Changes in legislation provide interesting opportunities for natural experiments. Tax law is one of those fields where legislative changes occur on an annual basis and students quickly become aware of their inability to save money on used statutory supplements. This paper explores said opportunity to observe the effect of variations in tax law on the much-contested topic of senior executive compensation.
Since 1993, the deductibility of senior management salaries in public companies has been limited under section 162(m) for payments above $1 million. Section 162(m) was enacted with rising scrutiny on executive pay during the 1990s. At the same time, then section 162(m) contained an exception that allowed deductibility above the $1 million threshold to the extent the compensation was performance-based. This exception encouraged firms, once the $1 million cap was reached, to pay compensation based on performance via shares, stock options, and bonuses. This performance sensitivity in executive pay was viewed as shareholders-friendly as it was based on objective performance goals, approved by an independent compensation committee of the board, and encouraged managers to take more risk to achieve better financial outcomes.
Yet, the aftermath of the enactment of 162(m) indicated overall levels of executive compensation did not decline, but in fact increase, as did the proportion of pay that was performance-based. Post-162(m)’s adoption executive pay tripled over the next eight years— from a median of $2.9 million per year among S&P 500 CEOs in 1993 to $9.3 million (in constant, inflation-adjusted terms) among the same group in 2001—before slowing during the first decade of this century. This upward trend corresponded with rising grants of performance-based compensation, mainly via stock options. From this data it seems like section 162(m) did not create a churn in executive pay but actually achieved the opposite effect.
Critics contended the non-deductibility tax rule was not punitive enough to nudge market players to change their pay practices and was easily abused through based-pay exceptions. Some even suggested that section 162(m) essentially pushed executive pay higher by setting the $1 million level as the “reasonable” market norm. The tax change created an increase in option awards seeing traditional stock options qualified for the performance-based-pay exception to section 162(m). Such stock options were a predominant form of performance-based compensation because they were counted as costless under accounting rules and required no cash paid by the firm when granted. This form of back-door compensation was claimed to contribute to the deepening of the inequity gap in society. Yet, studies following section 162(m)’s enactment were mixed regarding its impact on salary growth rate. The causal relationship and whether changes in executive pay were a direct respond to the enactment of that tax rule remained inconclusive. The Tax Cuts and Jobs Act (“TCJA”) was enacted against this background.
In 2017, with no apparent warning, the TCJA surprisingly canceled the said exception for performance pay. The Act sneaked in an overall limitation on deductibility of compensation over $1 million paid to senior executives of public companies, regardless of the form of the compensation and whether it is performance-based or not. The media reported business leaders were up in arms. Public companies, such as Netflix, stated in the media (and in its public filing) that it is shifting its pay structure from performance-based bonuses to salaries as a response to these tax changes. This paper aims to appraise whether such statements by the industry were just rhetoric or do pay design choices are indeed influenced by tax considerations.
The Authors empirically examine the point when the rule changed and whether this variation influenced the practice of performance-based pay of senior executive compensation. Specifically, they ask whether firms shifted their pay to be less performance-based once there was no longer any tax advantage for performance-based pay. The study employs standard difference-in-differences technique comparing two similar groups, one subject to TCJA and the other not, and observing whether TCJA is correlated with differences in outcomes. Within these two groups the study isolated firms that paid federal income tax and those that did not. It restricted the treatment group to new CEOs who entered into contracts during the two-year post-TCJA period not constrained by existing contracts and a grandfathering rule. The study also acknowledges general stickiness and sensitivities with the firm data. For example, the fact that firms have different tax years and having to respond to a rule adopting mid-year. It also notes executive pay contracts caught in the middle of the section 162(m) change were not renegotiated due to practical realities (including the potential for grandfathering) and contracting lags.
Undeniably, as more time passes the influence of the change to section 162(m) will become more apparent as existing contracts expire. Thus far, the Authors find no evidence that firms changed their compensation practices in response to TCJA. Nevertheless, they do suggest that the tax change had a significant influence on smaller technical pay features. At firms with positive tax liability, where tax planning was most important, contracts after TCJA moved in the opposite direction from what tax planning would suggest: salary, total compensation, and performance pay were all up. The share of compensation paid as salary declined slightly at both kinds of firms but was well in line with pre-TCJA trends. These findings suggest that tax considerations revolving around 162(m) did not play a role in compensation design decisions during 2016-2019 period. The Authors hypothesize that other non-tax forces might independently drove compensation choices so that the removal of tax incentives with the TCJA did not change the decisionmakers’ pay calculation.
Still, the study reveals a more nuanced narrative by focusing on one particular detail of compensation design. Before the TCJA, salaries earned by managers in one year but not actually paid until retirement were always deductible by the company in the later year. Thus, careful tax planning allowed executives earning more than $1 million of salary to defer portions of the salary until after retirement. This was an end-run around the section 162(m) limitation. Congress attempted to close this loophole via the TCJA by applying the deductibility cap even to departed executives. The study found that firms indeed took advantage of the deferred compensation loophole and that TCJA was not fully successful in closing it. Before TCJA, the use of deferred compensation has been strongly correlated with executives who likely earn more than $1 million in salary. After TCJA, the data reveals that correlation vanishes, but another appears in a different context.
Accordingly, the Authors conclude that tax does not influence the arrangements between senior management and boards regrading pay and incentives design. Compensation decisions are determined by factors beyond tax such as increased transparency, shareholder pressure, path dependency, to name a few. Taxation does nudge firms to take advantage of subtle tax planning regarding elective deferred compensation arrangements and technical structuring of pay. Transparency and salience of those decisions to other constituencies are key factors. These results imply that lawmakers seeking to use tax policy as an influential social tool should increase its salience and make sure people are paying attention. Apparently, some conglomerates like Netflix noticed the change. This work is another testament to the importance of including tax advisors at the executive pay negotiation table (and actually listening to them) in order to maintain managerial alertness to significant tax changes.