DAVID PEETZ. How tax minimisation affects CEO pay

Apr 6, 2017

Firms whose executives behave ‘unethically’, as proxied by not paying any company tax, are also likely to pay their CEOs an average of around a fifth more than firms of similar size and circumstances who do pay company tax.  

The two ongoing political scandals of corporate behaviour, featuring in public debate in many countries, concern company tax and executive pay.

There is growing awareness and widespread criticism of large companies for not paying enough tax, with many paying no tax. This is paralleled by other criticism of large companies regarding excessive payments given to chief executive officers (CEOs), other senior executives and board members.

The lobbyists for business defend the low (or zero) tax some companies pay by arguing that they have made losses, either now or in the recent past, and so it is entirely fitting that they pay no tax.

Those lobbyists also defend high CEO pay by arguing that such payments are necessary to reward high performance and to attract and retain the high quality CEOs that enable such high performance.

By that logic, the firms that pay little or no company tax would also be paying their CEOs poorly, because their financial performance had been so poor. This is the ‘corporate model’ of CEO tax and pay.

But what if the reverse was the case? What if, instead, ‘paying no tax’ was rewarded by higher CEO pay, rather than being a sign of poor performance? It would suggest that the corporate lobbyists’ arguments were misplaced, and a different explanation for both those things was necessary.

To test this, I compared information from two recent datasets. One was 2013-14 taxation data at the company level, that covered 1700 large companies, from the Australian Taxation Office (ATO). Almost a third of firms in that group paid no tax. The other source was the 2014 Annual CEO Salary Survey data collected and published by the Australian Financial Review on CEO pay in the top 300 firms (that is, the 300 firms that pay their CEOs the most). I linked those datasets using company names and found 221 matches. That overlap wasn’t surprising, as the biggest single predictor of CEO pay in a number of studies is company size, so both datasets ended up having a lot of large companies in them.

You can’t just do a simple correlation, because company resources or size is the biggest predictor of CEO pay. So you have to control for company size. The simplest way of doing this is with what’s called ‘ordinary least squared regression’. In effect, this statistical technique enables you to ask ‘what is the relationship between tax paid and CEO pay, if you can hold company size constant?’

In some studies, size is measured by revenue, assets, market capitalisation or number of employees. In this dataset, we can use revenue—in particular, ‘total income’ (excluding deductions) or ‘net income’ (‘total income’ minus deductions and minus tax paid).

The results are in the table below. In short, the results suggest that a company that pays no tax gives its CEO around 20 per cent per annum more than an equivalent company that pays tax—but there are a number of important caveats to bear in mind.

These caveats are as follows. First, there are four different equations below. Two use total income (to measure size), and two use net income. In each pair, one equation uses industry (there are 13 of them) as control variables, to account for average industry differences in legitimate tax deductions, and one does not. As it turned out, industry did not have much effect.

Size is probably better measured by total income, and after controlling for that paying no company tax is worth roughly an extra 23% in CEO pay.

Net income is a weaker measure of size. It also reflects performance and the ability of firms to claim deductions. By the ‘corporate model’, this would be a better predictor of CEO pay, but it is not. Without including ‘paying no tax’, equations using net income would be barely significant. When we control for ‘net income’, then ‘paying no tax’ adds two thirds or more to CEO pay, but that probably reflects the weakness of net income as a measure of a firm’s resources.

Still, it’s feasible that if more variables were available, we might reduce or remove the impact on CEO pay of not paying tax.

Similarly, if sample size was higher we might find more significant industry effects. By concentrating on the highest-paying firms, we might also be oversampling those with dodgy practices (explained a bit more below) and overstating the average effect of ‘not paying tax’.

Second, the data only relate to Australia, to a particular period, and to a particular group of companies. I have compared CEO pay in one year with predictors from the previous year. This use of ‘lags’ is common in studies but does not affect the results much. (If the explanatory variables were measured in 2015 rather than 2014, the net effect on CEO pay of ‘paying no tax’ changes from 23% to 26%.)

One thing that is apparent from earlier research is that the determinants of CEO pay change, according to the circumstances and the norms of the time. For example, it seems that in boom times increases in CEO pay tend to be associated with improvements in company performance, but this is not the case in times of decline. So maybe in different years there would be a different link between tax and CEO pay.

Third, our measures of size (income) are also measures of performance—net income in particular includes aspects of both. This result cannot prove whether performance does (or does not) have an impact on CEO pay. There are other studies with more control variables that look at that issue.

How you should interpret it then depends on to what extent you think that income is a good measure of corporate performance. But no matter how you interpret it, it is bad news for the ‘corporate model’. If net company income fully measures corporate performance, then paying no company tax, as an indicator of poor corporate performance, should have no separate impact on CEO pay. If net income contains nothing that proxies corporate performance, the paying no company tax should be negatively (and very strongly) related to CEO pay in the ‘corporate model’.

The reality is probably somewhere in between. That is, it is likely that income reflects partially, but not fully, corporate performance as well as size. So even after controlling for a measure of income, ‘paying no tax’ should be negatively related to CEO pay under the ‘corporate model’.

The finding that CEO pay goes up when companies pay no tax directly contradicts the corporate model. So, how should we make sense of it?

Elsewhere on this site, I’ve written about the influences on executive pay. Aside from company size, the main things that appear to shape executive pay are a series of norms that describe the behaviour of participants in the executive pay market. First, the status of a corporation depends in part on the status, and hence pay, of its CEO. As Warren Buffet argues, ‘No company wants to be in the bottom quartile as far as CEO pay goes’.  Second, the ability of CEOs to extract rents is influenced by their personal connections.   Third, CEO pay is heavily influenced by comparisons with other CEOs. (Business lobbyists admitted the veracity of this when they claimed that pay disclosure rules caused a surge in pay growth.) Fourth, institutions (such as pay surveys and remuneration consultants) emerge to grease pattern bargaining involving CEOs and boards. Fifth, the incentive structure of executive pay adjusts over time, to minimise the risk that pay falls to match performance, to justify high growth and to deflect shareholder concerns. Sixth, different norms shape pay in different segments or CEO markets, though references will be made to other segments (e.g. overseas) to justify increases. Seventh, CEO pay is contested and its determinants change over time. To which we add: gendered images of the “ideal manager,” and patterns of social interaction, caring responsibilities, and relative pay expectations also influence executive pay outcomes.

What do the results here tell us about CEO pay? It’s hard to believe that paying no company tax is itself the direct cause of higher CEO pay. After all, it’s only money, and shouldn’t that be reflected in income anyway?

It’s much more likely that ‘paying no tax’ is a proxy for something else. Those who complain about companies ‘paying no tax’ also criticise their lack of morality or public duty in doing so, arguing that they are manipulating the tax system to avoid their responsibility. So, suppose that ‘paying no tax’ is instead a proxy for that sort of behaviour? It seems more plausible.

In other words, firms whose executives behave ‘unethically’, as proxied by not paying any company tax, are also likely to pay their CEOs an average of around a fifth more than firms of similar size and circumstances who do pay company tax.

This is not to say that all the other determinants of CEO pay I mentioned above are ‘ethical’. Some would argue that it’s not ethical, for example, to change pay incentive systems to make sure that CEOs’ pay does not decline, or that it’s not ethical for boards to give higher pay to CEOs who are in the right social networks. So we’re likely to be capturing here something about ‘unethical’ behaviour that goes beyond the behavioural norms I mentioned earlier.

And remember, some firms that pay no tax will have a very good reason for doing so—they’re genuinely making a loss. To the extent that firms making a loss genuinely pay their CEOs less, the effect of ‘unethical’ behaviour on CEO pay will be understated by these equations.

Mind you, if loss-makers are amongst the top 300 firms in terms of CEO pay, despite making a loss, there’s something strange happening. That’s why I said that, by concentrating on the highest-paying firms, we might also be oversampling those with dodgy practices.

That this is a firm-level dataset that differentiates between firms on the basis of, amongst other things, whether they pay company tax, also suggests that not all firms are behaving the same here: some are more ‘unethical’ than others, by this measure.

And that’s something that makes sense: each year there are usually some particular firms that are the focus of media or public attention for outrageous CEO pay practices. That in turn suggests not all firms behave the same way, at least on that issue. The ESG (environmental, social and governance sustainability) movement is based on the idea of getting more firms to practice something called corporate social responsibility, which includes ‘good’ practices on governance and executive pay.

In short, the findings suggest we need to take another factor into account in explaining CEO pay. Aside from those factors described above, CEO pay is also influenced by the agency of the firms and CEOs themselves, who exercise choices as to how much they appropriate rents for themselves. Firms with less ethical practices will pay their CEOs more, and by implication, poor ethics are one of the reasons (but by no means the only reason) for the substantial levels of CEO pay that sit in contrast with the slow growth of ordinary wages.

Table 1: Determinants of CEO pay: OLS regression equations

Equation numbers
(1) (2) (3) (4)
Total income 0.328** .319**
(0.029) (.028)
Net income .022** .026**
(.006) (.006)
No tax paid 0.213* .206* .513** .596**
(0.094) (.085) (.151) (.157)
Industry controls yes no no yes
r2 .460 .408 .072 .155
adjusted r2 .411 .401 .063 .079
F significance .000** .000** .001** .013*
marginal effect of no tax paid +23.7% +22.9% +67.0% +81.5%

Source: ATO database of large tax entities 2013-14 and AFR CEO pay survey database 2015.
Standard errors in brackets
Dependent variable: ln(CEO total pay in 2015). Explanatory variables are for 2013-14.
Income variables and are also expressed as logarithms. Zeros recoded as 0.00001. Negative income values treated as zeros.
** Statistically significant at 1% level
* Statistically significant at 5% level
N = 194 in all equations.


David Peetz is Professor of Employment Relations, Griffith University.


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