The Impact of Deductibility Limits on Compensation Contracts: A Theoretical Examination

Abstract

In 1993, Congress passed § 162(m) of the Internal Revenue Code. Section 162(m) disallows a deduction for compensation in excess of $1,000,000 paid to the chief executive officer (CEO) and the four highest compensated officers other than the CEO of a publicly traded corporation unless the excess is “performance-based.” Several articles in the popular and professional press (The New York Times 1993; The Journal of Taxation 1994) predicted that executives whose nonperformance-based compensation exceeded $1,000,000 before the passage of the legislation would find their salaries reduced and their performance-based compensation increased as a result of the legislation. Other predictions regarding the impact of § 162(m) have been mixed, with some commentators predicting no real effect (Burzawa 1993). While several empirical studies have examined firm reactions to § 162(m) in terms of compensation packaging, no prior research has considered the impact of this legislation on executive performance. This paper provides a theoretical examination of both firm and executive responses to the deductibility limit imposed by § 162(m). The results of this study may be useful to tax policymakers considering the effectiveness of § 162(m) in meeting Congressional objectives, and to empirical researchers examining the impact of this legislation on firm and executive performance.