San Francisco’s tax on CEO pay takes aim at inequality —

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Last week, voters in San Francisco passed a bevy of new taxes aimed at the top of America’s income brackets. The most striking is Proposition L, informally dubbed the “CEO tax.” By targeting businesses with highly paid executives and low-paid workers, it won approval with a resounding 65% of votes. That makes San Francisco the largest city to enact an idea long championed but seldom enacted in left-leaning circles: a corporate inequality tax.

“We were looking for revenue measures that clearly target the top of the economic ladder,” says Dean Preston, a member of the San Francisco Board of Supervisors, who supported the proposition. “There is an economic theory that has frankly driven this country for a long time: If you tax the wealthy folks, this hurts others. I don’t think that’s accurate.”

The tax applies to companies in which the highest-paid managerial employee earns 100 times more than the median worker in San Francisco. Businesses above this 100 to 1 threshold pay an extra surcharge on their gross receipts. The greater the inequality, the bigger the tax. The bill is expected to bring in between $60 million and $140 million per year, about 0.4% to 1% of the city’s annual budget.

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For large firms  (business with more than $1 billion in gross receipts and 1,000 employees nationwide, the tax is applied top  up to 2.4% of its city payroll expenses.

But the message, as much as revenue, appears to be the point. Entitled “Tax on Businesses with Disproportionate Executive Pay,” the bill drew deep support from figures across the city’s democratic party institutions. Its sponsor, supervisor Matt Haney, called it “a very simple, straightforward tax measure. Big companies that can afford to pay multimillion-dollar salaries every year can afford to pay more taxes.”

But the economics are not straightforward. This tax on inequality, as some advocates refer to it, is headed straight for a tangled web of executive compensation packages and tax codes. They’re structured in such a way that the tax may actually harm workers, without reining in high executive pay.

Without national, or at least state-level, enforcement of such provisions, the potential to dodge the tax is high. Yet economists, citing near-total inaction of the US government to rein in inequality, say it still may be worth a shot.

Mind the gap

Proposition L is a tax tailored to our times. The US is one of the most unequal countries in the developed world. In 2018, the top 10% of earners made 12.6 times more than the lowest 10%. That’s up from nine times more for the highest earners in 1980, found the Pew Research Center.

The trend is especially pronounced for executives. Since 1978, C-suite compensation has risen 940%, compared to 12% for the average worker, according to the Economic Policy Institute. That gives the US the highest ratio of executive to worker compensation (354:1) in the world, nearly twice the next closest country, Switzerland (148:1). The last time the US witnessed this level of inequality, Cornelius Vanderbilt and John D. Rockefeller were building their monopolies in steamships, railroads, and oil during the robber-baron era in the late 1800s.

The latest CEO tax is part of a decade-plus movement to narrow the pay gap. Tax reform after the 2008 financial crisis forced companies to disclose executives’ pay, empowering legislative attempts to rein in inequalities. A 2016 “CEO Accountability and Responsibility Act”  in Congress proposed increasing federal tax rates on firms with CEOs earning more than 100 times their median employee (corporations in the S&P 500 alone would have paid an additional $8 billion per year). At least six states considered similar measures.

None passed. But in 2016, Portland approved its own tax, the first major city to do so. It imposed a minimum 25% surtax on public companies with pay executive-worker pay ratios above 250 to 1.

So far, Portland has seen neither lower executive pay (nor businesses fleeing the city). That’s likely because the tax is too small to affect executive compensation for most companies: About 153 companies made median payments of just $3,900. But the real point, said former Portland city council member Steve Novick, was establishing a model. “It’s nice to have the money,” he said, “but the ultimate goal was to get a precedent other jurisdictions would follow.”

San Francisco is the next experiment. “Corporations can avoid the tax by simply paying their executives less or by raising their employees’ wages,” according to official ballot measure arguments mailed to voters.

But legal analysts argue taxes targeting inequality aren’t that simple.

“Executive compensation is incredibly complicated at the highest levels,” says Craig Becker, a tax lawyer at the Pillsbury Winthrop Shaw Pittman, noting that CEO pay often includes equity packages tied to stock prices and other performance milestones. “You could see people falling in and out of the ratio not due to any policy of the company, but because the market is up.” Since companies won’t know their pay ratios until the end of the year, it’s difficult to predict—and may incentivize creative accounting to avoid the appearance of high executive pay.

That may have unintended consequences for workers. If employers seek to reduce their tax exposure, they may refrain from hiring more seasonal workers (such as during the holidays), accelerate automation efforts, or relocate middle- to low-wage jobs outside city limits. Breann Robowski, another tax lawyer with the Pillsbury firm, predicted corporate behavior in the C-suite was unlikely to change: “Unfortunately, we’re not likely to see a change at the top end, but less hiring on the bottom end.” The industries most severely impacted by those changes might surprise you.

It’s not about tech

Despite San Francisco’s reputation for tech wealth, technology firms where median incomes can sit comfortably in the six-figure range are unlikely to be hit by the new tax. The city’s chief economist predicts just 17% of tax revenues will come from them, while retailers, hotels, and grocery stores are likely to pay more, according to SPUR, a Bay Area non-profit promoting good governance.

The largest share, in fact, will come from retail and finance, each of which is predicted to account for 23% of total tax revenues. SPUR estimates a company with a CEO who earns $13 million and workers with median salaries of $65,000 annually will owe $200,000 under the new tax scheduled to go into effect in 2022.

In many cases, the CEO pay ratio is the result of how a business is structured rather than C-suite salaries and bonuses. “This ratio is deceiving,” says Nick Mazing, head of research at the private equity research Sentieo. “Business models, even inside the same industry, dramatically distort the figures from company to company.”

Mazing points to the pay discrepancy for fast-food businesses: McDonald’s has a CEO-to-worker pay ratio of 1,939 to 1, while Dunkin’ Donuts’ parent company is just 42 to 1. The vast discrepancy is due to the franchise model. Fast-food employees at the donut chain are technically not corporate employees, but fall under the franchisee’s business, while McDonald’s workers are direct employees. The true difference in hourly wages for entry-level workers is less than $1.

“I think when most people hear about Prop L, they think it’s going to impact large, well-known tech companies,” says Jay Cheng  with the San Francisco Chamber of Commerce. “That’s not true. The companies who are going to bear the brunt of the tax are going to be hospitality, manufacturing, retail—the same industries who have been most impacted by the pandemic.”

The data bears this out. Public companies headquartered or operating in San Francisco with some of the highest CEO-to-worker pay ratios include McDonald’s (1,939:1), Levi’s (1,167:1), and Wells Fargo (550:1), according to government filings.

At the other end of the spectrum are tech startups like the fashion firm Stitch Fix (26:1), and Twitter and fintech company Square helmed by Jack Dorsey (both are less than 0.001:1). Stitch Fix’s CEO Katrina Lake earned $453,032 (compared to about $17,000 for its workers, many of whom are part-time), while Dorsey earned a combined salary of $4.15 between his two companies. Dorsey’s compensation is primarily equity: He sold $80 million of Square stock in 2018 adding to an estimated $10 billion net worth. Founders of Google and Facebook are paid through similar compensation schemes.

That has the potential to confound the tax’s purpose. “We absolutely respect the will of the voters,” added Cheng. “We’re not planning a legal challenge. But we are deeply concerned about the long-term economic impacts of Prop L and what it will do to worsen SF’s current unemployment crisis.”

What economists say

Kathryn Edwards, a labor economist with the nonprofit think tank RAND Corporation, says the big question about Proposition L is how it impacts the hiring incentives of companies. If the tax causes companies to hire fewer workers or let go of low-paid ones in order to keep down their ratio, then it probably won’t have been worth it. But it is also possible the tax will generate revenue for the city, while having little impact on hiring. That money can be used to improve public services.

Fundamentally, Edwards believes Proposition L is a response to the US federal government’s neglect of inequality. “[Local governments] have had to pioneer policies because of inaction at the federal level,” she said. “It takes guts to try and tackle a problem of this magnitude.” Proposition L is an experiment that we can learn from, she thinks, and if successful could be used at the state and national level. Edwards also thinks increases to the minimum wage, increased unionization, and stronger anti-discrimination practices would help fix the problem.

Even given federal inaction, some economists think going after CEO pay is an ineffective poor approach to solving inequality. Alex Edmans, an economist at the London Business School, argues in the Harvard Business Review that corporate boards structure CEO pay in ways that allow them exorbitant compensation without doing whats best for the company. He thinks that policies that improve corporate governance would be more efficacious than pay caps at delivering more reasonable CEO pay.

Gabriel Zucman, an economist at the University of California Berkeley, is one of the world’s leading researchers studying global inequality. Zucman is a co-director of the World Inequality Database, a repository of data on inequality that shows the top 1% of earners are gaining a larger share of income across most major economies in the world (pdf), including the US, China, and Germany. His work finds that tax policy is one of the reasons for the increase in inequality (pdf), with the richest people in the world paying less tax due to lower top marginal income taxes and the increasing use of tax havens.

Zucman sees Proposition L as a reaction to the increasing disparities between CEOs and the average worker, but thinks higher income taxes are the ultimate way to solve the problem. “Given the explosion of CEO pay, Proposition L is perfectly understandable,” Zucman told over email. “Perhaps this (and similar measures in other cities or states) will ultimately pave the way for changes in federal tax policy.”

The most effective way to regulate top-end inequality, he says: sky-high top marginal income tax rates to match sky-high income.

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