1996 JATA Conference Taxes and Business Strategy

Volume 18, Supplement

Response to Tax Law Changes Involving the Deductibility of Executive
Compensation: A Model Explaining Corporate Behavior

Steven Balsam and David H. Ryan


The Revenue Reconciliation Act of 1993 (hereafter RRA93) limits corporate tax deductions for executive compensation to $1 million per individual. Firms can avoid the limitation if compensation is based on a performance plan approved by shareholders. This study examines the modification by firms of their compensation plans, which would allow them to preserve their tax deductions while minimizing their political costs. Consistent with the Scholes and Wolfson (1992) paradigm, we test a multilateral model of employee-compensation contracting that considers all parties to the contract and incorporates both tax and non-tax elements.

This study demonstrates that the decision to forgo the deduction can be explained by non-zero recontracting costs and executive risk aversion. The results show that the magnitude of the potential tax savings, firm size, the degree to which the CEO is overpaid relative to other CEOs in our sample, the pre-existing tie between pay and performance, and insider ownership, all positively affect the probability of conforming to RRA93.

LIFO Adoption and the Tax Shield
Substitution Effect

Robert H. Trezevant


Consistent with the tax shield substitution effect, this study documents that firms that adopted LIFO in 1974 exhibit a negative association between the post-adoption change in their cost of goods sold and the post-adoption change in their interest expense. This negative association is not observed for firms that retain FIFO. These results suggest that the capital structure and LIFO/FIFO choices are not independent of each other. A contribution of this study is that it investigates the response of tax shields to the change in a non-investment tax shield (i.e., cost of goods sold), thus providing evidence concerning the generalizability of the substitution effect.

Foreign Investment Decisions in the
Presence of Real Options

Richard C. Sansing


This paper expends the literature on the effect of taxes on foreign investments in two ways. First, it shows that the effect of tax depreciation on investment decisions depends jointly on whether the home country uses a territorial or worldwide tax system, and whether the investment is financed from accumulated foreign earnings or new capital.

Second, the paper examines an investment decision in a setting in which technological improvements create a benefit to postponing the investment in a positive net present value project. The conventional wisdom that repatriation taxes are neutral with respect to investments financed by the foreign subsidiary does not hold in this setting. A subsidiary with earnings subject to repatriation taxes will not exhibit less patience than a subsidiary not subject to repatriation taxes.

Organizational Form and Taxes:
An Empirical Analysis of Small Businesses

Benjamin C. Ayers, C. Bryan Cloyd, and John R. Robinson


Organizational form is among the most fundamental of business decisions. Among other possible influences, it is often asserted that differences in the taxation of various organizational forms systematically affect this decision. Because small businesses undertake the vast majority of organizational form decisions and are not necessarily limited to the corporate form for nontax reasons, they are the most likely businesses to be affected by tax considerations. This study examines the extent to which the choice of organizational form by small businesses is influenced by tax and nontax factors. We utilize a multinomial logit model to analyze the selection of organizational form for a sample of small businesses organized as taxable (C) corporations, electing Subchapter S (S) corporations, partnerships, and proprietorships. We conduct a separate logit analysis for single-owner and multiple-owner firms. The logit results suggest that nontax factors (e.g., business risk) are important considerations in the selection of an organizational form. However, the logit analyses provide only partial support for the hypothesis that income taxes are an important consideration in the selection of an organizational form.