Response to Tax Law Changes Involving the Deductibility of Executive Compensation: A Model Explaining Corporate Behavior.

The Revenue Reconciliation Act of 1993 (hereafter RRA93) limits corporate tax deductions for executive compensation to $1 million per individual. Firms can avoid the limitation if compensation is based on a performance plan approved by share-holders. This study examines the modification by firms of their compensation plans, which would allow them to preserve their tax deductions while minimizing their political costs. Consistent with the Scholes and Wolfson (1992) paradigm, we test a multilateral model of employee-compensation contracting that considers all parties to the contract and incorporates both tax and non-tax elements. This study demonstrates that the decision to forgo the deduction can be explained by non-zero recontracting costs and executive risk aversion. The results show that the magnitude of the potential tax savings, firm size, the degree to which the CEO is overpaid relative to other CEOs in our sample, the pre-existing tie between pay and performance, and insider ownership, all positively affect the probability of conforming to RRA93.