NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Does the Tax Code Influence CEO Compensation?

"The legislation consequently has had relatively little real impact on overall compensation."

Reacting to public and political scrutiny of high CEO compensation, Congress enacted legislation in 1993 to limit the corporate tax deductibility of executive pay. But a recent study by Nancy Rose and Catherine Wolfram indicates that this legislation had no significant effect on overall executive compensation levels.

In Regulating Executive Pay: Using the Tax Code to Influence CEO Compensation (NBER Working Paper No. 7842), the authors use data on nearly 1400 publicly traded U.S. corporations and examine the effect of "Section 162(m)," which limits the corporate tax deduction for compensation paid to the CEO and the next four highest-paid executive officers to $1 million per person. This cap represented roughly the median level of total compensation for large firms' CEOs at the time the legislation was enacted. Two exceptions are noteworthy. First, the limit applies only to the five named executive officers of the firm as of the end of the fiscal year. This creates the possibility of using post-retirement or deferred compensation to mitigate the effect of the tax limits. Some corporations have in fact restructured executive compensation to take advantage of this.

Second, Section 162(m) included an exemption for "qualified performance-based compensation." Firms may continue to claim tax deductions in excess of $1 million for compensation under shareholder-approved plans that link pay to objective measures of firm performance and are administered by a committee of "outside" directors on the Board. Three-quarters of all the firms studied by Rose and Wolfram qualified some type of compensation for this exemption, and roughly 40 percent of the firms affected by the pay cap qualified both bonus and stock options plans for exemption. Salary payments are considered non-performance-based by definition, and are therefore entirely subject to the $1 million cap.

Rose and Wolfram find that Section 162(m)'s limit on the deductibility of executive pay slowed salary growth and compressed executive salaries around the $1 million cap, but had little effect on bonus payments, stock option awards, and long-term incentive pay. The authors conclude that the legislation consequently has had relatively little real impact on overall compensation, and note that this is "consistent with the views expressed by many compensation consultants and corporate directors." This may reflect dilution of politicians' original intent to limit executive pay in the final legislation, and suggests that corporate pay decisions are better insulated from "blunt political pressure" than from direct stakeholder pressure brought to bear on individual firms.

-- Lucille Maistros


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