A common argument whenever calls are made to raise public spending is that it should be funded by taxing the wealthy more than they currently are. While it may seem intuitive that the wealthy have more to give, research from North Carolina State University reminds us that it’s an action that is not without consequences.
The study shows that when income taxes go up, it’s more likely that executives will look to increase their profits from insider trading as they look to offset any losses from the higher taxes (and vice versa).
“This study stems from longstanding interest in how taxes affect executive compensation,” the researchers explain. “Executive contracts generally don’t get renegotiated when tax rates change. We wanted to see if there was a relationship between increased tax rates and executives effectively increasing their compensation by engaging in more insider trading—which can pose risks for their companies and may or may not be legal.”
Insider trading
The researchers explain that while it’s commonly believed that all insider trading is illegal, the majority is actually not, as it is above board to trade in shares in the company you work for providing those transactions are disclosed or the transactions are made based on information not in the public domain.
“For example, if an executive knows that their company is about to lose a major contract—but that information is not yet public—the executive is not allowed to sell shares in the company until that information becomes public,” they explain. “Insider trading is not illegal; trading on insider information is illegal.”
Even when it’s a legal practice, however, it still tends to attract considerable scrutiny from regulators and shareholders alike, and threatens confidence in those companies. The law states that executives must publicly disclose any share dealings in their own company within two days.
The researchers looked at insider trades by these top executives at 2,708 companies between the years 2000 and 2019. The researchers also collected information on changes in state income tax rates in states where those 2,708 companies are headquartered.
Changing behavior
After analyzing to see if there was any change in the trading behavior of executives after the income tax regime they were subjected to changed, the researchers found no real relationship between changes in tax rates and the volume of insider trades.
“However, we found that insider trades were more profitable in the wake of tax increases, and declined in the wake of tax decreases,” they explain.
They then explored whether there was any link between the increased tax rates and the likelihood of the company or executives being investigated by the SEC. That analysis clearly showed a link, with the increase in taxes more likely to result in SEC investigations for insider trading.
“Altogether, it appears that executives are willing to take greater risks with shareholder confidence and SEC investigations by making more profitable insider trades in order to boost their compensation when taxes increase,” the authors conclude.
“These results have implications for how companies contract with their executives. It may be in the company’s best interest to increase executive compensation directly when tax rates increase, rather than leaving them to increase their compensation via insider trades that increase risk for both the executive and the company.”
