Can Tax Regulation Curb Excessive Executive Pay?

Courtesy of Tobias Bornemann, Martin Jacob, and Mariana Sailer

For at least two decades, executive compensation has been widely discussed in public policy. Debates about inequality, risk-taking behavior, and excessiveness led to policy interventions – often by means of tax instruments – intending to control executive compensation. For example, back in 1993, the U.S. introduced section 162(m) of the Internal Revenue Code, which limited the tax deductibility of non-performance-based remuneration components. Moreover, in 2009, under the impression of the financial crisis, the U.K. implemented a bonus tax that was supposed to curb bonus payments; a measure which many believed encouraged excessive risk-taking. However, firms were able to circumvent these regulations easily by adjusting the composition of remuneration, and empirical research points out rather mixed successes.

In 2014, Austria introduced unprecedented reform intended to “counteract increasing income differentials”, as the Austrian legislator put it. The reform limits the deductibility of executive pay, applying to all pay components, which include fixed pay, all kinds of variable and equity-based pay, and pensions. Hence, the limit is unavoidable, unlike tax instruments of previous reforms in different countries. Since executive compensation is a tax-deductible operating expense at the firm level, the tax burden increases as larger parts of executive compensation become non-deductible.

In 2017, the U.S. Tax Cuts and Jobs Act (TCJA) implemented a similar deductibility limit along with numerous other tax-related changes, thereby making it harder to attribute potential effects to the introduction of a deductibility limit. However, the Austrian reform created a clean and unique setting to assess the consequences of limiting the deductibility of executive compensation.

The Austrian reform provoked opposing reactions. On one side, the Austrian Chamber of Labor praised the limit as a “first important step to implement appropriate executive remuneration.” On the other side, the Austrian Federation of Industries found the reform to be “harming Austria as a business location” and to be “raid-like”, since it was unforeseeable. The Austrian newspaper Der Standard harshly criticized the reform and called the deductibility limit of EUR 500,000 “arbitrarily chosen”.

The reform can be economically meaningful to firms. Tax payments by Austrian firms, as a share of average corporate taxes paid, can increase up to 4% after the law went into effect. The average executive board of Austrian companies consists of four members with an average salary of EUR 1,000,000. Since only EUR 500,000 of compensation per executive are deductible, this adds up to EUR 2,000,000 in non-deductible compensation per firm. Factoring in the Austrian corporate income tax rate of 25%, the typical firm faces an additional tax burden of EUR 500,000, or an additional 12.5% of the total executive board remuneration.

Our recent paper examines how executive board members’ remunerations evolved after the implementation of the deductibility limit. Hence, we are interested in the development of remuneration for executives in excess of the EUR 500,000 deductibility limit. In order to determine the effects of reform, we compare the growth of remuneration of affected executives to that of unaffected ones, whose compensation amounts to less than EUR 500,000. We also use wage development in three other European countries and the U.S. as external benchmarks.

Although there are differences in corporate governance regulations in all countries, Austria and the benchmark countries – Germany, France, the U.K and the U.S. – follow the OECD Principles of Corporate Governance. Thus, remuneration policies are comparable across these countries. We base our research on detailed data on executive compensation from 2012 to 2017 and individual executive characteristics, such as age and tenure. The sample period is naturally restricted due to legal circumstances in Austria, but we are able to rely on information from all listed Austrian firms that disclose pay data in their financial reports.

What does theory tell us about the effects of limiting executive pay? Two different outcomes are equally conceivable. On the one hand, the compensation of affected executives could decrease. If firms have more market power in the labor market for managers, they could share the additional tax burden with their executives. Previous research points out that executive compensation varies with their personal characteristics, which determine their individual firm fit and negotiating power. Hence, younger, or less experienced, executives could have lower market power, which enables firms to shift part of the tax burden to them. However, if contracts and remuneration were already optimal in the first place, firms could face weaker alignment of interests, which could ultimately result in lower executive and therefore firm performance. An optimal contract incentivizes an executive to provide effort so that firm performance is maximized with regard to (remuneration) costs. This risk might not exist if executives have been overpaid, or, in other words, extracted rents beyond optimal remuneration amounts. In this case, firms could share the tax burden with them and partly adjust compensation to the optimum level.

On the other hand, compensation could remain unaffected. This holds true if executives have higher relative market power in the labor market. That is, executives are so important for the firm, that they can simply not accept a cut in their pay because of corporate taxes. Prior research shows that firms are less likely to pass additional tax burdens to high-skilled employees, such as executive board members. In addition, even younger, or less experienced, executives could still optimally match a firm’s characteristics and the specific leadership tasks. Consequently, firms might not want to risk negative consequences, such as dismissals, when they do not provide a competitive wage level. In this situation, executive pay does not respond, and the intended goals of the reforms do not materialize.

In our analysis, we find strong evidence that the second case arises. Neither the amount nor the composition of remuneration of affected executives develops differently from their unaffected peers as a result of the deductibility limit. This means that incentive structures (fixed versus different kinds of variable pay) as well as the overall level of pay are likely not affected by the increased corporate tax burden. In comparison to the benchmark countries, we find that any possible change is attributable to a global compensation trend with lower salaries evolving quicker over time than higher salaries.

To obtain a differentiated picture, we also check whether our insights vary with personal executive characteristics, which could approximate varying degrees of market power. For this, we take a closer look at executives’ (non-CEO) status, firm experience, age (a proxy for general professional experience) and firm performance (a proxy for management success). We detect no differences, hinting at strong labor market power for executives and good executive/firm fits. We also consider the possibility for contracts to take longer to adjust to the new circumstances created by the deductibility limit. Hence, we check the compensation evolvement of contracts, which were concluded after the limit has already been in force. We again find no modifications in terms of amount or composition of executive pay. In addition, we test the evolution of compensation only for those executives who were board members for the entire six-year period from 2012 to 2017, to see if our results are robust for an unchanged sample. Again, we do not see any relative changes in compensation. From these results, we cautiously infer that executive board members do not bear the consequences of increased corporate income taxation.

If not executives, who bears the additional tax burden associated with deduction limits on executive compensation? The simple answer – shareholders. For example, firms may reduce capital investments and research and development (R&D) or decrease dividends. These countermeasures can be interpreted negatively by shareholders. Our findings suggest that firms reduce their cash holdings as a result of the higher tax burden, thereby reducing firms’ defenses against volatile markets and hostile takeovers.

Our findings suggest that intentional corporate tax increases via compensation deduction limits have no effect on the amount, or composition, of executive compensation. Rather, the effects of the deductibility limit are felt by shareholders. Our results are also informative for tax policy makers in other countries assessing corporate taxes as a tool to curb social inequalities.

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