Taxes, Risk-Taking Incentives, and Relative Performance Evaluation

We predict and find that corporate taxes affect compensation contracting. Exploiting plausibly

exogenous changes in state tax rates, we observe firms shifting away from equity compensation

toward greater cash compensation following state corporate tax rate increases. In contrast, we

observe no changes to compensation structure following corporate tax decreases or personal tax

rate changes. Our results manifest primarily for compensation contracts that lack relative

performance evaluation features, which moderate executives’ equity incentives to increase

systematic risk. Our results indicate that increases in corporate taxes reduce the variance of project

payoffs and therefore mitigate the disutility of risk taking on project selection. We confirm that

state corporate tax increases are associated with subsequent increases in systematic risk. Overall,

our findings provide novel insight into how taxes can affect the design of compensation contracts

and the allocation of firm resources.