The gap between those at the top and those at the bottom of leading organizations has seldom been more in the spotlight. Prolonged pressure to narrow this pay gap resulted in the Tax Cuts and Jobs Act in 2017, which Congress hoped would help to curb CEO pay by repealing the exemption that allowed firms to deduct large amounts of performance-based pay.
Research from Indiana University suggests, however, that the impact of the bill was limited, and indeed, in some cases, CEO pay actually grew after the law was introduced as it became costlier to award executives high levels of compensation.
Difficult change
The researchers explain that the legislation was largely designed to move executive compensation away from stock-based compensation and performance pay, as these can draw attention towards short-term results, whereas cash-based fixed compensation encourages longer-term thinking.
The study explores the pay packages of executives both before and after the change in tax policy, and discovers little real evidence that companies changed their compensation, whether in terms of its size, mix, or pay-performance sensitivity.
“It’s very politically amenable right now to say they’re going to tax these corporations and these executives and it’s going to reduce income inequality, but our research—and that of others—suggests that taxes are just not a big enough stick to change the structure or the magnitude of executive compensation,” the researchers say. “We found no statistical effects, which is counter to what Congress intended. We looked very hard and see no evidence of a reduction in CEO pay.”
Executive pay
Publicly-listed companies have been subject to a $1 million a year cap on executive compensation that was deductable from taxable income since 1994. The only exemption to this was when the pay was linked to the performance of the company. This exemption was removed in 2017 alongside a reduction in the corporate tax rate to 21%.
The researchers used an array of around 40 tests to examine the changes in executive compensation during 2017 and 2018, when the new tax rules were introduced. They were able to select a group of companies that were affected later as a control group.
“Even three full years after the law took effect, we didn’t see any evidence of a reduction in CEO pay,” they explain.
The study strongly suggests that taxes don’t play a huge role in determining executive pay, and as a result, tax regulation is pretty ineffective at curbing executive excesses. This finding has significant policy implications, not least as some members of Congress want to introduce corporate tax surcharges linked to CEO pay ratios.
“If Congress’ fundamental assumption about the relative importance of taxes in the design of executive compensation is overstated, its ability to shift current compensation practices through changes in tax policy is also likely overstated,” the authors explain. “Our results and those from prior studies suggest increases in firms’ cost of executive compensation do little to reduce its amount.”
“As a consequence, policymakers should reconsider whether changes to the taxation of executive compensation are a viable path towards addressing the perceived issues of excessive executive pay and inequality. Although our results speak only to the effects of the TCJA, we believe our results can inform the broader debate on the efficacy of tax regulation to influence executive compensation.”
