The Determinants of the Choice of Income Type as a Measure of Performance in Bonus Plans

October 1, 1995

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Executive Summary The focus on strategic planning has increased tremendously in recent years. Despite this trend, the integration of tax strategies into the overall planning process has not been consistent across firms (Morrione and Racioppo, 1985), even though firms’ strategic plans cannot be considered complete until the tax implications of their plans are understood. On the other hand, tax planning is not effective unless the consequences of the tax strategy for other business costs are also considered. Once other costs are considered, firms may discover that a plan that minimizes taxes is not the best (Scholes and Wolfson 1992). The optimal strategy will consider taxes and other business costs simultaneously by focusing on the maximization of after-tax income in the strategic planning process.

This paper investigates the manner in which bonus plans are used to facilitate the goal of maximizing after-tax income by certain firms. Although most large U.S. corporations have an earnings-based compensation plan (Fox 1980), many, if not most, bonus and performance plans reward managers based on income before taxes (Newman 1989, 762). Thus, these plans do not necessarily provide managers with an incentive to implement the optimal plan because taxes are ignored in the remuneration process. The purpose of this study is to discover plausible explanations for why some firms reward managers based on before-tax income while others use after-tax income. An identification of the reasons for these differences in plans across firms should facilitate an understanding of why firms place varying levels of importance on strategic tax planning. Once these reasons are identified, opportunities should exist to develop methods to improve the incorporation of tax strategies into the decision-making processes of firms, which should lead to more competitive and efficient firms. The results suggest that larger firms that report a larger number of operating segments and those firms that have management stock ownership levels in a range where management is entrenched are more likely to select after-tax rather than before-tax bonus plans.


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