The tax reform bill heading toward passage in Congress is likely to help the bottom lines of many companies with lower taxes, but a new academic study suggests the impact on CEOs could have mixed results.
The study, which appears in the January issue of the American Accounting Association journal The Accounting Review, found that CEOs put their jobs at risk when their companies are much more taxed and less taxed than peer companies. It also found the situation dates back to the passage of the Sarbanes-Oxley Act of 2002.
The study, by James A. Chyz of the University of Tennessee and Fabio B. Gaertner of the University of Wisconsin–Madison, said the “post-SOX period coincided with increased IRS scrutiny of aggressive tax positions and legislation that led to increased regulatory scrutiny over the tax function. Consistent with increased pressures to be less tax-aggressive, we find that being in the lowest quintile of benchmarked tax rates [became] influential in predicting CEO turnover… This is consistent with boards responding to…increase[d] political and reputational costs surrounding tax avoidance.”
The professors believe the sharply reduced statutory tax rate in the tax reform bill could even inhibit some companies. They contend that, if tax aggressiveness damages a company’s standing when the statutory rate is 35 percent, it would likely cause even more damage at 21 percent, since aggressive tax maneuverings would be perceived as less justifiable.
Some of the findings seem counterintuitive, particularly in terms of CEOs being at risk when their companies' taxes are low. The tax reform bill promises to lower taxes for corporations up to 40 percent, and is expected to benefit CEOs in terms of stock options and performance bonuses. In addition, most corporations don't disclose their effective tax rate to investors.
For the study, the researchers analyzed the relationship between year-by-year tax rates of approximately 5,100 public companies during a 14-year period and the incidence of forced turnover of those firms’ CEOs. For each year the researchers calculated each company’s three-year tax rate (the aggregate tax for that year and the two previous years divided by aggregate three-year income) and calculated a benchmarked measure of that rate (how it compared with the rates of firms of about the same size in the same industry). Finally, they investigated whether there was a significant relationship between those benchmarked measures and concomitant forced CEO departures.
The companies had great variation in tax rates. For example, when the study’s full 30,000 company-years’ worth of data was divided into five groups based on benchmarked tax rates, the companies in the lowest quintile had a mean effective rate about 20 percentage points lower than the average for peer companies, while companies in the highest quintile had a rate about 20 percentage points higher than their peers’. In the 14 years covered by the paper (which included years preceding and subsequent to the enactment of SOX), the 5,108 companies constituting the study sample had 1,459 forced CEO turnovers.
Controlling for various factors that can affect forced turnovers, the researchers found CEOs to be at increased risk when their company tax rates are high. “Because taxes represent a wealth transfer from shareholders to government authorities, CEOs are more likely to be terminated when their firms pay high taxes,” they wrote in the paper, noting also that “boards not only focus on effective tax rates but also regularly compare these rates to those of their peers.”
The study found that companies in the highest tax quintile (highest taxed relative to peers) have forced turnover rates about 20 percent higher than the average for the three middle quintiles. The pattern held true during both the pre-SOX and post-SOX eras.
The study found increased likelihood of CEO turnover when company tax rates are low. Companies in the lowest tax quintile are, on average, about 15% more likely to have forced CEO turnovers than companies in the middle three quintiles. Yet, if the analysis is restricted to the years before SOX, there is no significant difference in forced turnovers; in contrast, the authors write, “the effect is positive and significant in the post-SOX period consistent with the predicted effect of regulatory changes and an increased scrutiny on the corporate tax function.”
To test their findings, the researchers analyzed the relationship between company taxes and unforced CEO turnovers (such as through death, illness and planned retirement). They found no statistical relationship between the two, reinforcing the conclusion that both high and low company taxes evoke board disapproval.
Finally, they investigated changes in tax avoidance as new CEOs take the reins in firms that had relatively high or low tax rates just before their predecessor’s forced departure. They found that replacement CEOs moved the rates closer to those of their peers.
