Changes in individual-level tax rates represent exogenous shocks to executives’ net compensation. While these shocks may increase or decrease compensation, there is little evidence that firms respond by changing executives’ explicit compensation. One explanation is that executives bear the brunt of any tax rate change by directly reflecting these changes to their own compensation. Alternatively, executives may implicitly adjust their compensation by passing on some of the effects of these changes to shareholders through their share transactions.
Executives must carefully balance the risk and rewards of trading on insider information. However, as individual income tax rates increase or decrease, their after-tax compensation decreases (increases), and the equilibrium for using private information to profit from insider trading changes. We posit, and provide evidence, that executives’ use of private information in their trades increase with increases in individual-level income tax rates.
Methodology & Results
We begin by analytically demonstrating a positive relation between changes in income tax rates and insiders’ incentives for using private information in their trades. Based on our model, we predict a positive relation between insider trading profitability and changes in income tax rates that varies with insiders’ level of compensation, shareholdings, and private information, as well as the effectiveness of the monitoring of insiders’ transactions. We also show that, in contrast to income tax rates, an increase in capital gains tax rates does not encourage the use of private information in insider trades.
We empirically examine our research question using two different types of individual tax rate changes. We first examine two federal tax acts: the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) and the American Taxpayer Relief Act of 2012 (ATRA). The JGTRRA lowered the top marginal income tax rate from 38.6% to 35%, whereas the ATRA increased the top marginal income tax rate from 35% to 39.6%. We next examine 12 state tax rate changes of 2% or more. These include seven increases to the state income tax rates (California – 2013, Hawaii – 2009, Illinois – 2011, Minnesota – 2014, New Jersey – 2004, New York – 2009, Oregon – 2009) and five decreases to the state income tax rates (Hawaii – 2016, Montana – 2006, North Carolina – 2014 Rhode Island – 2011, Utah – 2008). We proxy for an insider’s use of private information by examining their change in abnormal profitability from insider trading from before to after each tax rate change. To mitigate concerns of a capitalization or lock-in effect biasing our results, we compare months t-9 to t-3 to months t+3 to t+9 for each tax rate change.
Consistent with our analytical model, we find that following increases (decreases) in individual income tax rates, there is a significant increase (decrease) in profitability from insider trading. Our point estimates suggest that the changes in insider trading profitability offset between 12% and 16% of the effect of tax rate changes on net compensation for an average executive. We also find higher sensitivity of abnormal insider trading profits to changes in income tax rates among insiders with low compensation, for whom the marginal utility of compensation is typically higher. Next, we provide evidence that insider trading profits are more sensitive to changes in income tax rates for shareholders with smaller shareholdings. This finding is consistent with the notion that insiders with smaller shareholders adjust their profits more through profitability per share than per the number of shares. We also examine the role of monitoring and find that in firms with strong monitoring, insiders have lower profitability from insider trading and that these profits exhibit greater sensitivity to tax rate changes. Finally, we document greater sensitivity of insider trading profitability to tax rate changes when insiders possess more private information. In additional analyses, consistent with predictions from our model, we find that changes in capital gains tax rates offset the effects of income tax rate changes on insider trading profitability when a larger portion of insiders’ compensation is subject to capital gains taxes.
Our study provides three key contributions. First, we contribute to the literature examining optimal taxation. A standard tenet in discussing the effects of taxation on equity markets is that taxes distort investment behavior, and we provide evidence on an unintended consequence of taxation on insider trading. Second, we add to the literature on the sensitivity of executive compensation to individual-level tax rates. Our findings suggest that executives’ ability to adjust opaque components of their pay, such as insider trading profitability, is one factor that can help explain the observed unresponsiveness of executive compensation components to changes in individual-level tax rates documented in this literature. Third, our study contributes to the literature on the determinants of insider trading profits. We provide evidence that individual-level tax rates are systematic and plausibly exogenous factors that influence insider trading incentives. Changes in tax rates affect all insiders that are subject to them and, as such, their effects are widespread and worthy of attention. The time-varying nature of tax rates suggests that they contribute to variation in insider trading profitability over time and should, therefore, be a factor accounted for in the analyses of insider trading profitability.
Nathan C. Goldman is an Assistant Professor of Accounting at the Poole College of Management at North Carolina State University.
Bugra Ozel is the Judith and William Bollinger Visiting Associate Professor of Accounting at the Wharton School of University of Pennsylvania and an Associate Professor of Accounting at the Naveen Jindal School of Management at the University of Texas at Dallas.