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Taxes as a Determinant of Managerial Compensation in Privately Held Insurance Companies. (Doctoral Research in Taxation).

BIN KE, Taxes as a Determinant of Managerial Compensation in Privately Held Insurance Companies, Ph.D., Michigan State University, 1999; Assistant Professor of Accounting, Pennsylvania State University.

This study investigates empirically how taxes affect managerial compensation in privately held firms whose managers own a large percentage of the firm's stock (I refer to these as management-owned firms). Shareholder/managers receive two types of income from the firm they own: compensation income as employees and investment income as shareholders. Although compensation income is taxable to employees and deductible by employers, investment income is subject to double taxation. Thus, I predict that shareholder/managers pay themselves more tax-deductible compensation when individual tax rates are lower, relative to corporate tax rates, and vice versa.

I test the research hypothesis using a sample of management-owned, privately held property-liability insurers (PL insurers) and a sample of nonmanagement-owned, privately held PL insurers during 1989-1996. I chose the insurance industry because firm-level data are available for privately held insurers. The sample of nonmanagement-owned insurers is used to control for nontax trends over time. I chose the 1989-1996 period because the 1993 Budgetary Deficit Reconciliation Act significantly increased individual tax rates relative to corporate tax rates.

Consistent with my prediction, I find that, relative to nonmanagement-owned insurers, the level of tax-deductible employee compensation that management-owned insurers paid declined significantly from 1989-1992 to 1993-1996. The mean (median) reduction in deductible compensation over the two periods is $134,000 ($114,000) per year, representing 4.10 percent (2.42 percent) of the management-owned insurers' net premiums written. Furthermore, the reduction in shareholder/managers' compensation after 1992 was not limited to the two years adjacent to the 1993 tax law change, suggesting that their responses were persistent.

This study's findings are interesting for two reasons. First, the existing managerial compensation literature finds that taxes exert little influence on managerial compensation in publicly traded firms. This literature implies that managerial compensation will be more responsive to taxes when managerial agency costs are reduced. This study provides direct evidence consistent with this implication using a sample of management-owned insurers, where managerial agency costs are low. Second, the estimated magnitude and persistence of management-owned insurers' responses to taxes provide useful information in assessing potential revenue and efficiency effects of future tax changes.

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Publication:Journal of the American Taxation Association
Article Type:Brief Article
Geographic Code:1USA
Date:Mar 22, 2002
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