Top

Review of Accounting Studies

Published in:

01-12-2008

Tax incentives for inefficient executive pay and reward for luck

Author: Robert F. Göx

Published in: Review of Accounting Studies | Issue 4/2008

Activate our intelligent search to find suitable subject content or patents.

search-config

AI-assisted search

Off

Abstract

I study the economic consequences of tax deductibility limits on salaries for the design of incentive contracts. The analysis is based on an agency model in which the firm’s cash flow is a function of the agent’s effort and an observable random factor beyond the agent’s control. According to my analysis, limiting the tax deductibility of fixed wages has two consequences. The principal rewards the agent on the basis of the observable random factor and adjusts the amount of performance-based pay in the optimal incentive contract. The new contract can have weaker or stronger work incentives than without the tax. The theoretical findings have implications for empirical compensation research. First, the analysis shows that reward for luck can be the optimal response to recent tax law changes, whereas earlier empirical literature has attributed this phenomenon to managerial entrenchment. Second, I demonstrate that a simple regression analysis that fails to control for separable measures of luck is likely to find an increased pay for performance sensitivity as a response to the introduction of tax deductibility limits on salaries even if the pay for performance sensitivity has actually declined.

previous article Rewriting earnings history

next article Does acquirer cash level predict post-acquisition returns?

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

über 102.000 Bücher
über 537 Zeitschriften

aus folgenden Fachgebieten:

Automobil + Motoren
Bauwesen + Immobilien
Business IT + Informatik
Elektrotechnik + Elektronik
Energie + Nachhaltigkeit
Finance + Banking
Management + Führung
Marketing + Vertrieb
Maschinenbau + Werkstoffe
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

über 67.000 Bücher
über 340 Zeitschriften

aus folgenden Fachgebieten:

Bauwesen + Immobilien
Business IT + Informatik
Finance + Banking
Management + Führung
Marketing + Vertrieb
Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Available only for authorised users

For qualifying as “performance-based remuneration” a number of requirements must be met, see Balsam and Ryan (1996), or Balsam and Yin (2005) for details and illustrative examples of company practice.

For more details, see e.g. Hall and Murphy (2003) or Jensen et al. (2004).

Similar observations are reported in Rose and Wolfram (2000), Balsam and Ryan (2005a, b), who find an increased pay for performance relation for executives hired after the introduction of section 162(m).

See Bertrand and Mullainathan (2000, 2001). The “skimming hypothesis” has been put forward by practitioners such as Crystal (1991) as well as by academics, such as Bebchuk and Fried (2003), who also refer to it as the “managerial power approach”.

See e.g. Hemmer (2004), who also provides a critical assessment of the “LEN-model” and its limitations. The formal introduction of the model is frequently attributed to Holmström and Milgrom (1987) but at least the term “LEN-model” goes back to Spremann (1987).

This result follows from the informativeness principle established by Holmström (1979).

See e.g. Hemmer (2004), or Christensen and Feltham (2005). A formal derivation of the optimal incentive weight can be found in the Appendix.

Referring to the terminology of Banker and Datar (1989) b represents the sensitivity and \(1/\sigma _\varepsilon ^2\) the precision of gross cash flow as a signal for the agent’s effort.

See Fellingham and Wolfson (1985) for a general analysis of optimal contracting in the presence of income taxes.

These first-order effects apply to an increase of both bonus coefficients, v _x and v _z. As a second-order effect, however, an increase of v _x also increases the cost of effort, which is not the case for v _z.

Condition (24) states that no filtering is preferred for an arbitrary incentive weight v _x if \(\Uppi _n (v_x) > \Uppi _f(v_x).\) Because \(\Uppi _n\) and \(\Uppi _f\) are strictly concave in v _x, the same relation must also hold for the optimal bonus coefficients \(v_x^n\) and \( v_x^f \) because \(\Uppi _n(v_x^n) > \Uppi _n(v_x)\) for all v _x including \( v_x^f,\) so that \(\Uppi _n(v_x^n) > \Uppi _n(v_x^f) > \Uppi _f(v_x^f).\)

Note that for the unconstrained optimal contract, \(v_z^{\ast}=-c\cdot v_x\) from (12), so that the expected amount of variable pay and the risk premium become \(E[v|v_z^{\ast}]=v_x\cdot b\cdot a\) and \(R(s|v_z^{\ast})=\frac{r}{2}\cdot v_x^2\cdot \sigma _\varepsilon ^2.\)

See e.g. Christensen and Demski (2003), chapter 11.

A formal proof of this result is provided in the Appendix.

This is a standard result in expected utility theory. It holds for most concave utility functions with strict inequality. An exception are exponential utility functions for which the risk premium is a constant. See e.g. Mas-Colell et al. (1995) for a formal proof.

Because the agent’s effort is modeled as a probability, a is restricted to take values between 0 and 1. See Halperin et al. (2001) for a detailed description of the model details, and the discussion of Sansing (2001) for numerical examples.

Banker, R. D., & Datar, S. M. (1989). Sensitivity, precision and linear aggregation of signals for performance evaluation. Journal of Accounting Research, 27, 21–39.CrossRef

Balsam, S., & Ryan, D. (1996). Response to tax law changes involving the deductibility of executive compensation: A model explaining behavior. Journal of the American Taxation Association, 18, 1–12.

Balsam, S., & Ryan, D. (2005a). The effect of internal revenue code section 162(m) on the issuance of stock options. Working Paper, Temple University.

Balsam, S., & Ryan, D. (2005b). Limiting executive compensation: the case of CEOs hired after the imposition of 162(m). Working Paper, Temple University.

Balsam, S., & Yin, J. (2005). Explaining firm willingness to forfeit tax deductions under internal revenue code section 162(m): The million-dollar cap. Working Paper, Temple University and Rutgers University.

Bebchuk, L. A., & Fried, J. M. (2003). Executive compensation as an agency-problem. Journal of Economic Perspectives, 17, 71–92.CrossRef

Bertrand, M., & Mullainathan, S. (2000). Agents with and without principals. American Economic Review, 90, 203–208.

Bertrand, M., & Mullainathan, S. (2001). Are CEOS rewarded for luck? The ones without principals are. The Quarterly Journal of Economics, 116, 901–932.CrossRef

Christensen, J. A., & Demski, J. S. (2003). Accounting Theory. Boston: McGraw-Hill.

Christensen, P. O., & Feltham, G. A. (2005). Economics of accounting. Volume II—performance evaluation, New York: Springer.

Crystal, G. S. (1991). In Search of Excess.

Fellingham, J. C., & Wolfson, M. A. (1985). Taxes and risk sharing. The Accounting Review, 60, 10–17.

Hall, B. J., & Liebman, J. B. (2000). The taxation of executive compensation. Tax Policy and the Economy, 14, 1–44.

Halperin, R. M., Kwon, Y. M., & Rhoades-Catanach, S. C. (2001). The impact of deductibility limits on compensation contracts: A theoretical investigation. Journal of the American Taxation Association, 23, 52–65.

Hall, B. J., & Murphy, K. J. (2003). The trouble with stock options. Journal of Economic Perspectives, 17, 49–70.CrossRef

Hemmer, T. (2004). Lessons lost in linearity: A critical assessment of the general usefulness of LEN models in compensation research. Journal of Management Accounting Research, 16, 149–162.CrossRef

Holmström, B., & Milgrom, P. (1987). Aggregation and linearity in the provision of intertemporal incentives. Econometrica, 55, 303–328.CrossRef

Holmström, B. (1979). Moral hazard and observability. Bell Journal of Economics, 10, 74–91.CrossRef

Jensen, M. C., Murphy, K. J., & Wruck, E. G. (2004). Remuneration: Where we’ve been, how we got to here, what are the problems, and how to fix them. Harvard NOM Working Paper No. 04-28; ECGI - Finance Working Paper No. 44/2004. http://www.ssrn.com/abstract=56130.

Johnson, M., Porter, S., & Shackell, M. (2001). Stakeholder pressure and the structure of executive compensation. Working Paper, University of Michigan.

Mas-Colell, A., Whinston, M. D., & Green, J. R. (1995). Microeconomic theory. New York: Oxford University Press.

Perry, T., & Zenner, M. (2001). Pay for performance? Government regulation and the structure of compensation contracts. Journal of Financial Economics, 62, 453–488.CrossRef

Rose, N. L., & Wolfram, C. (2000). Has the “million-dollar cap” affected CEO pay? American Economic Review, 90, 197–202.

Rose, N. L., & Wolfram, C. (2002). Regulating executive pay: Using the tax code to influence chief executive officer compensation. Journal of Labor Economics, 20, 138–175.CrossRef

Sansing, R. S. (2001). Discussion of the impact of deductibility limits on compensation contracts: A theoretical investigation. Journal of the American Taxation Association, 23, 66–69.

Spremann, K. (1987). Agent and principal. In: G. Bamberg, & K. Spremann (Eds.), Agency Theory, Information, and Incentives (pp. 3–37). Berlin Heidelberg: Springer.

Title: Tax incentives for inefficient executive pay and reward for luck
Author: Robert F. Göx
Publication date: 01-12-2008
Publisher: Springer US
Published in: Review of Accounting Studies / Issue 4/2008
Print ISSN: 1380-6653
Electronic ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-007-9057-9

Springer Professional

Abstract

Please log in to get access to your license.

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Springer Professional "Wirtschaft"

Other articles of this Issue 4/2008

The relevance of quantifiable audit qualifications in the valuation of IPOs

Are executive stock option exercises driven by private information?

Investor reactions to derivative use and outcomes

Rewriting earnings history

Does acquirer cash level predict post-acquisition returns?