Finance & Accounting

Restricting Executive Compensation is an Uphill Battle

Why taxing companies differently doesn’t combat excessive executive payments

Well. At least they tried. In the fight against a widening pay gap, the Austrian government limited how tax deductible an extraordinarily high executive compensation can be. A new study reveals that this tax reform failed to meet its goals—and that someone else may have to foot the bill.

At least since the start of the banking and financial crisis in 2007, there has been a palpable desire throughout society to see the amount that executives earn limited. Even polls taken before the crisis show that the majority of people in western, industrialized nations consider executive pay disproportionally high. Since then, the media has continuously posed one simple question: Do these executives truly deserve what their income would suggest?

Even though the limited market for top-level executives follows the rules of supply and demand, politicians still believed that a change in corporate taxation could do something about the disparity. In 2014, the Austrian government decided to enact tax reforms intended to limitexecutive compensation, which was spinning out of control. From that point on, companies were only allowed to deduct a maximum of €500,000 per person and per year. The government expected executive compensation to decrease or, at the very least, increase at a significantly slower pace. And that is because every euro that exceeded the cap was no longer be subsidized by the state, making compensation more costly for these firms.

The results are in: The tax reform only had a limited effect

In a joint study performed by WHU – Otto Beisheim School of Management and WU Vienna, researchers compared executive payments in Austria to those in other countries. The results show that the new tax reform essentially had no bite. Executive compensation in the majority of the analyzed Austrian companies did not react to the reform. Quite the opposite. It increased at a similar rate as those in other countries, such as Germany, which had not enacted similar tax reforms. In other words, substantially limiting the tax deductibility of executive pay had no appreciable effect on how it developed.

Did the tax reform change anything in the end?

There were only two exceptions where the tax reform had the desired effect: first, in the case of managers with remarkably little negotiating power; second, in companies with exceptionally strong governance and control mechanisms. In both cases, decision-makers proved unwilling to distribute the increased cost among other stakeholders. In the end, any executive who had not been with their employer for very long—and had to face a particularly strong compensation committee—often found the tax reform working against them.

The study also analyzed the potential effects the tax reform could have had on the way executive compensation is composed. This can include, for example, fixed compensation, variable compensation, non-cash assets (e.g., stock options), fringe benefits, retirement benefits, and long-term incentive measures. But in the end, the 2014 tax reform had no direct effect here, as the plan for tax deductibility took all forms of compensation into account equally.

All that said, it was evident that the increased costs of retaining executives led to higher expectations—and a simultaneous decrease in the employer’s level of tolerance for mistakes. This resulted in shorter contract cycles. On average, contract periods in Austria were reduced by two months, which was not seen in Germany or even in Austria before the tax reform was put into effect. By offering shorter contracts to these executives, Austrian companies redistributed part of the business risk to executives because their performance is now more frequently reviewed and contracts might not be renewed at a quicker pace.

What impact did the increased costs have?

The limited tax deductibility of executive compensation leads to the conclusion that the international job market dictates how much managers are paid. This, notebly, does not leave the firms much room to negotiate. The increased compensation costs then had to be set off through other channels. The study shows that the firms had to make budget cuts after the reform, particularly when it came to research and development. The sum of cost cuts even exceeded the amount that would have been necessary to counterbalance the lack of tax relief. This effect is related to the shorter contract duration: Managers with shorter tenure have less time to ensure high long-term profitability for their companies. To make up for this shortcoming, managers now rely on cost-cutting measures to boost company performance and to ensure that their contracts will be extended.

Ultimately, those who were hurt by the tax reform were the stockholders of these Austrian companies—and not the managers. Although the reform may demonstrate Austria’s willingness to take political action, it has also proved itself unsuitable for curbing the growth of executive compensation.

 

Tips for practitioners
  • As a political decision-maker, you should look beyond tax deductibility if you want to fight against the exorbitant pay today’s executives earn.
  • As a stockholder, you should keep an eye on the company’s investments if the cost of compensating its executives increases (e.g., through a restriction on their compensation’s tax deductibility).  Investments may be the place they start cutting back in order to save on costs and keep the compensation they offer executives globally competitive.
Literature reference and methodology

The new study “Do Corporate Taxes Affect Executive Compensation?” saw a research team analyze how executive payments and work contracts in large Austrian corporations developed between 2012 and 2019. Germany, where no comparable tax reform came into effect during that time, acted as the team’s control.

Authors

Dr. Tobias Bornemann

Tobias Bornemann is Assistant Professor at the International Accounting Group at WU Vienna. His research focuses on financial and tax accounting. 

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Professor Martin Jacob

Martin Jacob is an expert on the effects of taxation on individuals and companies at WHU – Otto Beisheim School of Management. His research interest is the influence of tax policy on companies and their investments. He’s held the adidas Chair of Finance, Accounting and Taxation at WHU since 2019.

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Dr. Mariana Sailer

Mariana Sailer is an Assistant Professor at the Management Accounting and Control Group at the Vienna University of Economics and Business. Her research focuses on managerial incentive systems, with considerable regard to the influence of taxes.  

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