Taxes and the Use of Subjectivity in Executive Bonus Plans

Abstract

In this study, I examine whether taxes influence the design of executive compensation incentives. Recently, the Tax Cuts and Jobs Act (TCJA) removed the requirement that bonus plans be tied to objective and verifiable performance measures for the bonus to be tax deductible. A potential consequence of this removal is that firms will begin to rely more heavily on subjectivity and discretion in their bonus arrangements. I find an increase, post-TCJA, in both the number of and the weight applied to performance measures with discretionary criteria. In cross-sectional analyses, I further connect my findings to taxes and find that the effect I document is concentrated among firms with a greater sensitivity to the loss of a tax deduction from the TCJA. Overall, the results suggest that the recent tax reform influenced the design of executive bonus plans by facilitating the inclusion of additional subjective performance measures.

Keywords: subjective performance measures, subjectivity, discretion, executive compensation, bonus plans, managerial incentives, tax policy, TCJA

JEL Classification: M12, J33, G38, M41, H2