The Impact of Regulation on Executive Compensation: IRC Section 162(m) and the Unexpected Exclusion of CFOs

Abstract

ABSTRACT IRC §162(m) originally denied corporations tax deductions for nonperformance compensation in excess of $1 million per executive when paid to the CEO and the next four highest paid named executive officers. Following the 2006 SEC proxy statement revision, which the IRS deemed incompatible with §162(m), the IRS excluded CFOs from §162(m). This exclusion exogenously altered the CFO compensation environment, creating a natural experiment we exploit to examine how §162(m) influences executive compensation. Using a difference-in-differences design, our analysis allows us to draw causal influences generally lacking in prior §162(m) studies. We find that after the IRS exclusion of CFOs, firms increased the nonperformance compensation of CFOs who otherwise would have been affected by §162(m). Consistent with the shift to less risky compensation reducing the risk premium demanded by CFOs, we find some evidence of a reduction in their compensation growth. Our analysis provides evidence that tax policy influences compensation design.