NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Tax Policy Does Not Explain Option Growth

"Though inflation-adjusted salary and bonuses nearly doubled, the mean value of stock option grants has increased by 683 percent since 1980."

Since 1980, the cash component of CEO compensation has grown at an annual inflation-adjusted rate of 5 percent. The cash-plus-stock-option component has grown at a rate of almost 9 percent per year. The broadest measure of compensation, cash plus stock and stock option appreciation, has grown 11.5 percent per year.

The growth in CEO pay has been propelled by the increasing importance of stock options in executive compensation. Though inflation-adjusted salary and bonuses nearly doubled, the mean value of stock option grants has increased by 683 percent since 1980. For most top executives, the average stock option grant now exceeds salary and bonus combined. This implies that the link between CEO pay and firm performance is dominated by changes in the value of stock option holdings, not salary and bonus changes. For example, a 10 percent, change in the value of a representative firm may change salary and bonus compensation by about $25,000, but will increase the value of stock and stock option holdings by $1.25 million.

In The Taxation of Executive Compensation (NBER Working Paper No. 7596), Brian Hall and Jeffrey Liebman look at a sample of top executives from the largest publicly traded U.S. firms to determine the importance of tax policy in fueling the overhaul of executive compensation. They note that in 1980, the top personal tax rate was 70 percent; it fell to 50 percent in 1982, and was cut to 28 percent in 1988 following the 1986 tax act. Including the 2.9 percent Medicare surcharge, the top personal rate has now risen to 42.5 percent.

The top corporate tax rate was 46 percent before the 1986 tax act, 34 percent after the cut, and was increased to 35 percent in 1993. The same 1993 tax law also prohibited companies from deducting executive compensation in excess of $1 million unless it was performance related.

Although the 1986 Tax Reform Act sharply increased the tax advantage of stock options, the steady increase in top marginal tax rates already has eroded more than half of that advantage. At present, the authors estimate, non-qualified stock options have a moderate tax advantage over cash compensation on the order of $4 per $100 of compensation.

Another explanation for the dramatic increase in incentive-based pay is the rise in importance of bottom-line oriented institutional investors. Poor shareholder returns in the 1970s were followed by a wave of corporate takeovers in the 1980s and the percentage of shares owned by large institutional investors rose from 20 percent to almost 50 percent by 1994. This paralleled the increasing importance of stock options in compensation packages.

To separate the effects of taxes from the effects of changes in corporate governance on compensation packages, Hall and Liebman add information on the size and composition of corporate boards of directors and on the share of the firm's stock owned by institutional investors to their data on compensation and tax rates. They conclude that the observable effect of tax policy was modest at best, and that the rise in importance of performance-based pay is primarily attributable to nontax corporate governance factors.

-- Linda Gorman


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