The Role of Taxes in Compensation: A Case of Shareholder Expropriation

Abstract

In this paper I exploit a unique feature of the Greek institutional environment, whereby alternative cash compensation payments to directors are taxed differently from the point of view of both personal and corporate taxes. Specifically, board directors can receive cash compensation either in the form of taxable salary or in the form of tax-free profit distributions. Salary payments are deductible for corporate tax purposes whereas profit distributions are not, making a unit of profit distribution more costly to shareholders than a unit of salary. Ceteris paribus, rational directors prefer profit distribution to salary given that in the former case their personal taxes are paid by shareholders. Using this setting I document that board directors increase their net compensation by shifting their personal taxes to outside shareholders, who consequently earn lower after-tax income. Moreover, I show that profit distributions reduce shareholder value. Finally, I find that the degree of tax-shifting reduces as board ownership increases. This is particularly the case for family board members. Collectively, I show that the design of board compensation through profit distributions in Greece implies shareholder expropriation; this is in contrast with the findings of Aboody and Kasznik (2007), who document that the structure of executive stock-based compensation in the US helps to align the tax-related payout preferences of shareholders with the cash payout choices of managers. Similar to Aboody and Kasznik (2007) the study shows that taxes are a potentially important factor to be taken into account when analysing remuneration arrangements around the world.