The tax bill that Congress passed on Monday (called, with customary inattention to truth in labeling, the “American Jobs Creation Act of 2004”) could have been a straightforward resolution of an unnecessary quarrel. Several years ago, the World Trade Organization ruled that U.S. tax reductions on earnings generated by exports violated its rules. After much backing and forthing, the European Union last year imposed retaliatory tariffs, carefully calibrated to have their greatest impact on goods manufactured in “red” states. The purpose of the new law is to remove the offending “tax subsidies” in order to bring an end to the EU levies.
The legal merits of the WTO decision can be debated, but, if the reasoning may have been wrong, the result was right. Government favoritism of goods produced for export over those for the home market are minor league “industrial policy”, leading only to distorted resource allocations and reduced wealth. Getting rid of them is in our best interests, not Europe’s. Instead of retaliating, the EU would have been cleverer to encourage the continuance of this subvention from the American taxpayers.
The simple option for Congress would have been an across-the-board cut in business tax rates to replace the export incentives. Our lawmakers do not, however, like simplicity, which limits their ability to get credit for handing out favors. Hence, AJCA is a heap of narrow rate decreases, credits and deductions, balanced by a slew of tax hikes and enforcement initiatives to achieve a zero net revenue loss for the feds. Among the money raisers is a set of new rules governing the tax treatment of unfunded deferred compensation, an area within my direct sphere of professional interest.
What is most interesting about the new rules isn’t their technical details, but the impulse behind them. As a source of revenue, they are trivial, scored by that Joint Tax Committee staff at $1 billion over ten years, a figure that is probably an overstatement. Under pre-AJCA law, a for-profit company’s naked promise of future compensation, backed by nothing by its own word, is not a taxable event. Until the promise is fulfilled, the company gets no deduction and the employee recognizes no income. Hence, these transactions are of virtually no financial interest to the U.S. Treasury. No matter when the compensation is paid, the employee’s income is usually offset by the employer’s deduction. The only advantage to the government from earlier recognition of income comes when the payor is in a lower tax bracket than the recipient. If, for instance, a corporation in the 34 percent tax bracket pays $100,000 to an executive in the 35 percent bracket, the former owes $34,000 less income tax and the latter $35,000 more. It’s in the government’s interest to collect the difference sooner rather than later, but the revenue effect isn’t dramatic. (N.B. The tax consequences are different if the payor is tax-exempt. There being no balancing deduction, the government takes its tax bite from the executive as soon as his rights are not contingent upon continued rendition of substantial services.)
At the moment, the top individual and corporate tax rates are an identical 35 percent. Next year, selected manufacturing corporations will pay only 32 percent. That differential means that discouraging the deferral of compensation will accelerate the government’s cash flow, if only to a paltry extent. I’m fairly confident, based on the tentative reactions of my own clients, that the effect will be even smaller than the Joint Committee projects. The new law penalizes a few gimmicks that have become popular in recent years (notably options with exercise prices below fair market value at the date of grant and “haircut” provisions that allow employees to elect early distribution of deferrals in exchange for forfeiture of part of the amount deferred) and eliminates a couple of shady practices (such as setting up “rabbi trusts”, supposedly subject to the claims of the employer’s creditors, in out-of-the-way jurisdictions where creditors may be unable to enforce their rights), but none of those features is essential to any company’s compensation planning. There’s no reason to anticipate that their demise will have much real impact on executives’ propensity to accept postponement of the receipt of pay.
If that is so, why did Congress go to the trouble of enacting “reforms”? An examination of the changes shows that they lack rational coherence, either as revenue raisers or policy tools. Some of their consequences are anomalous by any standard.
If a company promises an executive in 2005 that it will him $100,000 in 2010, with the proviso that he can elect an earlier distribution by giving up ten percent of his entitlement, AJCA will tax him in 2005 at a top rate of 55 percent, compared to 35 percent for current compensation. Why should income in prospect be taxed more heavily (especially that much more heavily) than income in hand?
Another oddity is the disparate treatment of stock options and stock appreciation rights. A stock appreciation right is economically indistinguishable from a stock option issued at the money, yet AJCA (or its legislative history, to be more precise) characterizes SAR’s as deferred compensation, bound by the new rules, while exempting options on employer stock. (Options on property other than employer stock are not exempt, again for no discernible reason.)
The more one looks at AJCA’s deferred compensation rules, the more forcefully it appears that they are not thought-out tax policy but a simple concession to envy. For years, deferred compensation packages, such as Richard Grasso’s at the New York Stock Exchange, have been targets of faux-populist outrage, not because of the minutiae of the arrangements but because they involve lots of money and therefore are assumed to be evil. That is, unfortunately, the mentality of many Congressional and IRS staffers. People who are rich enough that they don’t mind putting off payday need to be slapped in the face, and a 20 percent surtax is a satisfying slap. That the punishment bears no relationship to any offense and won’t actually be incurred by anyone (save the occasional unwary executive who tries to act without an expensive tax advisor) doesn’t make much difference.
Ineffectual posturing is more irritating than injurious. I’m grateful that Envy has such inept champions in the federal government. On the other hand, I’m annoyed that it has any influence at all. Don’t we elect conservatives to office in order to cleanse the government of the spirit of ressentiment?
Addendum: For those who would like to know the nitty-gritty, here is my concise summary of the new deferred compensation tax rules: