Executive compensation and corporate taxation are both hot button issues, but can they be related? In a recent paper, we examine how CEO bonus contracts reinforce global tax incentives and show that executive pay practices helped drive corporate activity abroad. However, we also find that this trend was mitigated by the Tax Cuts and Jobs Act of 2017 (TCJA).

Corporate Taxation

In the decades prior to the TCJA, U.S. companies faced one of the highest statutory corporate tax rates in the developed world. U.S. companies also faced a worldwide tax system, which levied federal taxes on the repatriated foreign income of U.S. corporations, net of taxes paid to foreign jurisdictions. However, because U.S. firms could defer federal taxes on foreign earnings until these earnings were repatriated, and because corporate foreign tax rates were generally lower than the U.S. rate, foreign economic activity was largely tax advantaged relative to domestic activity for U.S. multinational firms. This meant that, on an after-tax basis, a pre-tax dollar of foreign income was more valuable than a pre-tax dollar of domestic income, creating incentives for U.S. companies to shift economic activity abroad. The combination of a high statutory corporate-tax rate along with the tax differential on foreign and domestic earnings were leading motivators for the enactment of the TCJA. Congress responded by slashing the corporate tax rate and altering the international tax system to tax foreign and domestic incomes more similarly. The hope was that the TCJA would stop the U.S. tax code from driving economic activity overseas.

CEO Compensation

CEO bonus contracts provide for enormous potential payouts that are almost always contingent on earnings performance in large, publicly traded U.S. companies. When the earnings measure underlying the payout is based on pre-tax income (e.g., operating income), a dollar of foreign income will result in the same amount of bonus compensation for the CEO as a dollar of domestic income. However, many CEOs are evaluated on after-tax accounting-based earnings (e.g., net income). Given that these contracts explicitly include only a single summary income measure, when combined with the differential in foreign and domestic statutory tax rates, they may give rise to differential incentives to pursue foreign and domestic income sources. Specifically, when the foreign tax rate is lower than the domestic tax rate, a pre-tax dollar of foreign income translates to higher bonus compensation and is thus more valuable than a pre-tax dollar of domestic income.

CEO Compensation Incentives before and after the TCJA

Our study uses data from the S&P 1500 to examine the mapping between CEO bonuses and pre-tax domestic and foreign incomes. Before the TCJA, when this foreign tax differential was large, we find that the payouts U.S. CEOs received for a dollar of foreign pre-tax income were significantly higher than the payouts received for a dollar of domestic pre-tax income. This suggests that CEO compensation contracts reinforced global tax incentives to pursue income abroad. However, the study also finds that, after the TCJA was enacted and foreign and domestic statutory rates were leveled, the contracting incentive to pursue foreign income over  domestic income was also leveled for CEOs whose bonuses were contingent on after-tax earnings measures. In contrast, the study finds no evidence that bonus contracts contingent on pre-tax earnings reinforce tax incentives in either period. Given the important role these contracts play in shaping executive behavior, understanding how they reinforce or counteract global tax incentives is imperative.

The study’s findings are unique to bonus compensation and to the period surrounding the TCJA. Other components of CEO compensation, such as salary, do not reinforce tax incentives as they are not contingent on earnings performance. Likewise, the study examines periods when tax incentives were static and finds no evidence of contracting-incentives leveling in these periods.

Outbound income shifting is an oft noted consequence of unfavorable foreign tax rate differentials and one that several provisions of the TCJA directly targeted. In examining whether this change in contracting incentives altered firm behavior, the study finds that bonus contracts based on after-tax earnings performance reinforced the tax incentives to shift income out of the U.S. prior to tax reform. While results show this politically undesirable behavior was reduced in the wake of the TCJA for all firms, the decrease was considerably greater for executives whose foreign incentive differential was leveled.

Overall, this study documents an important path through which corporate tax reform must flow – the firm’s executives. The highly lucrative compensation contracts of these executives can play an important role in reinforcing or counteracting global tax incentives. In the case of the TCJA, current bonus contract structures appear to have given executives further incentives to act in ways consistent with the law’s goal of decreasing the pursuit of tax favorable foreign income.

This post comes to us from Katie Boylen, a PhD student at the University of Wisconsin-Madison; Fabio B. Gaertner, the Cynthia and Jay Ihlenfeld Professor for Inspired Learning in Business at the University of Wisconsin-Madison; and Melissa Martin, the Michael B. Mikhail Professor a the University of Illinois-Chicago. It is based on their recent paper, “CEO Bonus Incentives for Domestic and Foreign Performance,” available here.