuk,Fried and Walker (2002) and Bebchuk and Fried (2004a), in which powerful CEOs extracthigh levels of compensation from captive boards of directors. The second is the “efficientcontracting” view in which the increase in pay reflects changes in the managerial labormarket caused by changes in the distribution of company size (Gabaix and Landier (2008)) orthe increased prevalence of hiring CEOs from outside the firm rather than promoting fromwithin (Murphy and Zábojník (2007)). We will return to a discussion of the debate and asurvey of the related literature below in Section 2.4. But, as evident from Figure 2.3, anycompelling theory of trends in CEO compensation must address explicitly its most prominentfeatures: the escalation in stock options from the mid-1980s through 2001, and the emergingdominance of restricted stock.In the rest of this section, we will show how the trends in equity-based compensationcan be traced in large part to USA tax policies, accounting rules, and politics, having little ornothing to do with either managerial power or changes in the managerial labor market.2.4.1. The Rise (and Fall) of Restricted Stock Options (1950-1969)While a modest number of companies issued stock options during the 1930s and 1940s,America’s fascination with stock options began in earnest with the Revenue Act of 1950.Prior to the Act, the gains from exercising stock options were taxed as ordinary income to theindividual, and deductible as compensation expense to the company. The 1950 Act created anew type of options called “restricted stock options” that would be taxed as capital gains(rather than ordinary income) not upon exercise but only when the shares acquired throughexercises were ultimately sold. While these capital gains were not deductible by the firm as acompensation expense, the spread between the tax rate on ordinary income and capital gainswas sufficient to make the new options highly tax advantageous. In particular, in addition tocreating restricted stock options, the Revenue Act of 1950 increased the top marginal tax rateon ordinary income to 91% while increasing the top corporate tax rate to 50.75%. 33 Giventhese rates, it cost investors approximately €5.47 in after-tax profit to convey an incremental€1 in after-tax income to the CEO through cash salaries (or “non-qualified” stock options33 Under the Revenue Act of 1950, the top individual rate of 91% was triggered at income levels exceeding$200,000; the top marginal rate was 90% for income between $150,000 and $200,000 and 89% for incomebetween $100,000 and $150,000. Fryman and Saks (2008) estimate that the median corporate CEO earnedabout $150,000 in 1950, putting the median CEO at or near the top bracket. The top corporate rate of 50.75%was effective for corporations with over $25,000 in taxable income.-27-
THE EXECUTIVE COMPENSATION CONTROVERSY: 24 MAY 2010A TRANSATLANTIC ANALYSISupon exercise). 34 In contrast, at the 25% tax rate on capital gains, it cost investors only €1.33to convey €1 in after-tax income taxable as long-term capital gains (even though such gainswere not deductible by the firm as a compensation expense).The passage of the 1950 Act launched a predictable wave of new option plans. In 1950approximately 4% of the companies listed on the NYSE had option plans for their topexecutives; by June 1951 the number had tripled to 12%. 35 In their study of the fifty largestfirms in 1940 and 1960, Frydman and Saks (2008) estimate that the fraction of executivesholding stock options in the increased from less than 10% in 1950 to over 60% by 1960.Grant sizes also grew: the grant-date value of options for those executives receiving optionsincreased from about 10% of total compensation in the early 1950s to over 20% of totalcompensation by the early 1960s.During the 1960 recession, companies began “repricing” options by either resettingexercise prices or by canceling existing options and replacing them with new options withlower exercise prices. This practice became highly controversial in the early years of theKennedy Administration, leading to a series of Congressional hearings aimed at repealing thefavorable tax treatment for restricted stock options. 36 The controversy intensified in late 1963and early 1964 when it was revealed that executives at Chrysler had realized $4.2 million ingains from exercising stock options in 1963, and had sold nearly 200,000 shares acquiredthrough earlier exercises. 37 Ultimately, as part of the Revenue Act of 1964, Congress stoppedshort of removing the favorable tax status of restricted stock options, but took several stepsthat substantially reduced their attractiveness. In particular, under the new law:34 At a 91% tax rate, the CEO must receive €11.11 before tax to realize €1 after tax. But, at a 50.75%corporate tax rate, paying €11.11 in deductible compensation costs reduces after-tax profits by €5.47.35 Mullaney, “Parley Here Indicates the Continued Spread in Industry of Stock Purchase Option Plans,” NewYork Times (August 12, 1951), p. 109. The percentages are based on average of 840 NYSE-listed firms in 1950and 876 in June 1951.36 “Options on the Wane: Fewer Firms Plan Sale of Stock to Executives at Fixed Exercise Prices,” Wall StreetJournal (December 6, 1960), p. 1; “Congress and Taxes: Specialists Mull Ways to Close “Loopholes” inPresent Tax Laws,” Wall Street Journal (January 7, 1959), p. 1; “House Group Hears Conflicting Views onStock Option Taxes,” Wall Street Journal (December 8, 1959), p. 16.37 “Chrysler Chairman Defends Option Plan, Offers to Discuss It With Federal Officials,” Wall Street Journal(December 23, 1963), p. 6; “Chrysler Officers Got Profit of $4.2 Million On Option Stock in '63,” Wall StreetJournal (January 15, 1964), p. 6; “Chrysler Officers' Sale of Option Stock Could Stir Tax Bill Debate,” WallStreet Journal (December 18, 1963), p. 1; “House Unit Seen Favoring Curbs on Stock Options,” Wall StreetJournal (February 25, 1963), p. 3; “Senate Unit Votes to Tighten Rules on Stock Options,” (January 15, 1964),p. 2.-28-
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