Taxation and Executive Compensation: Evidence from Stock Options

Andrew Bird is Assistant Professor of Accounting at Carnegie Mellon University Tepper School of Business. This post is based on a recent paper by Professor Bird. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

In light of rising income inequality and concern over government budget deficits, policymakers and the general public have become increasingly interested in increasing the progressivity of the tax system. The possibility and desirability of such a policy hinges critically on how high incomes, such as those of corporate executives, respond to changes in taxes at both the individual and corporate level. Further, a clear understanding of how taxes affect executive compensation can provide valuable insight into fundamental questions in both corporate and public finance. For example, the nature of the process determining executive pay is an area of much debate in the literature on corporate governance. Proponents of the board capture theory, such as Bebchuk and Fried (2003), argue that managers wield substantial influence in bargaining with boards of directors over their own pay. The magnitude of the compensation response to a change in tax rates yields useful information about the extent of this bargaining power.

These issues have come to the fore with the recent passage of the Tax Cuts and Jobs Act, a component of which was a change to Section 162(m) of the Internal Revenue Code. This provision, which originated in 1993, limited the corporate tax deductibility of executive compensation above one million dollars, but with an exception for performance-based pay. The recent tax reform eliminated this exception, thus removing the corporate tax deductibility of performance-based pay and so increasing the after-tax cost of using such compensation.

In Taxes and Executive Compensation: Evidence from Stock Options, I study a recent tax reform in Canada, which greatly increased the effective tax rate on stock option compensation for a subset of firms. Since this reform caused a similar change in the after-tax cost of compensation as the change to 162(m), it provides a natural experiment with which to study both broader issues of tax and executive compensation as well as to learn about the potential effects on executive compensation of the recent US tax reform. In Canada, stock options are typically taxed on exercise at favorable capital gains rates for the executive with no tax consequences to the firm. The firm and the executive can agree to “cash-out” the option, resulting in tax paid at ordinary personal rates by the executive with a tax deduction for the firm. However, for a particular type of option, a tandem stock appreciation right (TSAR), the firm could get the deduction at the same time as the executive got capital gains treatment. In 2010, the federal government eliminated this preferential treatment for TSARs, which effectively eliminated the corporate deduction for firms which had been using this kind of option, and so increased the effective tax rate on stock option compensation. From a research standpoint, this reform is very useful, relative to changes to 162(m), for example, in that it created variation over time in the effective tax rate on compensation for otherwise similar executives working at different firms.

To study the consequences of this reform, I collect a novel panel data set of compensation for the top five executives at 600 firms for the four years from 2008 to 2011. Difference-in-differences estimates, using executives at firms unaffected by the reform as a control group, suggest that this policy-induced tax increase reduced both stock option grants and the fraction of total compensation made up of stock options in the two years immediately following the reform. The point estimate suggests that option compensation fell, on average, by approximately the full value of the lost corporate deduction. The natural related question is the extent to which compensation was substituted towards other types of payment whose tax treatment did not change with the reform, such as cash bonuses. There is little evidence of any significant substitution response. Hence, the burden of the tax increase appears to have been substantially borne by the affected executives.

These results are useful inputs to models of the executive compensation-setting process, and the effects of possible policy responses to increasing income inequality. In particular, they imply that taxes, in this case on the firm, can have significant impacts on the form and level of compensation. The consequences for efficiency depend on whether compensation reflects bargaining over rents or the outcome of a competitive market. The observed decreases in compensation are consistent with the idea that executives are in a relatively strong bargaining position with respect to the board of directors. This is because such bargaining power would allow executives to capture the majority of the benefits of their employment, such as tax deductions associated with their stock option compensation; when such benefits are removed, their after-tax compensation must then fall. Furthermore, the significant impact of the reform highlights the importance of considering both firm- and personal-level tax incentives as key determinants of executive compensation (Scholes, Wolfson, Erickson, Hanlon, Maydew, and Shevlin, 2015). Specifically, my results suggest that the elimination of the deductibility of performance-based pay above one million dollars as part of the Tax Cuts and Jobs Act could lead to considerable reductions in executive compensation.

The complete paper is available here.

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