U.S. Tax Reform and How it May Impact Executive Compensation
by Patrick Powers and Tony Meyer of Meridian Compensation Partners, LLC
One of the promises of President Trump’s campaign was substantial tax reform. President Trump’s current proposal would significantly alter the tax landscape in the United States. The highest individual federal tax rate would become 35% (39.6% currently), the Alternative Minimum Tax (“AMT”) would be repealed and the corporate tax rate would become 15% based on United States income only (35% of worldwide income currently). This proposal begs the question, if enacted, how would these reforms impact executive compensation?
Impact on Compensation Pre-Reform
In the short term, there could be an uptick in the amount saved in deferred compensation plans, assuming the effective date for lower individual tax rates is not applied retroactively. With the belief that taxes will be lower in the future, executives could be more inclined to defer compensation for taxation in the future. Some companies, such as those with non-calendar year-ends, may try to delay payment of annual bonuses until the new tax regulations would take hold. However, the overall design of compensation would generally not change, as most companies would only react if changes in the Internal Revenue Code (“IRC”) actually were implemented, which remains far from certain.
In the long-term, however, there may be more of an impact. If the proposal is passed and becomes a part of the IRC, then the likelihood of taxes being lowered in the future once again may be remote. As such, executives may not defer compensation and instead take advantage of the then-current lower individual tax rates.
If the tax code reform operates as the Trump Administration (“Administration”) hopes, the lowering of taxes could spur growth in the U.S. economy. The expectation is that share prices could increase, at least to the extent that markets have not already priced in tax reform. Therefore, equity-based awards could have more value to executives than cash compensation. In turn, there could be a slight shift of pay mix towards equity-based incentives.
A lower tax rate could also cause companies to evaluate their capital mix. With a lesser tax advantage to carrying debt, especially if the deduction for interest expense is curtailed, companies may add incentive metrics which involve restructuring of the balance sheet. Such incentives, however, might be limited to senior-most executives.
For the first few years following enactment, the business and economic effects of tax reduction likely would not have fully taken hold. To account for such uncertainty, we anticipate that companies may set wider incentive plan spreads between their threshold and maximum goals in relation to their target goals, especially for earnings metrics.
If the AMT was repealed, there may be a resurgence in the use of Incentive Stock Options (“ISOs”). Currently, Non-Qualified Stock Options (“NQSOs”) are much more prevalent. NQSOs are taxed as ordinary income (currently 39.6% for the highest tax rate) on the date of exercise and at the capital gains rate (currently 20%) on the date of ultimate sale of shares. Conversely, ISOs are taxed at the capital gains rate if held for one year from the exercise date and two years from the date of grant. On its face, ISOs would seem to be better vehicles for executives. However, due to the AMT, which is calculated differently, ISOs are often effectively taxed at the ordinary income rate, making them less popular. The repeal of the AMT could make ISOs popular once again, as executives could be taxed at the lower capital gains tax rate; however, several other ISO requirements would need to be evaluated (including the relatively low annual ISO vesting allowance per year).
Impact on the Executive Labor Markets
Now, let us examine the impact of tax reform through an economic lens. Recall that a decrease in the corporate tax rate affects the labor demand and supply relationship. In order to remain revenue neutral, the Administration proposes to eliminate certain tax loopholes. However, it is also relying on significant GDP growth. A lower corporate tax rate, along with modifications and eliminations to border taxes and double taxation, would make the U.S. a more attractive place for companies to invest, both domestic and foreign. Investment would not only create manufacturing “blue-collar” jobs, but also increase the competition for executive “white collar” jobs. Investing here would allow foreign companies to more easily tap into the deep talent pool that exists in the U.S. Consequently, the labor demand curve could shift in a positive direction.
Now, let us consider the impact of lowering individual ordinary income tax rates. Such a move would result in a shift right in the labor supply curve. This would decrease pay levels, as companies would theoretically have to pay executives less in order to keep their after-tax income constant. However, lower taxes would also increase the opportunity cost of leisure. The substitution effect tells us that more people would enter the workforce. We could also expect that some senior executives would delay their targeted retirement date.
Whether you subscribe to the Keynsian school of economics or not, one can reasonably presume that the impact of these changes would not be felt immediately. In the long-term, upon reaching a new equilibrium, we would expect to have more executives working in the U.S., but with a minimum impact to competitive pay levels.
The passage of the tax reform proposed by the Administration would likely have a significant overall impact on the U.S. economy. Much rides on the fate and possible effective date of this recent proposal. Boards of Directors and senior human resources executives should not only prepare for direct impacts to their executive compensation program, but also for changes to the competitive landscape for executive talent.
Patrick Powers is a lead consultant and Tony Meyer is a consultant at the executive compensation consulting firm Meridian Compensation Partners, LLC in New York, NY and Lake Forest, IL, respectively.