Much of the public has long believed that executives are overcompensated, a sentiment that has occasionally crept into legislation.  In one case, Congress voted to impose punitive excise taxes on managers who received excessive golden parachute payments. Unlike most taxes meant to influence corporate behavior, these taxes aim directly at the corporate decisionmaker who receives the payment, potentially leaving him worse off economically. To avoid that result, some compensation committees have structured managers’ compensation to include tax gross-ups: a payment of some portion of the manager’s personal tax liability, plus any tax on the compensation triggered by paying the liability and so on.

In a recent study, we investigate how shareholders view tax gross-ups by examining the market response to a recent wave of company moves to eliminate gross-ups.  We also examine whether, after eliminating gross-ups, firms increase other forms of compensation to make up for the lost payments and whether that results in a tighter connection between pay and performance.

First, we examine the stock market reactions to announcements that tax gross-ups have been eliminated. Contrary to the view of investor activists such as RiskMetrics, companies often justify gross-up provisions by arguing these payments are consistent with “market practice in the general context of the importance of change-in-control benefits for attracting and retaining executive talent” (Papadopoulos 2008, 6). Indeed, some firms make the circular argument that they offer tax gross-ups because other firms do (Leder 2005).  Other companies have argued that the excise taxes Congress enacts represent penalties for engaging in mergers that trigger golden parachute payments and other behavior that may actually maximize shareholder value but are politically controversial. Tax gross-ups could be an efficient way for shareholders to move this politically motivated penalty on maximizing value from managers to shareholders. Further, excise taxes are often imposed when golden parachute payments exceed three times a manager’s average compensation over the past five years. Thus, depending on their past compensation and history of exercising stock options, managers in similar positions economically may have different excise tax liabilities.

Others argue that tax gross-ups represent the epitome of corporate greed and are not consistent with value maximization.  Indeed, one commentator described gross-ups as “a cherry sitting on top of the other cherry” (Leder 2010)  Another critic noted that, through gross-ups, firms “remov[e] taxes from the list of inevitable life experiences, leaving only death” for their executives (Maremont 2005).   Indeed, consistent with the notion that tax gross-ups are a sign of poor governance, $29 million of the allegedly $150 million that convicted fraudster Dennis Kozlowski helped pillage from Tyco was from tax reimbursements on his ill-gotten bonuses (Maremont 2005).

As a result of these criticisms and the Dodd-Frank Act’s provision allowing shareholders to vote on compensation matters directly, many companies are curbing their use of tax gross-ups.  In our study, we examine whether investors agree with firms that believe tax gross-ups are beneficial, or whether they share the concerns of proxy advisory firms. Examining a sample of about 200 companies that eliminated gross-ups beginning in 2011, we find that, on average, the announcement of the gross-ups’ elimination was accompanied by a positive market reaction, suggesting shareholders perceived it as a commitment to improved governance.  We also find that this increase in market price surrounding the elimination of gross-ups that occurred with a change in control are concentrated in firms that have a higher likelihood of experiencing a change in control.

Second, we examine whether compensation committees that get rid of gross-ups find ways to compensate managers for the loss of this benefit.  Since the gross-up payments are made by the acquiring firm in a change-in-control situation, it is not immediately obvious that compensation committees would feel the need to increase other forms of compensation when the gross-up provisions are eliminated. After all, any such increase in compensation is going to be paid directly by the firm and its shareholders. However, gross-up provisions could be important in attracting and retaining talented executives, and so committees may feel compelled to respond quickly following the elimination of gross-up provisions. Using a difference-in-difference design, we examine the change in CEO compensation following the elimination of excise tax gross-ups and find an increase in CEO bonuses.  We also find that the increase is concentrated in firms where the CEO is also the chairman of the board. Our results indicate that, at least among poorly governed firms, the board is quick to find alternatives for compensating executives following the elimination of excise tax gross-ups.

Our analysis provides new insight into two important issues. First, our results are consistent with investors taking a negative view of excise tax gross-ups and responding favorably to their elimination. Second, we find that the elimination of gross-ups, largely prompted  by proxy advisory firms, are at least partially offset by increases in bonus compensation. Our results suggest the efforts of proxy advisory firms to reduce excessive compensation might not be as successful as the dramatic reduction in gross-up provisions suggests, because these provisions are being offset by other forms of compensation.

Our findings challenge the assumption that compensation practices are undertaken by value-maximizing compensation committees that are looking to align the incentives of the CEO with shareholders. Our evidence suggests that, at least in one important case, shareholders did not agree that the compensation contract maximized the value of their share and rewarded the elimination of that contract provisions with a higher stock price. Our findings also provide new insight into how compensation committees view gross-up provisions. Given the relatively low likelihood of a change in control that would trigger these gross-up provisions, it is not clear to what extent executives would value these provisions and demand compensation for their elimination. Our findings suggest compensation committees respond as though they believe executives do require some offsetting compensation when gross-up provisions are eliminated.

This post comes to us from Professor Jeffrey L. Hoopes at the University of North Carolina at Chapel Hill, Professor Xiaoli (Shaolee) Tian at Ohio State University’s Fisher College of Business, and Professor Ryan J. Wilson at the University of Oregon’s Lundquist College of Business. It is based on their recent article, “Is the Market Grossed out by Gross-Ups? An Investigation of Firms That Pay Their CEOs’ Taxes,” available here.