Employee participation in corporate decision-making is a trending issue for politicians on both sides of the pond. In the U.S. and the UK, politicians and the popular press are debating whether assigning board seats to workers by law could be transferred to their corporate governance systems. In August 2018, U.S. Senator Elizabeth Warren proposed legislation requiring 40 percent of the board of directors of any large American corporation be selected by the company’s employees. Similarly, UK Prime Minister Theresa May proposed renewing the British corporate governance system and mandating UK corporations include employee representatives on all British company boards.
The mandated participation of workers in boardrooms is commonly viewed as a more collaborative and trustful decision-making structure. However, opponents argue that mandating worker representation could lead to sluggish decision-making and reduced shareholder wealth (e.g., Furubotn, 1988; Gorton and Schmid, 2004). This concept of mandatory board-level worker representation is a widely known phenomenon in many European countries. In Germany, workers directly influence the decision-making process in the boardroom. Our paper investigates whether worker representation on corporate boards in Germany is associated with improved monitoring of management or maximization of worker pay.
We took advantage of the German corporate governance system because of Germany’s co-determination model:
- It requires the appointment of worker representatives to up to 50 percent of a board’s seats.
- It has been widely used in prior theoretical and empirical corporate governance research (e.g., Jensen and Meckling, 1979; Fauver and Fuerst, 2006).
- It is typically referred to as a model for countries that have no legally mandated worker participation on corporate boards.
For our study, we use a hand-collected dataset that identifies German firms’ worker representation and other firm characteristics. We collected worker representation data and additional firm characteristics, including the number of workers in Germany, from annual reports of publicly traded German firms. From there we examined the relation between worker representation on the board and governance, honing in on tax aggressiveness and earnings management.
Worker Representatives Bring Balance to Tax Aggressiveness
Our expectations regarding workers’ preferences with respect to these firm outcomes are nuanced. In a recent study, Armstrong, Blouin, Jagolinzer, and Larcker (2015) provide evidence that board characteristics, such as board independence and financial expertise, are associated with less tax aggressiveness for firms that are highly tax aggressive and more tax aggressiveness for the least tax aggressive firms. This inverse U-shaped relation is consistent with better monitoring of management and reduced agency costs. Following Armstrong et al. (2015), we expect workers on the board will also improve monitoring because their lower risk-taking tendencies and non-existent diversification possibilities as well as their detailed operational knowledge result in better monitoring of management. To measure a firm’s level of tax aggressiveness, we use industry-size adjusted effective tax rates, which measure differences between a firm’s tax planning and tax planning of industry-size peer group firms (Balakrishnan, Blouin, and Guay, 2018). As we predict, we find workers on corporate boards decrease tax aggressiveness for highly aggressive firms and increase tax aggressiveness for the least tax-aggressive firms. However, evidence of monitoring when firms have worker representatives on the board does not rule out the possibility worker representatives prioritize payroll maximization when the incentives are high.
Worker Representatives Do Not Block All Tax Strategies Equally
We then examine the likelihood that tax aggressiveness results in workers’ jobs moving offshore and how that affects their monitoring of management. Williams (2018) provides evidence that multinational tax incentives are associated with decisions to move jobs offshore. Therefore, we expect worker representatives to block aggressive tax strategies in the boardroom that could result in job losses.
As expected, we indeed find that worker representation is primarily associated with better board monitoring of management. However, our results also indicate that worker representatives’ monitoring role is constrained by payroll maximization incentives. For example, we show that worker representatives do not block all tax strategies equally. Indeed, we find that worker representatives monitor aggressive tax strategies when the risk of losing jobs and wages is high.
Worker Representatives Promote Paths to Increase Job Security and Lower Uncertainty
To corroborate our inferences, we use firms’ efforts to manage earnings to test whether workers’ monitoring role is constrained by payroll maximization incentives. To separate worker representatives’ monitoring role and payroll maximization incentives, we differentiate between accrual-based earnings management and real earnings management. Managers may manipulate earnings either through accruals, which are unlikely to affect jobs or wages directly, or through real activities manipulation, some of which may affect jobs or wages. We expect to find a similar inverse U-shaped relation between worker representation and accrual-based earnings management consistent with worker representatives monitoring extreme “big-bath accruals” that decrease earnings as well as earnings-increasing accruals. We measure this type of earnings management by using the abnormal level of accruals (discretionary accruals) relative to an estimate of a firm’s “normal” level of accruals (Kothari, Leone, and Wasley, 2005). However, we expect real earnings management decisions to adjust production levels or discretionary expenditures, including R&D and administrative costs, to receive a different level of scrutiny from board representatives and that boards with worker representatives are more likely to block reductions in production and cuts in discretionary expenditures.
Our results indicate that worker representation leads to improved monitoring of accrual-based earnings management, both income increasing and income decreasing. However, we find that improved monitoring of earnings management is constrained by payroll maximization incentives when the risk of job losses or wage cuts is present. For example, our results show that worker representatives are associated with an increase in production levels for low-level earnings management firms but no corresponding decrease in production levels for high-level earnings management firms. This result is consistent with our expectation that worker representatives promote higher production levels in order to increase job security and lower uncertainty.
Union vs. Worker Representation
In additional tests, we examine different forms of worker representation on corporate boards. The German corporate governance setting mandates assigning up to 50 percent of board seats to workers, including external labor union representatives. External labor union representatives may have different interests, as they are not directly affected by board decisions and are appointed to act on behalf of their labor union’s interests. Our results show that better monitoring of management is generally attributable to both worker representatives and external labor union representatives. However, worker representatives, not external labor union representatives, drive payroll maximization. Consequently, we argue that labor union representatives have distinct incentives to monitor management decisions. This finding adds to the ongoing political debate about worker representation on corporate boards and shows that policymakers should carefully consider different interests on the labor side.
Our results suggest that worker representation incrementally contributes to board monitoring. However, workers’ monitoring role is largely constrained by payroll maximization incentives. Our results suggest lawmakers carefully evaluate whether corporate governance systems should adopt legally mandated worker representation. The findings of our study broaden the overall understanding of mandatory worker representation by using the inherent benefits of the tax aggressiveness and earnings management settings. We hope this timely evidence of the economic consequences of worker representation on corporate boards could be beneficial for policymakers to better understand the role of worker representatives in corporate governance systems.
This post comes to us from Professor Cristi A. Gleason at the University of Iowa; Sascha Kieback, a doctoral student at the University of Muenster; and professors Martin Thomsen and Christoph Watrin at the University of Muenster. It is based on their recent paper, “What Happens to Tax Aggressiveness and Earnings Management when Workers Enter the Boardroom?” available here.