How Taxes on Managers Affect Corporate Risk-Taking

Fiscal policy—and taxation in particular—is one of the most important tools that policymakers can use to influence the economy. While the effect of corporate taxes on managers’ corporate investment decisions has been extensively studied, little is known about the effect of managers’ personal taxes on their corporate investment decisions. In a recent study, we attempt to fill this gap by examining the relation between personal income taxes levied directly on senior managers, hereafter “managerial taxes,” and their corporate risk-taking. Given their unique position as primary decision-makers at the firm, understanding whether and how taxes on senior managers affect corporate decisions has important implications for fiscal policy. Senior managers are responsible for overseeing firms collectively worth trillions of dollars, and their decisions are important to the performance of the U.S. economy.

The intuition for how managers’ personal taxes affect their corporate investment decisions is similar to how taxes affect shareholders’ personal investment decisions. In particular, taxes facilitate risk-sharing with the government. By reducing the risk that a risk-averse manager bears in conjunction with risky investments, taxes increase the manager’s incentive (or, equivalently, reduce the disincentive) to take risk. Our study uses a simple theoretical framework to formalize the intuition that risk-averse managers who face different personal tax rates, but who are otherwise identical, will make different investment decisions.

We empirically examine the relation between the personal tax rate on senior managers and corporate risk-taking, using differences in federal and state personal income tax rates. We measure a manager’s marginal income-tax rate using the combined statutory tax rate for the top federal and state income brackets (assuming that the manager works in the state of the firm’s headquarters).

We test for a relation between managerial taxes and corporate risk-taking using multiple distinct sets of tests that exploit different sources of variation in managerial taxes. Our first set of tests consists of a between-group analysis that relies on comparisons across states and firms. We find a positive relation between managerial taxes and corporate risk-taking. This relation is robust to controlling for a battery of time-varying firm characteristics (e.g., size, performance, and growth opportunities), managerial characteristics (e.g., tenure, age, and equity incentives), and state characteristics (e.g., local economic growth, corporate taxes, and political affiliation of the local legislature). Our second set of tests consists of a within-group analysis that relies on temporal comparisons within a given state or firm. These tests estimate the relation between managerial taxes and corporate risk-taking using only state-level variation in managerial taxes. We continue to find that managerial taxes (at the state level) are positively related to corporate risk-taking.

In our third set of tests, we examine settings where our theoretical framework predicts that the effect of managerial taxes will be particularly strong. Specifically, we expect the positive relation between taxes and corporate risk-taking to be stronger in settings where the marginal benefit (marginal cost) of risk is relatively high (low). The higher (lower) the marginal benefit (marginal cost), the greater the amount of risk that is taken, and the greater the benefit to sharing risk with the government. Consistent with these predictions, we find that the relation between managerial taxes and corporate risk-taking is stronger in industries where the investment opportunity set provides a relatively high rate of return per unit of risk; and among chief executive officers (CEOs) who are less averse to risk.

Our research question and findings should be of interest to policymakers, boards, and academics. With respect to policymakers, our work adds to the large public finance literature on the responses to taxation. We contribute to this literature by documenting a previously unidentified margin of response to personal taxation—namely, corporate risk-taking. The effects that we document potentially represent a heretofore overlooked externality of changes in the top personal income tax rate. Changes in the top personal income tax rate cause a shift in corporate resources toward high risk projects which can affect lower-level employees and other corporate stakeholders who are not directly subject to the tax.

With respect to boards, our findings suggest that personal income taxes can alter the risk that senior managers bear in conjunction with risky corporate investments, and thus directly affect their corporate investment decisions. While our empirical results suggest that any tax-induced risk-taking is diversifiable, or idiosyncratic, to the extent that shareholders are undiversified, boards might want to consider how taxation affects managerial risk-taking incentives.

Finally, with respect to academics, our study contributes to the large literature on managerial risk-taking. Numerous prior studies have sought to link managerial compensation and corporate risk-taking, but in doing so have largely ignored the role of taxation. We add to this literature by showing that managers’ personal income taxes have a measurable effect on corporate risk-taking.

This post comes to us from Professor Christopher Armstrong at The Wharton School; Stephen Glaeser, a doctoral researcher at The Wharton School; Professor Sterling Huang at Singapore Management University; and Daniel Taylor at The Wharton School. It is based on their recent article, “The Economics of Managerial Taxes and Corporate Risk-Taking,” available here.

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