Executive Compensation, Insider Trading Profitability, and Individual-Level Tax Rates

Abstract

Prior studies suggest that executive compensation is unresponsive to changes in individual-level tax rates. We consider the use of private information in insider trading as an alternative means for executives to shift the impact of changes in individual-level tax rates to shareholders. We examine insider trading profitability around the enactment of three recent individual-level tax rate changes in the U.S. For each of these events, we find that the insider trading profitability is positively associated with changes in individual-level tax rates and that the economic magnitude of the effects varies between 170 and 290 basis points. Using a difference-in-differences analysis, we show that our findings apply to executives who are subject to taxation in the U.S., and not to executives in foreign firms, who are not subject to the U.S. tax laws. Our findings are stronger for firms with higher information asymmetry, where insiders likely have more private information to trade on, and for insiders with relatively low compensation, whose marginal utility from an additional dollar of compensation is likely higher. We conclude that executives implicitly adjust their compensation when tax rates change, and hence pass a significant portion of the tax effects onto shareholders.