Taxation and Executive Compensation: Evidence from Stock Options∗

Understanding the effects of taxes on executive compensation provides insight into the process determining this compensation and is a key input to policymakers considering changes in top income tax rates. A recent tax reform in Canada, which greatly increased the effective tax rate on stock option compensation for a subset of firms, by removing a deduction previously available at the corporate level, provides a natural experiment with which to address this question. I collect a novel panel dataset of executive compensation for the period 2008-2011. Findings from a difference-in-differences strategy suggest that this tax increase resulted in a relatively immediate reduction in both stock option grants and the fraction of total compensation made up of stock options. There appears to have been limited, if any, substitution towards other components of compensation, such as cash bonuses or grants of shares. Hence, the burden of the tax must have been substantially borne by the affected executives. This finding is in contrast with much of the extant literature, which typically has not found evidence for tax incentives as important drivers of executive compensation. ∗I would like to thank Michael Smart, Robert McMillan, Laurence Booth and Alex Edwards for their guidance and support throughout this project, as well as several anonymous reviewers for helpful comments. I gratefully acknowledge financial support from the SSHRC CGS Doctoral Fellowship, the Dorothy J. Powell Graduate Scholarship in International Economics and the Royal Bank Graduate Fellowship in Public and Economic Policy. All omissions and errors are my own. †E-mail: [email protected].