Abstract
This paper contributes to the question of how taxation of corporate profits and wages affects competition among firms for highly skilled human resources such as CEOs. Use of a theoretical model shows that wage taxes can have a substantial impact on the outcome of such a competition if marginal tax rates are different as in an international labor market. Further, the paper shows that increasing the wage tax rate unilaterally can have an ambiguous effect on observed gross compensation levels. However, in a local labor market for CEOs, observed gross fixed salaries should decline in the wage tax rate. Tax effects in a market for CEOs is a particularly interesting topic because recent developments with respect to compensation practices of top-level managers have opened a public debate about the use of instruments for regulating compensation of those managers. Furthermore, many countries around the world use tax incentives in order to facilitate immigration of highly skilled human resources. The investigation follows an analytical economics-based approach by extending an LEN model with elements of competition for scarce human resources and income taxation. It investigates the impact of differential taxation on the competition between two firms for the exclusive service of a unique, highly skilled CEO.
Highlights
Decisions of CEOs can have a fundamental impact on the financial success of firms
In trying to find valid explanations for the trend of increased CEO compensation, various studies suggest that firms are in competition for scarce human resources, including talented CEOs
This leads to the result that the competition outcome can differ between uniform and differential taxation and indicates that countries should consider potential negative consequences when unilaterally increasing wage tax rates
Summary
Decisions of CEOs can have a fundamental impact on the financial success of firms. For this reason, many companies seem to exert an extraordinary high level of effort on the hiring decision of their top level management, and try to attract the most talented person for this important job by offering wage payments which appear to be far beyond the compensation levels of the existing management (e.g. Frydman and Jenter, 2010). The paper illustrates that a sufficiently large tax rate differential is able to offset an existing pre-tax disadvantage a firm might have due to a lower compatibility with the manager This leads to the result that the competition outcome can differ between uniform and differential taxation and indicates that countries should consider potential negative consequences when unilaterally increasing wage tax rates. Under differential taxation, a marginal increase of the wage tax rate applied at the successful firm has an ambiguous effect on the offered fixed salary This result complements mixed empirical evidence about the effect of taxes on CEO compensation. An increase of the uniform wage tax rate reduces the fixed salary offered by both competitors This paradoxical effect occurs because wage taxes do reduce the expected utility that the CEO can gain from working for one firm, and reduce the reservation utility which would be generated at the other firm.
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