Tax-Sensitive Institutional Investors and the Design of CEO Compensation Packages

42 Pages Posted: 19 Aug 2022 Last revised: 26 Mar 2024

See all articles by Ariela Caglio

Ariela Caglio

Bocconi University - Department of Accounting; SDA Bocconi

Claudia Imperatore

Bocconi University - Department of Accounting; Bocconi University

Cinthia Valle Ruiz

Catholic University of Lille - IESEG School of Management

Date Written: March 17, 2024

Abstract

This paper investigates how firms balance the heterogeneous tax preferences of institutional investors through the design of executive compensation. Specifically, we analyze how the weight of stock options in CEO compensation packages varies with the presence of tax-sensitive institutional investors (TSII) in the firms’ institutional ownership base. TSII have a tax-driven aversion to dividend payouts, which contrasts with demand for dividends from other institutional owners. As a result, when TSII are present in the institutional ownership base, conflicts among institutional owners can arise, weakening their monitoring of managers. We contend, and find, that the co-existence of TSII’s tax-related payout preferences and conflicts among institutional owners leads to a non-monotonic relationship between the relative ownership of TSII and the weight of stock options. When TSII are not the prevailing institutional owners, firms include fewer stock options that incentivize managers to distribute dividends, thus reducing potential agency problems. As TSIIs become the prevailing type of institutional investor, the weight of stock options in CEO compensation is higher to discourage dividend payouts and satisfy TSII’s tax-related payout preferences. We document that this relationship is stronger when CEOs have stronger incentives to distribute dividends and the need for aligning the interests of managers and shareholders is higher. Above all, we find that the increased weight of stock options in CEO compensation when TSII are the prevailing institutional investors is associated with a lower dividend payouts, but it does not lead to sub-optimal investment choices. Our findings underscore the importance of shareholders’ tax preferences in corporate decisions and executive compensation.

Keywords: Tax sensitive institutional investors, shareholder taxes, executives’ compensation packages, stock options, dividend payout

JEL Classification: G35, H24.

Suggested Citation

Caglio, Ariela and Caglio, Ariela and Imperatore, Claudia and Imperatore, Claudia and Valle Ruiz, Cinthia, Tax-Sensitive Institutional Investors and the Design of CEO Compensation Packages (March 17, 2024). Available at SSRN: https://ssrn.com/abstract=4188982 or http://dx.doi.org/10.2139/ssrn.4188982

Ariela Caglio

Bocconi University - Department of Accounting ( email )

Via Roentgen 1
Milan, 20136
Italy

SDA Bocconi ( email )

Via Bocconi 8
Milan, Milan 20136
Italy

Claudia Imperatore

Bocconi University - Department of Accounting ( email )

Via Roentgen 1
Milan, 20136
Italy

Bocconi University ( email )

Cinthia Valle Ruiz (Contact Author)

Catholic University of Lille - IESEG School of Management ( email )

Socle de la Grande Arche
1 Parvis de la Defense
Puteaux, Paris 92800
France

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