Tax-code changes appear to have failed to curb short-termism

Martin Daks | Dec 19, 2019

Sections Accounting

A lesser-noticed element of the broadly controversial Tax Cuts and Jobs Act of 2017 is a provision that tweaked how much of highly paid executives’ salaries corporations can deduct from taxable income. The Republican-led Congress that pushed through the TCJA, the most sweeping tax overhaul in 33 years, was trying to steer top-executive compensation away from encouraging an emphasis on short-term results. 

Lawmakers appear largely to have failed at this effort, suggests research by Stanford’s Lisa De Simone, Chicago Booth’s Charles McClure, and Indiana University’s Bridget Stomberg. After examining executive compensation for fiscal years 2017 and 2018, the researchers find no evidence that companies affected by the TCJA changed total compensation, compensation mix, or pay-performance sensitivity.

Since 1994, publicly traded companies were generally subject to a $1 million-a-year cap on the amount of top-executive compensation that they could deduct from taxable income under Section 162(m) of the Internal Revenue Code. They could deduct more if the pay was linked to the company’s performance. However, the provision appeared to encourage shifting compensation away from salary and toward stock options and other performance-linked pay. Lawmakers were concerned that this focused managers too much on delivering short-term results, so the TCJA repealed the exception and disallowed all performance-based compensation, generally the largest component of executive pay.

This promised to dramatically lower the deductibility of executive pay, the researchers write. Congress also slashed the corporate tax rate to 21 percent from 35 percent, saving companies a bundle—but also limiting the deductibility of certain highly compensated employees to only $1 million. The researchers cite the example of Apple CEO Tim Cook. His compensation for the fiscal year that ended September 30, 2017, was $102 million. Under the pre-TCJA rules, Apple’s after-tax cost for his pay was $67 million, thanks to about $35 million in salary tax deductions. But under the new system, which took effect in 2018, his compensation would have had an after-tax cost of almost the whole $102 million because the cap on deductibility would have reduced the tax benefit from $35 million to about $210,000, or the $1 million of deductible salary expense multiplied by the new corporate tax rate of 21 percent.

To study the effects on corporate compensation policies, the researchers analyzed a sample of salaries from CalcBench, a data-compilation service that provides real-time, searchable access to Securities and Exchange Commission filings for a broad range of businesses. They limited the sample to executives who received total compensation above the $1 million threshold. They also examined fixed pay, performance-based pay, and total compensation for CEOs and other top executives. 

The TCJA rules are effective for fiscal tax years beginning on or after January 1, 2018, so the researchers could compare changes in executive compensation among affected businesses from 2017 to 2018 against a control sample of companies that were not affected until calendar year 2019, because their 2018 fiscal years began before January 1, 2018. This allowed the researchers to compare the reactions of companies that were and weren’t affected that first year. 

For the most part, the researchers find no difference between affected companies and the control group. They also find no evidence of a relationship between corporate taxes and executive compensation for a sample of health-care insurers that were subject to the early repeal of the performance-based-compensation exception. 

The researchers conclude that tax considerations appear to have limited effects on the way businesses structure executive pay, although that may be, in this case, because some companies were reluctant to quickly change compensation contracts due to some initial uncertainty around TCJA grandfathering rules.

The research contributes to the policy debate on the effectiveness of the TCJA by providing early evidence on whether Congress achieved its objective of shifting the mix of executive compensation away from options to create a greater focus on longer-term company performance. The finding that corporations did not immediately respond to the law’s compensation provisions suggests Congress may have structured the law inefficiently or that the Treasury put off issuing guidance for too long, potentially causing delays in companies’ responses.