IRC Section 162(m) and the Law of Unintended Consequences

Abstract:     
In 1993, Section 162(m) of the U.S. Internal Revenue Code was passed into law. The intent of this law was to reign in outsized executive compensation by eliminating the tax-deductibility of executive compensation above $1 million unless the excess compensation was performance-based. One unintended consequence of the legislation was that executives' total compensation actually increased in the post-1993 period. One compensation package component whose use dramatically increased, as expected, following the adoption of Section 162(m) was performance-based employee stock options. Employee stock options, however, have unintended consequences of their own. For example, the economic value of performance-based stock options may be influenced by executive decision-making when the options are valued using the Black-Scholes model or some variant thereof. This study investigates whether the incentives embedded in stock options are associated with such unintended consequences as increased market volatility and reduced dividend yields. Using data from the Standard and Poor's ExecuComp Database, empirical results for the period 1992 through 2004 reveal a significant, positive relation between the quantity of options held by CEOs and share price volatility, and a significant, negative relation between the quantity of options held by CEOs and dividend yields. These results suggest that executives used their discretion to positively impact the performance-based component of their compensation through actions affecting share price volatility and dividend yields, assumptions implicit in option-valuation models.

Number of Pages in PDF File: 28

Keywords: Executive compensation, Employee stock options, IRC Section 162(m)

JEL Classification: H25, K34, J33, G35

working papers series