The taxation of bonuses and its effect on executive compensation and risk‐taking: Evidence from the UK experience

• Published date: 01 September 2017
• DOI: http://doi.org/10.1111/jems.12203
• Author: Maximilian Ehrlich,Doina Radulescu
• Date: 01 September 2017

Received: 28 May 2014 Revised: 5 December 2016 Accepted: 15 December 2016

DOI: 10.1111/jems.12203

ORIGINAL ARTICLE

The taxation of bonuses and its effect on executive compensation

and risk-taking: Evidence from the UK experience

Maximilian von Ehrlich1Doina Radulescu2

1Universityof Ber n, CRED,

and CESifo (Email: maximil-

ian.vonehrlich@vwi.unibe.ch)

2KPM, Universityof Ber n and CESifo

(Email: doina.radulescu@kpm.unibe.ch)

Abstract

This paper explores the effects of a bonus tax adopted in the UK in December 2009 on

the compensation structure of executives and on risk-taking behavior in the financial

sector. Excessive bonuses are blamed for encouraging risk taking and are regarded

as one of the pull factors of the financial crisis. The British government attempted

to reduce bonuses and accordingly bank risk taking by means of a special tax on

cash-based bonuses. Using a comprehensive dataset on executive compensation, we

show that the introduction of the bonus tax decreased the net cash bonuses awarded to

directors by about 40%, accompanied, however, by a simultaneous increases in other

forms of pay leaving total compensation as well as risk levels unaffected.

1INTRODUCTION

In the aftermath of the financial crisis that has shaken the economies of many developed countries worldwide, governments have

struggled to find ways of dealing with the possible roots of the crisis. Most of the measures regulators have contemplated upon

aim at the financial sector in particular. A number of governments adopted policies targeting compensation of financial sector

employees that is perceived as excessive and unjustified by the public. Recently, the European Parliament passed a law that will

require bonuses of certain bank employees in the EU to be limited to 100% of their salary or twice this amount if shareholders

approve to it.

The focus on the financial sectors’ pay is not only based on distributional and fairness arguments, but it is also rooted in

the view that lavish bonuses have fueled short-termist behavior and risk taking. Many politicians and economists suspect that

the rapid increase of variable compensation may have created incentives that contributed to the vulnerability of the financial

industry that may justify government intervention. To this purpose, European regulators have made concerted efforts aimed at

curbing bankers’ pay. The first country to implement such a measure was the United Kingdom. In the tax year 2009/10, the

British Treasury introduced a 50% levy on bonuses in excess of GBP 25,000 awarded to employees of certain types of financial

institutions. This bank levy represented an experiment which many regard as a step in the right direction:

If we want to intervene on pay in addition to (not instead of) reformingcapital requirements, the most effective way

is a variation of the tax imposed by former British Prime Minister Gordon Brown:a special tax on all compensation

above a certain threshold that is not paid in stock. This tax would have two positive effects: it would induce banks

to recapitalize, thereby reducing their excessive leverage, while forcing managers to have more skin in the game.”

Zingales (2010)

Following the UK’s lead, a similar tax was adopted in France on bonuses exceeding Euro 27,500 in 2010.1

The authors gratefully acknowledge numerous comments by tworeviewers and the editor in charge. We also thank Peter Egger, Ray Rees, participants at the

faculty research seminars in Dortmund, Fribourg, Lucerne, Lugano, and Mannheim, discussants at IIPF, CESifoArea Conference on Public Sector Economics,

and the CEPR & IHS workshop on “Design and Impact of Tax Reform 2012” fortheir insightful comments.

J Econ Manage Strat. 2017;26:712–731. © 2017 WileyPeriodicals, Inc. 712wileyonlinelibrary.com/journal/jems

EHRLICH AND RADULESCU 713

Shortly after its introduction, UK government officials reported that financial institutions have not reduced bonus payoutsand

“the tax has not changed the behavior of big financial institutions” (Financial Times, 2010a). Yet, to be able to correctly infer the

consequences of the bonus tax, one should account for a number of additional factors that could bias these findings. First, the tax

was introduced immediately after the peak of the financial crisis in 2008 and not surprisingly bonuses may have increased two

years later, simply because the economy had recoveredto some extent. Second, not all UK financial institutions were affected by

the tax, but only those institutions meeting special criteria (see Section 4.1). Accordingly, if we just look at the plain numbers,

one would be tempted to jump to the hasty conclusion that the bonus tax did not succeed in curbing bonus payments. Third, to

judge the effects of the tax on managers’ incentives, the full set of compensation components including shares and options has to

be considered. For the tax to matter in terms of managerial risk-taking incentives, the structure of total compensation is decisive.

Hence, we also explore in this paper the role of different forms of variable compensation for risk taking in the context of Too

Big To Fail (TBTF) banks. On the one hand, in the standard principal agent framework, bonuses typically act as effort incentives

or screening mechanisms. On the other hand, in the case of TBTF banks, bonuses can be viewed as incentive alignment devices

by inducing risk-taking preferences in managers that match shareholders’ preferences. These are interested in encouraging risk

taking in order to maximize the value of the implicit guarantee provided to such a TBTF bank by the state. The motivation for

government intervention to discourage bonus payouts lies in the adverse systemic effects of risk taking. The bonus tax is one

means to achieve this end. If banks had responded to the introduction of the levy by say increasing fixed compensation, the

government could have achieved its objective. Hence, even if the tax was borne by the bank instead of the managers, the tax

could have been successful in curbing risk-taking incentives. In contrast, if shareholders increase the convexity of compensation

by awarding managers more options or shares instead of bonuses, the tax would have failed to meet its objective. Thus, the

response of financial institutions to the introduction of the bonus tax is an open question from a theoretical point of view and

we seek to address this with our empirical analysis.

In this paper, we draw on a comprehensive dataset covering detailed information on about 11,000 executive directors to iden-

tify the causal effect of a bonus tax for compensation practice of executives and address issues related to the effect of the tax

on risk taking by banks. Remarkably, the effects of a levy on cash-based variable compensation have not received any atten-

tion in the empirical literature thus far, despite its importance for current policy making. Addressing this issue is particularly

pertinent when governments disagree about the economic repercussions of different regulatory measures on the financial sec-

tor. We choose to focus on the executive directors of the financial institutions affected by the tax instead of considering all

employees receiving bonuses because executives provide the authority to manage an institution and are the main decision mak-

ers of a company. Hence, their remuneration is key for the performance of the firm they run. Executives who are not properly

compensated may not receive the correct incentives to perform in the best interest of shareholders. Our empirical identification

strategy draws on variation across countries, firms, directors, and time. We construct different sets of suitable control groups to

evaluate the effect of a bonus tax (i) for managerial compensation practice and (ii) bank risk. Our comprehensive data enable

us to account for numerous director and firm-specific controls that may confound the estimates. The causal interpretation of our

results is supported by equal pretax trends of compensation across treated and control groups. As a sensitivity check, we con-

struct synthetic controls using a data-driven procedure introduced by Abadie and Gardeazabal (2003) and Abadie, Diamond, and

Hainmueller (2010).

We show that the bonus tax has triggered a significant reduction in net bonuses awarded to employees in the UK financial

sector by about 40%. However, our analysis also reveals that the drop in net bonuses was accompanied by a simultaneous

increase in other variable pay components such as to keep the executives’ overall compensation unchanged. To make up for the

decrease in cash-based bonuses, financial institutions indemnified executives by awarding them higher equity-based pay in the

form of shares, stock options, or target-contingent equity-based compensation (long-term incentive plans [LTIPs]). The shift in

the compensation structure toward equity along with the unchanged total compensation implies that (i) an effect on managerial

incentives and in particular risk taking seems unlikely and (ii) the burden of the tax was borne by the banks.

The remainder of the paper is structured as follows. The next section presents an overview of the literature on the role of

variable compensation in the banking sector and on the regulation and taxation of managerial pay. Section 3 describes the data

we employ before Section 4 presents our analysis of the causal effects of the British bonus tax as well as a sensitivity analysis,

whereas Section 5 concludes with a summary of our most important findings.

2LITERATURE

In the context of TBTF banks, bonuses represent an incentive alignment device between shareholders and managers risk-

taking preferences. This is so, because related to these specific types of financial institutions, shareholders have an incentive to