A Theory of Income Smoothing When Insiders Know More Than Outsiders

Abstract

We develop a theory of income and payout smoothing by rms when insiders know more about income than outside shareholders, but property rights ensure that outsiders can enforce a fair payout. Insiders set payout to meet outsiders’ expectations and underproduce to manage downward future expectations. The observed income and payout process are smooth and adjust partially and over time in response to economic shocks. Underproduction is more severe the smaller is the inside ownership and results in an \outside equity Laer curve.