We have a straightforward proposal: Congress should allow firms to obtain tax deductions for incentive pay only if they award as much to the bottom 80 percent of their workforce as they do to the top 5 percent. Each year the government allows major public corporations to deduct the full cost of incentive pay schemes (such as stock options and other forms of compensation whose value depends on the performance of the firm and thus would otherwise be part of capital income), even when such plans cover only the most highly paid workers. This means that taxpayers subsidize billions of dollars in compensation for the country’s wealthiest corporate executives. By contrast, the government allows firms to deduct the costs of pension or healthcare systems as a cost of business only if the system covers nearly all workers. National policy should encourage incentive plans that offer an equitable distribution for nearly all workers rather than those that concentrate wealth among the very few.

When Bill Clinton and Al Gore campaigned for the White House in the early 1990s, they launched a populist attack on excessive executive pay, arguing that corporations should not be allowed to deduct salaries over $1 million to help them reduce corporate income taxes. After the election, Congress and the administration turned the proposal into law. But the law allowed corporations to get unlimited deductions if they paid the top executives in “performance-based pay” over and above their yearly fixed salaries. That permitted firms to design plans for profit-sharing, gain-sharing (where, for example, executives get a share of increases in revenues), grants of company stock and stock options—and to get unlimited deductions for the entire cost of these programs. Corporations do not have to prove that these plans improve performance. The plans can reward executives for performance that had nothing to do with their decisions—for instance, the economic recovery following the 9/11 attacks.

Has this deduction been costly to the public? You bet. The Treasury’s Office of Tax Analysis found that the number just for stock option deductions for all employees more than doubled, from $49 billion in 1997 to $126 billion in 2000. Using figures from Standard & Poor’s ExecuComp database, we computed that the stock option deductions averaged more than $50 billion a year from 2001 to 2007. Simply for the top five executives of public companies, our best estimates are that these deductions ranged from about $5 billion to $25 billion each year from 1992 to 2009, and more than tripled over this period—but a definitive IRS study is needed.

Studies of broad-based incentive systems show that when all workers are incentivized, company performance improves. Studies of incentives limited to those at the top show that executives take home huge sums without necessarily improving company performance.

Many of the country’s top-performing corporations—such as Silicon Valley firms like Intel and Google, and firms like Procter & Gamble and Wegmans Food Markets—have broad-based profit sharing and employee stock-ownership plans. Changing the tax system to induce other firms to adopt similar plans can improve the economy and assure that more workers benefit from incentive compensation. If public companies want to pay a narrow slice of their workers in this way, it is their right to do so—but taxpayers should not subsidize it.

See the entire policy proposal.

Read the next proposal in the “Reimagining Capitalism” series, “A Richer Shade of Green: The Wisdom of Sustainable Investment Funds,” by Leslie Christian.