The Effects of a Selective Tax on Contract Design and Tax Timing

Abstract

Taxation affects income via both a compensation contract response and a worker response. I show that executive contracts adjust to a tax on severances, and executives shift their taxable income timing in response to the interaction of tax and contract. In particular, “golden parachute” severances tend to bunch at a threshold (tied to taxable income) where the tax rate discontinuously increases, and CEOs exercise stock options in bulk to raise their taxable income and boost their threshold. Identification comes from a bunching analysis exploiting a discontinuous change in exercise incentives over time and variation across CEOs in contract incentives and deal timing. The paper demonstrates the role of contract structure in tax avoidance and additionally shows how contract structure affects worker behavior.

Keywords: Executive Compensation, Contract Structure, Golden Parachutes, Tax Gross-Ups

JEL Classification: H26, K22, G34, G39