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Faculty Insights

After-Tax Compensation of CEOs Encourages Tax Avoidance

By Wisconsin School of Business

February 19, 2014

The U.S. tax code allows publicly held corporations to deduct compensation paid to top executives above $1 million only if this compensation is performance-based. As a result, corporations have been using more and more performance-based compensation to award top executives. In the large majority of cases, company performance is measured using accounting earnings. When companies structure contracts for their executives, one important decision is whether to compensate the executive based on the company’s pre-tax earnings or after-tax earnings. Presumably all investors care about is after-tax earnings, but we still find that a significant number of companies base their executives’ compensation on pre-tax accounting profits. For example, I found that 40 percent of companies in my sample compensate employees on a pre-tax basis.
Still, 60 percent of the companies I studied compensated their CEOs on an after-tax basis, and I suspected they were doing this as an incentive for the CEO to reduce the company’s tax burden. My analysis suggests this is true: companies that compensate their CEOs on an after-tax basis have a significantly lower effective tax rate. The puzzle, therefore, lies in why not all firms use after-tax compensation. The key is that tax laws can change in unpredictable ways, so after-tax compensation is inherently riskier from the CEO’s perspective. Thus, companies that use after-tax compensation must pay their executives more to compensate for the additional risk; otherwise, the executives would not accept these terms. What I predicted, and found, is that firms that base CEOs’ compensation on after-tax company profits also pay their CEOs more. This compensation is a premium for the higher risk inherent to after-tax compensation. For some firms, this increase in compensation exceeds the tax savings they would acquire, so these firms pay their executives based on the pre-tax profits of the firm.
It’s not clear whether companies are explicit about their use of this incentive (for example, by telling CEOs outright that their pay will be higher if they minimize the company’s taxes) or if the incentive is merely implied. Whether explicit or implicit, my results suggest that after-tax compensation does act as an incentive for CEOs to minimize their firms’ effective tax rate. As expected, my results showed that CEOs who were compensated on an after-tax basis received higher compensation overall, consistent with what we would expect. CEO compensation is generally difficult to study because publicly available information is limited; in my paper, which is forthcoming in Contemporary Accounting Research, I develop methods that others might use in the future to study this topic, thus making a methodological contribution as well.
Importantly, I found that companies that compensate their CEOs on an after-tax basis not only have a lower effective tax rate, but also actually pay less in taxes. What companies report to their investors is different than what they report to the IRS—for example, they might have made a large sale but not received payment yet. They won’t be taxed on the revenue from this sale until they’re actually paid, so they wouldn’t report the revenue to the IRS until they actually receive it, but they would want to report the sale to investors. Thus, there are two relevant sets of numbers relating to corporate taxes, and both are lower on average for companies that offer their CEOs after-tax compensation.
Let me be clear that tax avoidance is not the same as tax evasion. I am not alleging that the companies I study are doing anything illegal. This may indeed be happening in some cases, but in general, the behavior I study focuses on companies that use all the mechanisms available to them under the tax code to minimize their tax burden in a way that is perfectly legal.
It is well established in a variety of contexts that managers make choices to maximize the value of their own compensation. This study demonstrates the effect such compensation-maximizing has on corporate tax planning activities.