Salary vs. Deferred Compensation Exercise (Turn in Solutions)

1. It is now 10 years after you have graduated. You are advising a large company regarding its compensation and tax planning for its highly-compensated employees. Suppose that the top personal tax rate and the corporate tax rate are both 35%. Suppose Congress increases the top personal tax rate to 40% decreases the corporate tax rate to 31%, but the changes will not take effect for another three years.

(Assume r = 6.5% throughout this problem.)

a. What is the amount of deferred compensation that the employer could offer and be indifferent between deferred compensation and $1 of salary?

b. The employer is aware that, if he offers the deferred compensation computed in (a), then the employee will choose salary. In fact, the employer recognizes that the employee would choose salary over deferred compensation even if his salary was reduced a bit. Using the deferred compensation figure computed in (a), how much of a pay cut would the employee accept and still prefer salary over deferred compensation?

c. Same facts as #1. However, the company is short on cash and must pay deferred compensation. How much deferred compensation will the employee demand three years from today to be indifferent between salary today and deferred compensation three years from today?