The Influence of Internal Revenue Code Section 162(m) on Pay Sensitivity Estimates: The Case of Section 162(m) Qualifiers and Non-qualifiers and the Value of Subjectivity in Compensation Arrangements

Abstract

We examine the impact that Internal Revenue Code Section 162(m) had on pay for performance relationships for two sets of firms- those U.S. firms that qualified their CEO’s (Chief Executive Officer’s) annual bonus under Section 162(m) and those that did not take such steps during the years 1992 to 2003. We hypothesize that the link between pay and objective measures of performance would improve more for the Section 162(m) qualifying firms classified as “subjective evaluators” of CEO performance in years prior to Section 162(m). We also hypothesize no change in pay for performance for those firms that did not qualify certain of their CEO’s pay programs under Section 162(m). Our regression results are generally consistent with our hypotheses that states that observed pay for performance improvements associated with Section 162(m)’s passage were largely driven by firms that qualified their pay programs and which based their CEO’s compensation on subjective performance measures prior to the passage of Section 162(m). We also look at the benefits (in terms of tax savings) or the loss (in terms of added tax costs) incurred by companies which qualified and those that did not qualify their CEO’s annual bonus as performance based under Section 162(m). We find that the benefits from qualifying the CEO’s bonus as performance based were the highest for those companies which had used subjective criteria to evaluate a CEO’s annual performance prior to qualifying this compensation as performance based. To us, this suggests that subjective based performance measures have value to a company and that forfeiting the use of such measures requires that a benefit be received for doing so.