Why is Executive Compensation not Responsive to Firm Performance? - The Effect of Tax Avoidance on Pay-Performance Sensitivity -

Abstract

Previous studies have shown that there is a significant positive correlation between corporate performance and compensation. However, recent studies have shown that there is no significant relationship between corporate performance and executive compensation, or the relationship only exists in specific cases. The purpose of this study is to clarify why performance and compensation are not linked properly. Desai and Dharmapala (2006, 2009) argue that tax avoidance has a complementary relationship with managerial private benefit pursuits, as the likelihood of tax avoidance decreases corporate transparency and the use of corporate resources for managerial pursuits. In particular, the incentive to pursue managerial private benefits will increase even when managerial compensation is not given. If an enterprise adopts an aggressive tax avoidance strategy, the uncertainty about their financial information will increase, and the proportion of noise will also increase in evaluating their performance. This is expected to reduce the performance-repair sensitivity of firms that have aggressive tax avoidance because the weight of the performance measures is reduced in concluding a compensation contract. This study expects that aggressive tax avoidance of the firm causes lowered the weight of the performance measures and therefore lowered ‘pay-performance sensitivity (PPS)’ in an incentive compensation contract. As a result, the PPS of the corporations with aggressive tax avoidance lower than that of the corporations with less aggressive tax avoidance in various combinations of manager’s compensation and corporate performances. Thus, it has been proven through this study that tax avoidance is one of the causes lowering the PPS.