The Effect of Statutory Tax Rates on the CEO Performance-Turnover Relation

Abstract

Although theory predicts boards should replace underperforming CEOs, archival studies estimate that CEO underperformance has only a modest effect on turnover. Higher corporate statutory tax rates increase the sharing of corporate profits and losses with the government, partially shielding shareholders from the consequences of CEO underperformance and reducing the expected net after-tax benefits of improved performance by a replacement CEO. Thus, we predict higher corporate tax rates contribute to the modest documented effect of CEO performance on turnover. We use the corporate tax rate reduction enacted by the Tax Cuts and Jobs Act to test our prediction. Consistent with expectations, we estimate an increased sensitivity of CEO turnover to firm performance after the Tax Cuts and Job Act. Furthermore, this increased sensitivity is stronger among firms for which the expected net after-tax benefits of replacing an underperforming CEO are greatest either because the firms expect a larger gross benefit from the rate reduction or have lower estimated replacement costs. Our study extends the literature on CEO turnover and suggests statutory tax rates are an important friction in the CEO replacement decision.