The Impact of Personal Income Taxation on Executive Compensation

This paper analyzes the effect of personal income taxation on the sensitivity of executive compensation to company performance and the use of stock option and restricted stock grants underlying this sensitivity. The theoretical model predicts that, if a single tax rate applies to the entire compensation package, an increase in the tax rate weakly diminishes the equilibrium level of managerial effort and the after-tax pay-to-performance sensitivity, with the effect on the pre-tax pay-toperformance sensitivity being ambiguous. When salary and option gains are taxed at a higher rate than stock gains, tax changes also induce shifting among the individual compensation instruments. Interestingly, this differential taxation leads to a positive amount of stocks in the compensation contract even in the absence of any desire to incentivize the manager. In addition, an increase in the tax rate applied to salary and option gains may increase the level of managerial effort in equilibrium. On the other hand, an increase in the tax rate applied to stock gains weakly decreases the equilibrium level of managerial effort and strictly decreases the amount of aftertax pay-to-performance sensitivity generated by stock grants. The second part of the paper uses the increase in the U.S. federal personal income tax rate legislated by the Omnibus Budget Reconciliation Act of 1993 as a “natural experiment” to empirically evaluate the impact of personal income taxation on the pay-to-stockprice sensitivity generated by stock-option and restricted stock grants. The results reveal that the tax increase decreased the pay-to-stock-price sensitivity generated by option grants, both pre-tax and after-tax, consistently with the prediction of the one-tax model. In addition, the pre-tax effect is almost entirely concentrated among companies with a relatively weak corporate governance structure, suggesting that executive pay may be driven by different factors in strong and weak corporate governance companies.