CEO Compensation Incentives and Tax Avoidance

Abstract

This paper investigates whether firms tax avoidance differs depending on the level of CEO compensation incentives. Prior literature shows mixed results for the relationship between CEO incentives and tax avoidance – either positive or negative. The purpose of this paper is to find the reason for this opposite sign, and find the true underlying shape of the relationship. Under low levels of CEO incentives, increasing pay-performance-sensitivity leads to more tax avoidance, leading to lower ETR. However, very high levels of incentives should lead to firms reducing R&D expenditures, one of commonly used tax-favored activities, thereby increasing ETR. This leads to a U-shaped relation between CEO incentives and effective tax rates. In addition, I also document that this U-shaped relation is stronger for firms under weak corporate governance.